Rising Interest Rates and Startups: Will the Surge End?

The Relationship Between Interest Rates and Tech Valuations

Anshu Sharma, an investor and entrepreneur – previously a partner at Storm Ventures and currently the CEO of SkyFlow – recently posed a question on Twitter regarding the correlation between interest rates and technology valuations.

Sharma’s inquiry wasn’t simply seeking praise; he intentionally sought to initiate a discussion with Jeff and myself. His tactic proved successful, as evidenced by this response.

Sharma’s Perspective

Possessing substantial experience in both technological trends and financial markets, Sharma’s question wasn’t superficial. He desired a more nuanced exploration of the underlying principles.

Therefore, a detailed examination of the interplay between interest rates and tech valuations is warranted.

Let's delve into this complex relationship.

Understanding this connection requires considering how capital is allocated and valued within the technology sector.

Fluctuations in interest rates directly impact the cost of capital, influencing investment decisions and ultimately, company valuations.

Higher interest rates typically lead to decreased investment in growth-focused tech companies.

Conversely, lower interest rates can fuel investment and inflate valuations.

The impact isn't uniform across all tech companies; those with strong cash flows are less sensitive to rate changes.

However, companies reliant on future earnings are significantly affected by shifts in the cost of capital.

Valuations are often based on discounted cash flow models, making them highly susceptible to interest rate adjustments.

Historical Context & Capital Costs

A significant factor contributing to the substantial funding rounds seen by startups – reaching record levels – is the prevailing environment of low interest rates.

Globally, interest rates are currently low, resulting in inexpensive borrowing. This affordability of capital allows companies to secure funding at reduced costs. For instance, Coinbase recently secured $2 billion in debt financing, structured in two installments. The first, maturing in 2028, carries a yield of 3.375%, while the second, due in 2031, yields 3.625%. Increased investor demand enabled Coinbase to expand its initial target from $1.5 billion to $2.0 billion, demonstrating the attractiveness of readily available, low-cost capital.

The limited returns available through traditional lending – reflected in low bond yields – are driving capital towards alternative investments, including the venture capital market. This influx of funds has facilitated larger and more frequent fundraising efforts by venture capitalists and attracted a broader range of investors to the startup ecosystem.

A considerable portion of the recent surge in unicorn companies is directly linked to this period of inexpensive money.

Shifting Monetary Policy & Potential Impacts

However, this situation is not indefinite. With the U.S. government poised to reduce its bond-buying programs and subsequently increase the Federal Funds Rate, expectations are mounting that certain asset values may experience a decline.

As the cost of capital rises, investment in venture capital may become less appealing compared to other opportunities, at least in theory. Simultaneously, the stock market could undergo a reevaluation. Historically low interest rates have encouraged investment in growth-oriented companies, anticipating greater valuation increases than slower-growing alternatives.

This trend peaked last year, when early-COVID restrictions impacted numerous sectors, and software stocks provided a means to pursue yield through corporate revenue growth, realized not through dividends but through market value appreciation.

This dynamic is noteworthy.

Generally, rising interest rates should diminish the attractiveness of venture capital investments by making alternative asset classes more competitive. Furthermore, the emphasis on growth-driven stock valuations may lessen as other investment options regain prominence.

Challenging Conventional Wisdom

Technical explanations further illuminate these potential shifts. Consider the insights presented in a recent Twitter thread:

However, the core of the argument lies in questioning established assumptions. The question posed is: Why should it necessarily be true that companies like Amazon and Salesforce will be less valuable as rates increase – are they genuinely overvalued? The perspective suggests that the expanding total addressable market for software and e-commerce has increased the intrinsic value of these companies, and this value shouldn’t automatically diminish with higher interest rates.

Gradual Adjustments & Market Dynamics

To fully grasp the argument, it’s essential to consider incremental changes. Interest rate adjustments are typically gradual, and governments are unlikely to drastically alter the cost of money quickly. These changes will unfold cautiously and progressively.

Beyond potential shifts in market sentiment, which could lead to more pronounced asset price fluctuations, we shouldn’t anticipate significant changes to the fundamental market dynamics when rates begin to rise. A modest 25-basis-point increase (0.25%) in the Federal Funds Rate, for example, will have limited impact unless further, consistent hikes are anticipated.

The value of companies like Amazon and Salesforce likely won’t change substantially as the cost of money starts to increase. Should rates reach 5%, a decline in Amazon’s market capitalization relative to other assets is plausible, but this would represent a comparative shift rather than an absolute loss of value for Salesforce and similar firms.

This perspective challenges the expectation of a dramatic repricing of tech valuations based on initial, incremental changes in interest rates. It suggests that the impact may be less severe than anticipated.

As previously noted by The Exchange regarding the current startup boom and its potential longevity:

All economic cycles are cyclical. All rising trends eventually experience some decline. However, the enthusiasm for startup and tech shares will not abruptly return to Earth at 1 g. A more gradual, lunar-gravity descent appears more probable, barring unforeseen circumstances.