The era of free money is now officially behind us: The United States Federal Reserve raised a key interest rate benchmark by 0.50%, or 50 basis points, this week.
Startups have long basked in the sun of effectively zero-cost money. As a result of a historic period of low rates, the comparative attractiveness of investing in bonds and other safer, if lower-yielding, assets was reduced, meaning investors around the world were looking for a place to park funds and have a shot at material incomes.
Technology did well during the period, with tech startups receiving an even larger shot in the arm. The mechanism is simple to understand: Low rates led to capital flowing into more exotic investments, like venture capital funds. Those funds then grew in size and number. The result of that influx of cash to investors was a burst of funds for startups.
More capital pools with more funds led to competitions for deal access, putting founders in the driver’s seat when it came to valuations and terms. Another factor at play was the COVID-19 pandemic bolstering the value of public tech companies while many other concerns took a gut punch due to travel restrictions and other related economic changes.
Crossover funds piled into tech companies public and private, the latter case leading to a wave of funding events that stretched valuation multiples to the moon.
Now we are seeing the rubber band snap back. As interest rates rise, available funding to venture capitalists recedes and crossover capital has already left the scene to lick its wounds. Meantime, other investments — think bonds — are simply more lucrative than they were.
Even more, the pandemic-era tech trade has faded, leaving public comps for startups far from their peak valuations. This creates a uniquely shit moment in which startups are fighting what must feel like a capital drought at the same time that investors are becoming more conservative and exits are constrained due to depressed public-market prices.
It’s a mess out there for startups that have only known summer. Winter is not coming; it’s here.
The venture reaction
Venture capitalists are talking about the changing climate publicly, a shift from earlier in the year, when such commentary felt scarce. Whether it’s due to more near-term pain in the market or VCs simply finding their voice, the commentary is now strident and regular.
“Investor sentiment in Silicon Valley is the most negative since the dot-com crash,” investor and former startup founder David Sacks recently tweeted. Benchmark investor Bill Gurley struck a similar tone, tweeting that “an entire generation of entrepreneurs and tech investors built their entire perspectives on valuation during the second half of a 13-year amazing bull market run,” adding that the process of “unlearning” the lessons of the prior market “could be painful, surprising and unsettling to many.”
Gurley added that he expects many to deny the new reality.
Other investors took a more self-critical take. Citing the impact of low interest rates and a “flood of fast dumb late-stage capital,” investor Gil Dibner of Angular Ventures said that “nearly every VC fund/platform has scaled beyond its capacity to effectively deploy capital against its strategy or expertise.”
Regardless of whether you are looking at the changed market from the perspective of a founder or an investor, the interest rate hike is indicative of how much things have shifted. Given that much of the rate-change news was priced into markets, we’ve actually been in a higher interest rate environment for far more than the last week.
To better understand the changes that are unfolding, TechCrunch reached out to Brian Aoaeh, co-founder and general partner at REFASHIOND Ventures and Dell Technologies Capital’s Ryan Wexler. We wanted to get their full notes on what the Fed’s policy shift means for startups and their venture backers. We also asked about short-term expectations and what startups should do in the new financial world they find themselves in.
According to Aoaeh, startups will find it more difficult to win new customers and experience a higher risk of churn as businesses and consumers cut spending. For VCs, he said fundraising may prove more difficult as partners adjust to what’s happening in the public markets and try to determine how that affects their asset allocations.
“[S]tartups will find it more difficult to raise new rounds of venture capital, and those that experience a meaningful decline in growth will have to make some tough choices,” Aoaeh told TechCrunch via email. “[I]nvestors with longer time horizons than traditional venture capitalists might see this as an opportunity to enter the market. But, it’s hard to say.”
Wexler believes that limited partners will be tempted to invest in categories besides venture, like endowments and pension funds, that were less attractive when the Fed kept rates closer to (or at) zero. (Higher interest rates increase the return of fixed-income accounts and bonds, encouraging savings.) He expects that limited partners will slowly start to divert their funds away from startups, making it more challenging for traditional VCs to continue securing record-breaking fund sizes.
“[It] will be much harder to raise an initial fund from limited partners without a solid track record. For the crossover funds that are able to deploy elsewhere, they may find more interesting opportunities in the public markets that have already been battered versus the private market that hasn’t seen a full impact just yet on pricing,” Wexler said.
However, Wexler doesn’t predict too much of an impact on startups and valuations in the near term, noting it can take months for rounds to close and become public. Looking further ahead, he anticipates that valuations will indeed begin to come down, mirroring the public market, even as total invested dollars remain relatively stable.
Wexler cautioned that later-stage startups that have already raised capital at high valuations will have to prepare for the possibility of down rounds or the inability to raise, even with strong growth.
“Multiples will drop over time, and startups can no longer expect raising at inflated valuations with limited real traction. For companies that [are] currently raising, we are still seeing some 50x to 100x multiples, but that is no longer the norm,” Wexler added. “For the majority of companies that are starting to show traction and now raising Series B/C, we see investors starting to focus much more on public comps and path to profitability versus previous questions focused on market sizing and how large of an exit opportunity there may be.”