The Interest Rate Effect on the Startup Community

For the first time since 2020, the Federal Reserve cut interest rates. It was generally expected by markets, perhaps not the .50% cut that occurred but most would have been surprised if at least a .25% cut wasn’t made. They then followed this cut with a second in November. Why does this matter to the early stage startup ecosystem? Unless a founder is out looking for a loan on a new house, the immediate effects of a rate cut are probably not very obvious. Perhaps they are one of the few that has access to debt facilities, but it is far more likely that how the Fed moves rates feels like it doesn’t have much impact on their company.

The reality is an immediate impact to early stage startups usually isn’t felt. Instead, there is a “trickle-down effect” of the current interest rate environment and trends that has the real effect on the startup community.

Where the most immediate impact will be felt by companies is in those beginning their M&A journey. While startups have very limited access to debt facilities, acquirers of startups do not run into this same issue, i.e., larger enterprises and private equity firms. When acquiring a company of with some level of scale, these organizations often leverage, pun intended, this access in order to preserve cash, improve return profiles and, to some extent, help mitigate risk. There is a direct correlation between the cost of capital for these firms (i.e. current interest rates) and their willingness to pay for a company. If money is cheap to borrow, they can afford to pay more for a startup. This makes it easier to find the elusive middle ground (in non-distressed situations) where both buyer and seller are happy with a valuation.

Further, with higher Fed rates, there is more optionality for places to stash your cash risk free. For example, if you know you can make 5% on treasuries the appeal of taking on the incredible risk of acquiring or investing in a startup can be a bit less palatable! As interest rates fall, these relatively risk free investments with decent yields evaporate, and buying a startup begins to look more appealing.

Thanks to some borrowed Pitchbook data, you can see how the value of startup exit activity, IPO and acquisitions, fell off a cliff at the beginning of 2022. Perhaps unsurprisingly, this happened almost exactly when the Fed first began to increase interest rates (see below). It isn’t that deals don’t get done when interest rates are high, they just tend to be smaller with less risk associated. When money is cheap, multiples are higher and more deals happen. Startups that have optionality in environments similar to the last two years will often wait it out in the hope that interest rates will fall, driving multiples up.

Bread & Butter invests in early stage startups who aren’t thinking about getting acquired today. For them, that dream is 7+ years away. Yet the current M&A environment does have an effect on them even if they don’t realize it. It is the top of the funnel that starts the cash trickle for everyone else in startup land. For the funding cycle to work there need to be exits. From angels to the largest institutions, investors need to get cash back or they stop investing. As you know, we have been raising our fourth fund for over a year now. While we are close to the finish line, many others are not. There are estimates out there that 50% of funds under $100m in size have shut down or moved to zombie mode in the last 24 months. The big driver? Lack of distributions to the large institutions that fund the funds. Those institutions are overweight in venture investments and are now waiting for cash prior to making new commitments. Based on basic supply and demand principles, fewer funds is bad news for founders.

To be specific, this relative illiquidity in markets has a direct impact on valuations. As mentioned, when interest rates go up, exit multiples go down. When exit multiples go down, valuations on investment multiples go down. This dynamic holds fairly steady down through series A rounds. The correlation for valuations at pre-seed and seed stage to current exit multiples is less direct than it is for later stages but it still exists. Distributions make the startup world go round.

For fund managers there are both positives and negatives of any interest rate environment. It is wonderful to have dry powder right now to make new investments. There is less competition, rounds are open longer providing more time to make decisions and valuations are down. However, there is far more future financing risk than we have seen in the future and the more mature companies in our portfolio are going to have exit timelines pushed back. Some companies will be forced to exit early because they can’t raise additional capital in tight markets. Positives and Negatives.

If the most recent interest rate movement continues it seems that more M&A activity would naturally follow. This is consistent with messaging we are hearing from conversations with large enterprises in our network. At the end of the day, it is impossible to predict long-term macroeconomic trends. It is also impossible for us to control them. So we don’t try to. Instead, we will continue to focus on investing in world class founders which will always be the right strategy.