If you’re reading this, you definitely know what’s happening in the tech startup world. Founders struggling to fundraise, share prices tumbling, layoffs constantly in the headlines.
Only the graph above, we’re currently living through the slide that started November 2021. It’s not pretty, and it’s not fun.
You may be acutely aware of why this is happening. You may have absolutely no idea. You might understand enough to drop a knowing “macro trends” comment at the latest party catered with baked beans, cheap cider, and blackout candles.
As long as you’re not in the first group, this explainer is for you. I don’t often see it explained for non-financial folks, so I wanted to help.
Firstly, inflation has led to interest rate rises 📈
You’ve probably heard about inflation and interest rates on the news ad nauseam.
The gist is that inflation is running a bit wild. There’s a few reasons for this, including the war in Ukraine (pushing food and energy prices up) and supply chain issues around the world (pushing price of everything up).
Also a factor has been historically low interest rates. Low interest rates simply mean that the price of borrowing money is cheap. This makes more money flow through the economic system.
You can see in the graph below how interest rates plummeted in 2020 in the wake of Covid. This was to keep people buying things and the world economy flowing.
So we’ve got high demand for stuff, and low supply of stuff, which makes the price of stuff increase. If you had 10 widgets to sell to 10 people, you could sell them at a reasonable price. But if you had just 1 widget to sell, and 100 people that wanted it, you could charge whatever you wanted. That’s inflation. And very high inflation, like we see right now, is bad.
Central banks around the world have increased interest rates to try to curb this inflation. The higher the cost of borrowing money, the less demand there is to buy things, which reduces prices.
This is what your cooler financial friends might refer to as “taking the heat out of the economy”.
To summarise: the price of things was rising far too quickly, so interest rates were increased to try to reduce those prices.
This makes share prices fall 📉
Low interest rates means low cost of borrowing. It also means low returns for investors. If you put your money in a bank, and they lend it out, lower interest rates mean pretty average returns on your money.
So if you’re a professional investor you’ll look elsewhere for better returns on investment.
The stock market is one place where that money goes. Publicly traded companies pay dividends to investors, and if the share price goes up they can sell their shares for profit.
So inversely, as interest rates rise investors can get better returns elsewhere and investment flows away from the stock market. This means a drop in demand for shares, so share prices drop.
Stocks everywhere have suffered over the 18 months or so. Tech stocks more than most, as they often favoured high growth over profitability.
Publicly traded companies have a legal responsibility to do what’s best for shareholders. This means layoffs, reducing spend, to try and turn their share prices around.
Big Corp prices determine startup prices 💸
With few exceptions, every startup’s ambition is to become a big, publicly traded company. Investors and founders take on the high-risk journey in the hope of the high-reward of an IPO.
When investors work out how to value a startup, they’re basically predicting the size and likelihood of a good outcome. When publicly traded shares struggle, a startup’s value will fall. The peer group it wants to join is a strong indication of how it will perform at exit.
Investing in startups is only really as attractive as the potential outcomes. This makes the value of tech startups fall.
A hit to VC doubles the pain 🤯
To compound things, VC’s access to capital is hit by interest rates. Venture as an asset class is high-risk, high-return. A rise in interest rates improves the return of a fairly low-risk competitor for that same money. That means less money for VCs.
Although VC fund cycles are long (they invest over several years), any VC raising now will have a harder time than in the past. This means that we’ll see less money flowing into venture, which means less money flowing into startups.
Double-whammy.
Ok, so let’s all just give up and try another job? 🧑🏽💼👨🏼⚖️👩🏻🌾
It’s not all doom-and-gloom here. I’m not a medical doctor, but here are reasons why I’m still extremely bullish on tech startups:
Interest rate rises won’t last forever: There have been several big changes in my lifetime, and I’m guessing we’ll see more. I personally think rates will drop in the coming years, for a number of reasons.
Companies are adjusting to the new world: A big part of public share prices falling is that those companies were designed for the “capital is cheap” world. They’ve adjusted which, although painful, will mean improving prices over time.
Earlier stage startups are less impacted: A startup waiting to go public tomorrow will have a rough time, as their share price will be impacted by the last year’s events. A startup being created tomorrow will have expectations clear, set their strategy in this “new world”, and be priced accordingly. It’s simply less painful.
Cheaper technology costs: There’s one particular technology that is going through a phenomenal drop in cost 🤖. This will change so much that I don’t even want to mention it here.
Less competition: If you can successfully grow a company now, less investment means less competition. For me personally, price wars and weaponised capital aren’t interesting at all. Building a great product for customers is, and the opportunity to do that is arguably greater than ever.
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Would love to know your thoughts, as always.