The venture capital (VC) landscape has been on fire, with over 13,000 deals done in 2021 alone for a record investment of nearly $330 billion. One of the many factors that fueled this explosion in VC capital is the historically low interest rates we’ve seen over the last decade. Now, that favorable interest rate environment is about to change.
If you run a startup company and you’re considering raising capital through VC investment, you need to know how rising interest rates will affect your ability to secure funding.
What Happens When Interest Rates Rise
Earlier this year, industry pundits began attempting to predict what the Federal Reserve would do to tamp down the rapid surge in inflation. Fed Chairman Jerome Powell put all the speculation to rest in March when he announced a one-quarter percent increase in the Fed fund rate and set the expectation for an additional five rate hikes to follow this year. If that plan holds up, the fed fund rate is projected to stand at 1.9% by year-end 2022.
Why is This Trend Relevant to Startup Companies?
Because history shows that low interest rates provide a favorable environment for VC investments, while rising rates tend to put a damper on the capacity for VC funding.
A study conducted by the European Financial Management Association in 2017 assessed the impact of interest rates on venture capital over a 35-year-period in 20 major VC markets. The results were quite telling: A 1% increase in interest rates reduced venture capital fundraising (the ability for VC funds to attract capital from investors) by 3.2%. To put that into perspective, the nearly $330 billion in capital raised by VCs in 2021 would have been about $10.5 billion lower if interest rates had risen just 1% last year.
Why is VC Funding Sensitive to Interest Rates
There is a direct correlation between interest rate trends and a VC fund’s capacity and appetite for investing. And when you think about it, it makes perfect sense.
Most of a VC fund’s capital comes from pension funds, banks, and insurance companies that look for investments that will yield a good rate of return without requiring undue risk. When the cost of capital is low and the yield they can get on cash is small (or near zero, as in recent years), these investors are willing to take on greater risk for the promise of a higher yield, so they invest in VC funds.
In times when VC funds have no trouble attracting capital, they run into a different problem: How to deploy it all so they can provide their investors with a good rate of return. That’s when they go on a spending spree, looking for startups they believe have the right combination of a strong product, market fit, and management team. That’s exactly the scenario we’ve seen play out over the past decade, fueling a period of unprecedented VC activity.
But as interest rates begin to creep up—and the yield on cash goes up in tandem—the same investors who once flocked to VC funds are less willing to take on the associated risk if they can find more appealing places to deploy their capital for a better risk-reward. That’s when their focus tends to shift from VC funds to assets that offer relatively good yields at a lower risk.
Given the direct correlation between interest rates and VC investment, as the Fed tapers down its bond buying and raises interest rates throughout 2022 the market for VC funding will start to cool off. Since it typically takes time for higher rates to impact the VC capital markets, this trend will be more of a gradual decline as opposed to a sharp drop-off.
On the other hand, if your business is further along and more likely to attract private equity (PE) investment, the changing interest rate environment will impact your fundraising in a more direct, immediate way. The leveraged buyouts that are typical of PE investment require significant debt. And since the price of loans is governed by bond yields, and the combination of rising interest rates and higher inflation tend to spur bond selloffs (I.e., reducing bond yields), the cost of debt is likely to go up fast in response to a higher Fed fund rate and higher inflation.
How Interest Rates Increases Affect Your Funding Options
If you’re seeking capital to help accelerate your growth, a rising interest rate environment will affect you in two ways:
- There will be less VC capital available to fund companies seeking funding.
- It will be more costly for you to turn to debt financing as an alternative.
Let’s look at the potential consequences of each of those impacts.
First, as VC funds attract fewer investors and have less capital available to deploy, companies will be competing for their share of a smaller pool of capital. And as competition for their investments increases, VC funds will become more selective in which companies they back and will offer less favorable terms than they did when their coffers were overflowing.
Second, as higher interest rates make debt financing a more costly and less attractive option, business owners and c-suite executives will be even more likely to look to VC funding as a alternative way to fund their operations. That reality will only spur more competition for VC investment—exacerbating the supply and demand imbalance in favor of investors.
Taken together, that means if you need to raise funds for your company and you expect to attract venture capital, you’ll need to up your game! Be ready to ensure your operations and financials are ready to withstand the heightened scrutiny of an increasingly competitive VC market.
How Simple Startup Can Help
Simple Startup recognizes that raising capital is critical to the success of your company, but it’s a complicated effort. That’s why we leverage our finance and fundraising expertise to help CEOs secure the funding they need to accelerate their growth.
The professionals at Simple Startup know what VC funds and PE groups look for in an investment, how to develop the financials these investors will review and scrutinize, and how to prepare for their thorough due diligence. Our fractional finance services have helped many early-stage and later-stage companies attract the funding they need to achieve their growth milestones and scale their businesses to the next level.
We can even help you determine how much capital to raise, using financial modeling and forecasting to assess the possibilities of each funding round and ensure you don’t dilute your ownership too much in the process.
Book a call with a Simple Startup advisor to discuss your fundraising goals and learn how our fractional finance services can help you navigate a changing VC investment landscape.