Higher US Fed interest rates will hit startups over the head

You don't need to risk your capital when banks start paying out again

The US Federal Reserve’s decision in December to increase the target range for the interest rate it pays banks by one-quarter of one per cent, to 0.25-0.5 per cent, didn't seem like an Earth-shaking event at the time.

But it was the first time the world’s most powerful central bank had changed its rate target since 2008, and the first time it had increased it since 2006. Like many other central banks, the Fed pushed rates down to just above zero in response to the near-meltdown of the financial sector.

Since then, interest rates on bank deposits and bonds (which tend to follow bank rates) have been at rock-bottom: a third of government-issued bonds currently have negative yields, meaning if you buy them and hold them to maturity, you actually lose money.

This has given investors good reasons to put their money into riskier bets such as venture capital – the economic stimulus this provides is one of the reasons central banks have kept interest rates so low for so long. But it also means that companies have been enjoying a cheap-money party, with some of the largest tech companies including unicorns such as Uber and Airbnb only having known life since the party started.

The “unicorn” term was invented in 2013 to describe a firm valued at more than $1bn; in January there were more than 140 such privately held beasts, 90 per cent of them tech firms and with more than 50 having gained such valuations during 2015.

It’s easy to understand how a good party conjures up visions of unicorns, but what happens as it winds down? Doing this is part of a central bank’s job: in 1955, Federal Reserve chairman William McChesney Martin famously said that his organisation: “Is in the position of the chaperone who ordered the punch bowl removed just when the party was really warming up”.

While the Fed hasn’t yet whipped the punch bowl away, its quarter-point rise was the equivalent of removing the unopened bottles – a preparatory move before more serious intervention. In January, it left the target rate unchanged, but economists expect the Fed to up the rate again as 2016 progresses. The Bank of England, which has not changed its 0.5 per cent interest rate since 2009, looks likely to follow suit.

Both central banks had interest rates above five per cent before the financial crash, so there may be a long way up to go.

Laughing at unicorpses

Among its predictions for 2016, investment bank GP Bullhound said: “Unicorn hunting now in season”, expressing concern that some privately-held companies have enjoyed “astronomically high levels” of valuations in excess of 100 times their profits, known as a price/earnings ratio. Facebook is one of the rare publicly traded companies with a p/e at that level; Google’s is around 30 and Apple’s is near 10.

Manish Madhvani, managing partner at GP Bullhound, says that some companies can justify very high p/e ratios based on their frenetic growth, but adds: “It is clear that we are moving into a market climate where the public markets will not tolerate misses on forecasts, with ex-darlings such as LinkedIn being punished severely over the past weeks. This will have a knock-on effect into private rounds where investors have paid a premium for growth.”

Madhvani says that those hoping to spot a unicorn about to turn into a unicorpse should look for companies losing performance, and with it investor confidence. An initial public offering of shares can lead to a company being seen in a new, colder light: payments firm Square was worth $6bn based on what investors paid for shares when it was privately-held, but following its flotation it is now closer to $3bn.

“Critics have pointed out that the tech firm does not have the growth fundamentals to support its valuation publicly,” says Madhvani. “Other warning signs can include competition from other players, regulation that could threaten business models, and promising technology that fails to develop or deliver. General market uncertainty can also add to concerns.” And there has been plenty of the last so far in 2016 with stock markets falling sharply, a slowdown in the Chinese economy and tumbling oil prices.

Rising interest rates will start to make it harder for tech companies to obtain funding, according to one firm. Carwow.co.uk was founded in 2010 and has raised £18m from what it calls Europe’s leaving VCs. Joe Gallard, Carwow.co.uk head of finance, reckoned the quarter-per-cent increase, while small, was an important marker. “The signalling that the market is getting now of potential further rate rises will start to move investors' allocation of resources very slowly away from higher-risk growth opportunities; subsequently lowering the cash available for start-up firms and toughening the conditions to get that cash.”

Upstarts are worried the magic money fountains will run dry

Should liquidity begin to dry up, then that’ll also have an effect on investors and actual startups. Patrick Pulvermueller, chief executive of web services firm 123-reg, said a more bearish market weeds out the lightweight investors.

“The uncertainty around interest rate rises will put off some investors but that does not mean that there won’t be opportunities for entrepreneurs,” he said. That means a greater consolidation around angel investors, less numerous in number and more experienced than those pulling out of funding.

Steffan Aquarone, the founder of mobile payment start-up Droplet, told us that higher interest rates are unlikely to put off angel investors; they know they are taking a big risk when buying into firms at an early stage. Droplet was founded in 2011 and had £2.39m in three rounds from Ascension Ventures, Crowdcube and London Co-Investment Fund.

“I don’t think you look at the interest rate going up and think whoopee, I’ll move all my money back to my current account,” he says. “There is a general feeling that VCs are being more cautious – or should I say less ridiculous – in some of the valuations placed on American start-ups. I don’t think that UK or European VCs ever got that ridiculous.”

Back to Madhvani. GP Bullhound’s man reckons the few European unicorns that do exist are in less danger than the American breed, as VCs in Europe have less money than those Over There, a fact that’s made them automatically more cautious.

“EU tech firms have had to be more capital efficient, and prove the business model to a greater degree,” Madhvani said.

What happens next?

The exit strategy for tech startups – or rather, their investors' strategy – has been hoping for an acquisition in order to obtain a return on their investment.

What we might see now is tech firms punted for sale sooner than they would have done previously, or willingly going into the arms of others rather than looking for further investment. That's more of a possibility as the biggest and deepest-pocketed firms out there like buying startups, especially if those startups happen to own a piece of technology that could help them stay ahead of the competition.

That’s parties for you. As they end, the leftovers get eaten up. ®

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