The decision to raise US interest rates for the first time in seven years could have negative effects on established startup businesses, investors have said, marking the start a new era of more cautious investment.
“The historically low interest rates over the past few years have fueled asset growth in the public markets and real estate, as well as strong consumer and business spending,” says Kyle Lui, principal at DCM Ventures, a Menlo Park-based venture firm that specialises in early stage tech investments including BitTorrent, YikYak and Tiebaobei. “We could see companies across the board – from startups to large companies, start to feel the impact on normalized interest rates.”
Announcing the change on 16 December, Federal Reserve chairwoman Janet Yellen said the US economy was strengthening, and that the rate had helped ease the financial hardship of millions of Americans.
“This action marks the end of an extraordinary seven-year period during which the federal funds rate was held near zero to support the recovery of the economy from the worst financial crisis and recession since the Great Depression,” she said.
While the US recession officially ended in June 2009, those low rates have stayed in place. In addition to helping the economy rebuild, they have spawned a generation of well-funded startups. The federal funds rate has been increased from a range of 0% to 0.25% to a range of 0.25% to 0.5%.
Many have speculated that the higher rates will stunt the growth of some startups, working as a mini “bubble” of sorts.
“I think the effects are actually upstream, and the greater effect is the uncertainty in the market around later stage funding,” says Jeff Lee, also a principal at DCM. “While in the longer term, higher interest rates will pull some of the late stage capital out of the venture game and into more traditional asset classes, this actual effect is likely to be slow particularly given the expected measured pace of interest rate hikes.
“More importantly, the general fear that the market is slowing down, coupled with the fact that a lot of funds are likely to be fundraising in the beginning of 2016, will probably slow down the pace in Q1 as well as increase volatility.”
Companies that are looking for late-stage financing are often getting those funds from investors who are looking for a faster return on their cash. Those investors ultimately might move to investing elsewhere.
“Some of the reason that there’s a lot of availability of capital later in the curve is there’s just a lot of capital looking for return,” says Scott Kupor, partner at Menlo Park-based venture firm Andreessen-Horowitz, which has backed Airbnb, Slack, Facebook and Pinterest.
“Investors haven’t been able to find that in the stock market because yields are so low, therefore they have to move to riskier assets in order to achieve the kind of return that they want.”
Now that they have other options, some of those late-stage investors might choose to put their money elsewhere.
It’s an idea echoed by Aaref Hilaly, partner at Sequoia Capital, which has invested in DropBox, Square and Vulcun. “Higher interest rates will be another brake on a late-stage financing market that is already slowing down,” he says. “Some companies will be slow to adjust, and it will take some painful experiences before they realize the high burn, go-go days are – at least for now – behind us.”
Solid, early stage companies are less likely to be affected, says Kupor, because investors are looking at the prospects for seven to 10 years away.
“What the macro environment looks like today is largely irrelevant for early-stage financing, because obviously the time frames in which we’re thinking about potentially exiting these companies are so long,” says Kupor. “People are making decisions largely based on their view of what the seven to 10 year trends are from a broader technology perspective, as opposed to what the macro or stock market considerations might be on those investment.”
That’s an idea echoed by Christine Tsai, founding partner at 500 Startups, a Silicon Valley-based incubator that works with a number of early-stage companies. 500 Startups has backed Twilio, Mayvenn and Ipsy.
“We have told our companies that it will likely be harder to raise money next year, but we’ve been saying this for a while. I don’t think it’s a direct result of the interest increase,” says Tsai.
Investors, she says, are going to be looking for companies who have created sustainable business models, rather than those that have an idea but haven’t quite figured out how they’re going to grow and monetize it.
It’s yet more good news for firms that are on the way to building sustainable businesses, and likely to flush out some of Silicon Valley’s more frothy startups.
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