Tech startups don’t talk much about interest rates. New products, customer acquisition and growth, growth,growth are top of mind. To the extent that today’s emerging companies consider the cost of capital, it’s usually while raising a venture round.
Over the next year, that’s likely to change. Now that the Federal Reserve has removed the word “patient” from its plan for hiking rates, businesses have to start preparing for the end of the free money era.
Are they ready?
Consider this: The last time the Fed’s benchmark interest rate was above 0.25 percent, Uber didn’t exist, Airbnb hadn’t yet raised seed financing and Snapchat’s founder was in his first year at Stanford. In short, today’s Internet entrepreneurs could be forgiven for viewing Fed stimulus as the status quo.
“If this is a warning sign, let’s start paying attention and advising startups on something they haven’t thought about,” said Paul Martino, a managing director at Silicon Valley venture firm Bullpen Capital and previously a founder of multiple venture-backed companies. “We have a ways to go until it starts affecting their day-to-day lives.”
The line connecting interest rates and most startups is a jagged one. But what’s indisputable is that the current economic cycle has been pointing north for an historically long stretch and that it’s been dramatically aided by a record low interest-rate environment, courtesy of the Fed.
Still, the party isn’t necessarily over, or at least not just yet.
Whatever increase the country will see above the current rate of zero is likely to be slow. Market participants expect the rate to reach 0.625 percent by the end of this year and 1.875 percent at the end of next. Not exactly punishing.
Plus, most of the big venture firms have raised oversubscribed funds in the last couple years, leaving them with plenty of capital to spend, assuming they have the confidence to do so.
“Our capital is risk capital that’s locked up over a 10-year period,” saidTim Haley, a partner at Redpoint Ventures, who got started in venture capital in 1998, and has seen multiple boom-and-bust cycles. “On the margin, it squeezes a little bit, but i don’t think it’s significant.”
Still, interest rates matter, even for the smallest of startups. Whether you’re developing a smartphone app, a drone controller or subscription software for businesses, here are four reasons why you should care about the prospect of rising rates.
- Tourists go home
An inability to find yield in the fixed-income markets along with turmoil in many foreign countries has led big private equity shops, hedge funds and mutual fund companies to seek returns in alternative areas. Couple that with all the hype in startup land and it’s no surprise that a crop of big money institutions from New York, London and Singapore are circling San Francisco, writing nine-figure checks.
According to CB Insights, only two U.S. venture-backed companies have gone public this year, raising $250 million, while VC-backed tech companies have raised $9.8 billion in private capital. That’s a startlingly large gap caused by a flood of new money.
Rising rates typically translate into increased yields across the fixed income landscape. Borrowing costs for companies rise, sending rates on corporate and junk bonds higher.
That’s not to say that all the new late-stage money will hit the exits (far from it) but firms that have no loyalty to tech and have been overpaying to get in will surely be pleased to find attractive options elsewhere.
“If the Fed tightens its interest rate policy, yields in traditional assets will go up, as will the cost of borrowing,” said ShriramBhashyam, founder of EquityZen, a site that helps connect investors with startup employees who want to sell some of their shares. “That means there would be less money chasing startups, lowering valuations.”
Companies that have been spending wildly with the expectation that mega-financing rounds will be available in the future may be forced to turn off the spigot. For others, it may be too late.
Benchmark’s Bill Gurley has gone so far as to predict “some dead unicorns this year,” referring to billion-dollar startups that are unprepared for a change in market conditions.
- The dominoes fall
Once the big money starts to depart, the rest of the capital structure can start to normalize, and this market has been anything but normal. In 2014, U.S. startups raised over $48 billion from venture investors, compared with an annual average of about $30 billion going back to 1995, according to the National Venture Capital Association.
Traditional VCs, no longer forced to compete on price with hedge funds to get in deals, can go back to valuing businesses on more reasonable metrics and fundamentals and with more rational multiples. Investors can be more discerning, leaving the off-the-wall ideas or unappealing founding teams with nowhere to turn.
How could it all play out?
“A lot of companies that could raise that were sort of marginal companies can’t raise and go out of business,” said Kevin Mahaffey, co-founder and chief technology officer of mobile security provider Lookout and an angel investor in tech companies. “Everything slows down a little bit and startups tend to fail at a slightly higher rate, particularly early-stage ones that haven’t proven a revenue model.”
And then there’s venture debt, which as CNBC.com reported in October, has been soaring thanks to a handful of commercial banks getting into the mix. Startups have taken to referring to venture debt as free money, because rates are commonly in the neighborhood of a typical mortgage. As banks have to pay more to borrow cash, they’re naturally going to charge more to lend it.
- Corporate wallets fold up
When earnings are on the rise and stock prices are touching record highs, corporate America has money to invest and an open checkbook from shareholders.
Rate hikes mean higher borrowing costs, leaving companies spending more to service future debt. For companies with expectations of generating a certain amount of earnings per share, higher debt costs mean cutting expenses elsewhere. Remember that new billing system we were going to install? Maybe now isn’t the best time.
Similarly, consumers paying more on their mortgages and credit cards may be less inclined to buy that smartwatch or hot new app.
That’s one reason why so many software startups talk about the cost of their products in the context of return on investment, or ROI. If a customer is spending now to save later, the purchase makes sense in good times or bad.
But even if the ROI is obvious, getting the meeting with prospective customers becomes more challenging as belts tighten. Will the chief information officer or head of marketing still take your call?
Bullpen Capital’s Martino isn’t so worried about this piece, because big tech companies in particular are sitting on mountains of cash that have been earning nothing.
“We’ve never seen balance sheet quality like this in our lifetimes,” Martino said. “I can’t see a minor change in the Fed funds rate, which is kind of window dressing, really spurring a change.”
In other words, startups that have real businesses shouldn’t worry about spending drying up.
- Loss of appetite for risk (that Google job sounds pretty cozy)
Startups in the San Francisco area have been going head-to-head with Google, Facebook and Apple for talented developers by offering handsome perks, a cool culture, the chance to build something big and, perhaps most importantly, stock options that could eventually turn into millions of dollars.
But one area where they just can’t compete is with salary. Those massive tech balance sheets are a competitive edge in recruiting, particularly in an environment where appetite for risk is lower.
So why do rising rates matter?
Say you’ve been wanting to refinance a mortgage on that million-dollar Bay Area home, but you waited too long. Those bargain basement rates are no longer available.
Or you’ve maxed out a couple credit cards waiting for your big payday. That hot start-up that employs you just keeps raising money in the private markets, leaving your paper wealth sky high but your real world bank account screaming for some deposits.
Factor in college loans, and all of the sudden things look scary.
Until you start looking for developer roles at the tech giants you were so hoping to avoid. And guess what—you can make a pretty penny with your skills in Ruby and Objective-C. Furthermore, you can sell some of that hard-earned equity on the emerging secondary markets.
It’s good for programmers, but bad for startups. Once again, cash becomes king.
Image credit: CC by Kevin Krejci