Auction rates: or, what you don’t know CAN hurt you
March 13th, 2008 by Benjamin KuoFile this under one more thing you really ought to know as a startup: don’t invest in auction rate bonds.
For those who aren’t familiar with them, auction rates are a type of long term bond which are sold via a dutch auction by investment banks. They are typically used by companies to manage their cash, and have been popularly used by companies of all sizes to eke out additional gains on the cash they are sitting on. However–along with lots of the rest of Wall Street–there is a liquidity crisis here, which has resulted in a cash crunch for many startups.
Essentially, what has happened is that there are many VC-backed companies who had parked their VC investments temporarily in these auction rate instruments, as a way to pick up some additional interest. Auction rates are an alternative to things such as money market accounts, or just plain cash sitting in a bank account. The problem is, the market for those investments has essentially collapsed, locking companies from their cash. Even though those companies may have a bunch of VC financing, they cannot touch that cash until the market resumes–and it’s unclear when that might happen. For a startup with a rapid burn rate, that can mean they run out of cash very quickly — unless their venture capitalist steps in with a loan, or they are able to finagle some other kind of loan from an investment bank. There’s also the potential that a VC — seeing that a company has managed to muck up its handling of its cash, and looking at how a startup is doing–might reconsider their investment in a firm.
It appears that many of the companies caught in this crisis may have been caught because the folks managing that VC cash — a part time controller or even just an accountant — wasn’t aware of the liquidity dangers. I have heard that those with actual CFOs have for the most part been spared, since CFOs generally do more due diligence and are more conservative in their investments for their cash. But, in any case it’s a case of “what you don’t know CAN hurt you.”
I chatted yesterday with Joe Morgan, who has been credited as being the very first person to start warning about the liquidity danger of auction rates, and he told me the whole story behind this fiasco.
