Debt makes the business world go round – from lines of credit to bank loans to bonds, companies can accomplish more today by borrowing against tomorrow. It is, however, a double-edged sword; while generally boasting a lower cost of capital from a purely academic point of view and not requiring relinquishing control or ownership of a business, debt has far stricter rules than equity financing and, if mishandled, can be poison to businesses of any size.
For nearly a decade, the Federal Reserve has kept its benchmark interest rate at 0%, and a low interest environment across the entire yield curve has made debt financing more appealing than ever before – Business Insider estimates they’re the lowest in 5000 years! However, with the US economy recovering, Fed Chair Janet Yellen is poised to raise rates imminently. While small, the path towards normal rates will have far-reaching effects in every aspect of the business world – but the effects could be especially troublesome for startups.
First, for small startups themselves, there is the obvious downside – any debt financing today will be far more expensive in a year. In September, 16 of 17 FOMC participants expected interest rates to be at least 0.75% by the end of 2016, with estimates as high as 2.75%. The added financial strain caused by interest expenses rising by up to a factor of 10 could push some companies closer to, or over, the metaphorical debt cliff and into the pit of default or bankruptcy. While 2.75% might be an ambitious target, 0.75%-1% is very much in the realm of possibility. It is possible that a viable business model at an interest rate of 0.25% is considerably less viable at rates greater than 0.75%.
But fear not – rising rates are not all doom and gloom. The very reason for increasing interest rates is because the US domestic economy is strengthening – a bullish sign for all companies, not just small enterprises. However, this is a real cost and will have to be considered by anyone making interest payments. While startups can be notoriously lean, some will be forced to “trim the fat,” cutting costs. These may range from giving up some perks to perhaps delaying new hires. Renegotiating the terms of a loan is also a possibility – most lenders would prefer to receive interest payments than have to deal with a messy repossession process. If that’s not a possibility, the idea of equity fundraising is certainly an option. However, before issuing any debt, corporate board members should check with their treasuries and be fully aware of any and all anti-dilution clauses in the contracts of current shareholders to make an informed decision.
A lean, well-run company can easily navigate these rate-hikes, and stands to benefit greatly from increased market share as its competitors struggle and fall.
On the investor side of the table, there are other potential results of rising interest rates. Private Equity and Venture Capital (PE/VC) firms will be incentivized to pull out of riskier projects as investors don’t have to reach as far for yield. Currently, the private market is very frothy, with 145 private companies with a valuation of at least $1B having a total market cap of $506B at the time of writing. While some of these companies have undeniably earned such valuations, others, undoubtedly, have not. Rising yields will make riskier firms less appetizing for PE/VC firms and could cause a pullback from this market. In fact, this is already beginning to some extent – Fidelity recently marked down several startup holdings, and though they have reversed course on a few, several still remain below cost. The Kentucky Public Retirement System is also planning to reduce its Private Equity holdings by as much as 86% in its KERS Pension Fund, and by 80% in its SPRS fund.
Much like on the company-side of things, there is a silver lining to the investor end of the proposition, as well. With effectively fewer buyers at the table but a static level of sellers, market prices for these investments will fall, allowing for players in the PE/VC space to pick great companies up at lower valuations. As Warren Buffet famously said, “Only when the tide goes out do you discover who’s been swimming naked.” As market valuations correct themselves and the weaker players in the space fall to the wayside, the solid companies left over will be not only more affordable, but more easily seen. Furthermore, in a world where intellectual property is increasingly important, it is entirely possible that there are small companies out there with excellent IP but that are poorly run. Scooping up these companies at a major discount and turning them around is a recipe for a huge pay-off.
Clearly, rising interest rates will pose a challenge for businesses, as debt service costs force corporations to rethink the future. However, a well-run small company or an astute PE/VC firm that is properly prepared for this can turn this challenge into an exciting opportunity for enormous returns.