I was talking to a 25-year-old founder of a med-tech-health-tech startup yesterday who was just calmly eating his lobster roll with no fear or trepidation regarding the coming Fed rate hike. I realized why - the last time The Fed raised interest rates he was only 15. No wonder he was not in a complete panic! He hasn’t witnessed how interest rates affect the startup food chain.
So I feel obliged to spark everyone into a state of alarm.
Let’s start with basics, for those that were in their tweens the last time this happened (or those with fading memories of 2005).
The Fed = The Federal Reserve, established in 1913 created by Congress to provide the nation with a safer, more flexible, and more stable monetary and financial system.
The Fed Funds Rate = the interest rate that banks lend overnight without collateral. Banks do this by transferring money between their accounts at the Federal Reserve. Why these night time transactions? If lots of people - consumers and businesses - take money out of one bank on one day, then that bank borrows the extra money from another bank through its account at The Fed. This transaction affects the costs of lending and borrowing for every other aspect of the financial system.
The Fed Rate Hike = Yesterday Janet Yellen, the Chairwoman of The Federal Reserve, announced the first rate hike in 10 years. She targeted the overnight lending rate between bank accounts at The Fed from near zero to a range from 0.25%. The Fed can’t actually set an exact rate because it’s a transaction between companies, instead they control this interest rate by controlling the amount of money available.
Yellen looks at the economic data of the US economy and believes it is performing well, and is expected to do so, and the Fed’s job is to keep an eye on inflation. As she said yesterday, “The process of normalizing interest rates is likely to proceed gradually, although future policy actions will obviously depend on how the economy evolves relative to our objectives of maximum employment and 2 percent inflation.”
Oh NO! A gradual increase! Run!
OK seriously, don’t panic. But this gradual raising of rates will affect the more speculative entrepreneurs with uncertain business model plans. Here’s how:
1. Less Money For Your Company
Let’s think about the food chain where you get the capital you need to grow your business:
With interest rates near zero and a slowly recovering economy, investors sought out any investment that would generate an actual return. This increased the flow of investor money to the public stock markets, and most recently to private Venture-Capital-backed startups. Mutual Funds and Pension Funds increased their investment in Venture Firms, and they also started to participate in later-stage private company funding. Uber, Jet, Snapchat, and WeWork have all benefited from this shift of money to more speculative risky investments.
This flow of money - from individual investors to Mutual Funds to Venture Capital Firms to late-stage Unicorns - can create the conditions for a bubble when the market in total expects these companies to grow much faster in value than they are capable, simply because too much money is chasing too few deals.
These Unicorns are not all the same - but they are for the most part practicing deliberate growth-oriented unprofitability. What’s that? They have been able to grow, and earn revenue, without having to get to profitability, yet, because they are financed by ever-larger sums of money. If this starts to reverse, we could see a sharp fall in the valuations of these private companies. Unicorns may lose their sparkle, start to turn back into mere horses, or cattle, or may even die.
If you’re just starting out, your ability to convince an angel investor to give you $50,000 at a $5 MM valuation because your company may soon be worth $1 BN may no longer be considered logical.
2. More Scrutiny from Your Potential Acquirer
You should start to panic, now, however, if you’ve built your company to sell it.
Public companies have also benefitted from incredibly low-interest rates. Simultaneously, they’ve moved their cash reserves overseas, with tax penalties that occur when they bring that money back to the US. Therefore when big public companies make big acquisitions in the US, they tend to “float a bond” - take out extremely low-interest rate debt, backed up by their cash collateral overseas.
The leading tech companies are sitting on giant mountains of cash on their balance sheets (calculated as current assets plus long term investments). Apple: $253 Billion, Microsoft: $136 Billion, Google: $93 Billion,Cisco: $79 Billion, IBM: $65 Billion, Oracle: $66 Billion, Intel: $43 Billion, and little Facebook: $13.6 Billion. If it starts to cost real money to issue these bonds, you may see the rate, value, and speed of acquisition go down.
3. Less Time to Get to Profitability
What has defied logic in the last year is the shear number of companies raising huge sums of money at billion dollar valuations. As mentioned above, most large scale startups are intentionally losing money as they grow in order to get there faster.
Investors of all shapes and stripes have been willing to speculate - to back a business with an uncertain range of unproven options instead of a demonstrated path to a working business model.
The belief - companies like Uber and Airbnb and others are playing a zero-sum, winner-take-all game. It’s worth it to lose money as these companies grow because he who gets the largest customer base wins.
Early-stage investors have been more willing to get in early and fast - because the ultimate rewards are so huge. Angel investors writing a $25,000 check are willing to put money into a company without a strong theory about profitability just the first step in that food chain on the way to ultimate domination and massive valuation.
Phew. All of that speculation, and hurry, and speed to get to an imaginary future is what is most at risk when Fed rates start to rise. It will be like gravity finally taking effect again in the Bay Area.
The 1 reason why smart business leaders don’t have to worry:
If you have a solid plan to get to profitability and growth, or you’re already there (how quaint) then you will likely attract the funding you need. Business fundamentals and smart thinking about how you will actually make money, or grow without losing tons of money, will soon become valuable again. There is no need panic about the rise in rates - money is always attracted to strong business fundamentals. So sleep well tonight, you deserve it.
But for everyone else - it’s time to learn the art of figuring out your business model.
