Why do startup valuations go down when interest rates go up?

A new day, a new interest rate hike. A few serious faces from the Fed have announced that they will do whatever it takes to tame inflation. Wall Street invariably responds in the red, and startup outlets proclaim the tighter availability of capital and lower valuations.

But what is the actual connection between interest rates, startup capital and valuations?

Following Modern Monetary Theory (MMT), the Fed is increasing interest rates to “cool the economy” and prevent a further rise in inflation.

Despite the focus on interest rates, it is the second aspect — inflation and the consequent government response — that will have the most significant consequences for founders and the public.

Inflation affects your customers, providers and capital

The startup literature around inflation impact on startups focuses on cutting costs, getting to default positive, controlling burn and slowing hiring. But some of these measures, albeit useful during recessions, are too general to be helpful. Instead, a better way to prepare for inflation is to understand how price increases affect your business.

Each business has three major components: customers, providers (including employees) and capital. How is inflation influencing each of these factors?

If your customers are other companies, they will likely have all the same concerns. If you put yourself in their shoes, is inflation a good or bad thing? Will they have more purchasing power or will they be more constrained?

What does inflation mean to your target segment if you sell a consumer product or service? Are they going to have a hard time coping with increased living costs? Is your product a discretionary expense or a must-have?

If your customers benefit from inflation, then there’s a good chance that your company will too. In most cases, though, when your customers benefit, your service providers suffer.

For many startups, the main cost is their team. When living costs increase, the team naturally will pressure the company for salary increases. But, again, the specifics are important. Inflation varies widely, item by item, place by place. Some countries, even some cities, might have widely different inflation rates. Additionally, inflation affects different jobs and income levels in different ways. Understanding these nuances is key to setting the best course of action.

Finally, we come to capital. Inflation should improve capital availability, as it incentivizes investment of money that would otherwise be losing value at an increased rate. Investors are under additional pressure to put capital to good use. This is particularly notable at the moment, as venture capital firms build up significant reserves of capital in an increasingly inflationary environment. Something will have to give soon.

However, inflation is bad for governments and the monetary institutions that will try to lower it.

The effect of government responses to inflation on startups

As they try to tame inflation, monetary institutions will reduce the supply of capital by increasing interest rates. As a result, borrowing becomes more expensive and saving becomes more attractive. This is the least painful way to cool down the economy and reduce inflation. As a result, supply and demand are rebalanced and price growth is slowed. This in turn means economic growth, broadly speaking, will slow too — but this is considered a worthy trade-off.

So the consequences of the government trying to stem inflation are the same as those of an economic slowdown.

To apply the framework outlined above: What does this downturn, or potential recession, mean for your customer, your service providers (including your employees) and capital?

Clearly, if your service is part of the discretionary spending of your customers, and your customers will have less free cash, you can expect lower demand for your service or product.

As for service providers, including employees, the expectation of a slowdown in the economy will prompt them to accept lower salaries and hourly rates, and to sign more extended contracts. In this case, the effect is opposite to that of inflation, and they could well cancel each other out.

Regarding capital, the situation is a little bit more challenging to analyze. On one hand, capital is under inflationary pressure. On the other, capital is invested with an expectation that its value will appreciate in the future. When that expectation lowers, especially on long-term investments like startups, the outcome could be both. It could be that the bleak future outweighs the inflation pressures, or that the investor believes the recession will be short, outweighed by a longer-term view of the investment.

The main takeaway is that in an inflationary period, startup valuations should rise as all other prices rise. However, governments’ actions to combat inflation might very well lower the future potential of startups to such an extent that valuations decrease. The results, though, vary widely for each company. Each founder should look at their own company, customers, suppliers and capital needs to understand how they can best respond.