Startup Valuations in a Rising Interest Rate Environment

Over the past 6 months, we’ve gone from a “flat-line” interest rate environment hovering around 0%, to 1.5%-1.75%. Today, rates have been raised by 75bps—the biggest increase since 1994. Over the same period of time, we’ve seen late-stage startup valuations plummet while overall cost of capital has climbed.

This begs the question: are declining startup valuations and increases in the cost of capital caused by rising rates?

The short answer is that interest rates directly affect the cost of capital and indirectly affect valuations.

Background context

From 2009 - 2019, we experienced the longest bull run in history (3,453 days). This, in part, was fueled by economic expansion, near-zero interest rates, and an emerging tech-sector (think tech titans like Facebook and Uber, among others).

With the economy (and inflation) heating up, the Fed began slowly raising rates in Dec. 2015, and continued doing so until April 2019, with rates topping out at 2.42%.

The economy started to slow in response, so the Fed started cutting rates down. They first cut rates to 1.58%. Then Covid-19 hit and the Fed dropped rates even further to near 0 (0.05%).

Lower interest rates directly translates to lower returns on savings. This further incentivizes people to start investing their dollars instead of storing the cash inside a bank. Consumers started looking at stocks in publicly traded companies as an opportunity to maximize more of their capital. This increased demand in publicly traded companies pushed investors to look beyond traditional markets – causing a rush of investments into privately held companies.  

In fact,  from 2020 to the end of 2021, more cash flowed into startups ($329.9B in 2021 vs $166.6B in 2020) and into Venture Capital funds ($100B+) than ever before. This is because cheap interest rates meant low returns on savings, so people started investing their dollars rather than keeping them in the bank. As a result, more dollars were competing for investments, pushing investors to look beyond traditional public markets—causing an influx of investment into private markets.

More than five hundred venture-backed companies reached unicorn status in 2021, nearly 2.85x the previous record. To say that startup valuations merely rose over this two year period is an understatement—they didn’t just rise, they rocketed to levels not seen since the dot-com bubble.

Things seemed great, but trouble was brewing just below the surface.

Enter inflation.

Bust, Boom, and Inflation

Inflation is caused by many factors—too many to list out here. At the broadest level, inflation is caused by pressures on the supply / demand side of the economy, and money supply policies of the Federal Reserve. *Note: The description below is an oversimplified financial account of what the response was to the pandemic.

During 2012 - beginning of 2020, the supply / demand side of the economy was fairly consistent, as were the monetary policies of the Federal Reserve. This balance was disrupted when the world went into lockdown due to the Covid-19 pandemic.

In response to Covid-19, The Federal Reserve stepped in in an attempt to keep credit flowing and limit the potential economic damage from the pandemic. The immediate response by the Federal Reserve was to:

• Cut the federal funds rate to 0%
• Purchase large amounts of U.S. government bonds, mortgage-backed securities and later public equities (e.g. quantitative easing)
• Expand the scope of its repurchase agreement (repo) operations to funnel cash to money markets 
• Eliminate the banks’ reserve requirement (which required banks to maintain a certain percent of deposits as reserves to meet cash demand)

Note: the Federal Reserve took a handful of other actions, but these are some of the most important.

The Federal Government also stepped in with the support of Congress by providing stimulus checks to families throughout the United States, rolling out a first-of-its kind unemployment benefits package, as well as the emergency tenant protections to help safeguard Americans against eviction.

The goal of all of these programs was simple: keep consumers and businesses afloat, while enabling banks and other financial institutions to maintain their liquidity.

The initial response from consumers was less than expected—fear was at an all time high and people were isolated at home, so they were not spending. The result was almost immediate deflation. Gas dropped from nearly $4 per gallon to below a dollar. Hotels and airlines launched flash sales in a bid to attract flyers, and restaurants were forced to completely upend their business models to meet changing consumer needs. Businesses that depended on or facilitated in-person events were immediately impacted and had to layoff a good portion of their staff.

With the world in lockdown and international travel at a stand still, consumers began to look at other opportunities to spend their discretionary income. Consumer electronics, digital goods, home goods and even — securities saw bumps. The increased consumer demand for  stocks and crypto fueled the meteoric rise in company valuations, which trickled down into late stage startup valuations and eventually early stage startup valuations as well.

Towards the middle of 2021, unemployment improved as restrictions were lifted and consumers began liquidating their market holdings. Market gains, coupled with stimulus payments, resulted in average household savings reaching previously unseen levels.

Fueled in part by the pent up demand from the past 18 months and the higher-than-ever household savings, consumer demand for (and prices of) necessities and luxuries exploded towards the end of 2021s. Needless to say, the Feds programs worked a little too well.

The Mantra of “Growth at Any Cost”

Investment firms who invest in startups place many strategic bets. They know that roughly 99 out of the 100 investments they make will fail, but count on a few startups in their portfolio succeeding to cover all of their losses.

During periods of economic expansion, cash is cheap so investors become much more lenient and comfortable placing more low-conviction bets: when borrowing money is affordable, the returns needed to cover the cost of borrowing are low, and moderate growth can justify investments. Easy investments in turn created massive competition across tech investors, causing them to go toe to toe and provide more and more competitive terms to win deals. Eventually, these investments no longer tie into company fundamentals, and instead are driven by hype, urgency, and a fear of missing out (fomo). Investors see their peers effectively double (sometimes 10x) their investments in a matter of months, so everyone wants in on the action.

Startups, wanting to cash in on the boom, create forecasts that show tremendous growth. They depict scenarios in which they can continue to grow by attracting more customers.

But this growth wasn’t cheap.  In order to grow, startups need to continuously raise more money to support their growing monthly burn and customer acquisition costs. In periods of economic expansion, more customers meant that a startup could command a higher valuation, VCs and other institutional investors subscribe to the narrative and continue to write checks in, hoping of reaching a highly lucrative liquidation event.

This exact scenario panned out from 2012-19.

2020-21.

VCs are flushed with cash from recent liquidity events and they’re looking to repeat the success for new investments. They begin getting into bidding wars and valuations balloon. Companies that historically would’ve raised capital at a 20-30x revenue multiple, now raise at a multiple 5-10x higher than that (think 100-300x revenue multiples). Venture capitalists have high conviction that things will continue as planned—startups will continue to fuel their unsustainable growth with cheap cash regardless of their unit economics.

Unraveling Federal Reserve Actions

With inflation looming (7% in 2021), the Fed begins unraveling all of the programs it instituted at the beginning and during the height of the pandemic.

They begin selling-off assets, removing funds from the repo market to reduce liquidity and most-important to startups—they start slowly increasing the federal funds rate.

Inflation, rising rates, the cost of capital & valuations 
So how, if at all, do rising rates affect the cost of capital and startup valuations?

Simply put, rising rates cause the cost of capital to rise, because each dollar borrowed becomes more expensive. Equity investments are not directly impacted by rate hikes (since they’re not loans), but they are correlated.

Back to the startup story to explain in more detail…

At the end of 2021, with rates on the rise, the same cash that was once considered “cheap” just months prior was now “expensive”—VCs and institutional investors began re-evaluating their assumptions and assessments. At the same time, consumers, and the Fed began pulling funds (and liquidity) from the public markets to deploy in other places (e.g. travel, restaurants..etc.). In other words: investors starting expecting hire returns and have less cash to deploy as their own LPs starting shifting their bets towards safer assets.

The moment institutional investors acted on their perspectives, valuations started to drop dramatically (in some cases 80%+) and trillions in valuation got erased. The hardest hit were the tech and crypto-enabled companies that experienced ballooning valuations just months prior.

As the decline in public valuations spread to the private markets, VCs too became more stringent. Late stage startups that had negative unit economics and a large burn were the first to be penalized because they are the closest comps to publicly traded companies. VCs were no longer willing to value companies at 100-300x revenue multiples because the threat of interest rate hikes made the eventual liquidity event far less probable and profitable.

Tying it all together

The strategy of “growth at any cost” works until it doesn’t. When the Fed raised rates the cost of capital rose. Startups that built their businesses on top of cheap cash and unsustainable  unit-economics, saw  their valuations come down to earth.

With what some are calling the  “worst economic downturn of a lifetime” just on the horizon, are things all doom and gloom? We don’t think so.  

What we’re seeing in the market is a shift back to conservative growth and there’s still plenty of opportunities for startups to succeed. At Arc, we base our offers on solid business fundamentals—the way it should be. Whatever is coming, know that we are ready for it and we want to help. We will push through it and come out stronger on the other side of it together.

If you have strong business fundamentals and are in need of non-dilutive growth capital, reach out to us or apply here: https://app.joinarc.com/