Venture Capital/Opinion/

Founders need to batten down the hatches as interest rates rise

As global interest rates rise, founders should make sure they have runway and prepare for a challenging fundraising environment.

Lily Shaw, OMERS
Lily Shaw

By Lily Shaw

Most founders won’t have missed the fact that interest rates, on both sides of the Atlantic, are rising. The Fed has said that it will move decisively to increase rates this year, and analysts are anticipating a half-point increase in the next May meeting. But what does this mean for your startup business?

Few startups will have significant short-term debt that would be affected by rising interest rates. But the changing macroeconomic environment is still something they should understand and prepare for. 

If central banks can quell inflation with relatively low interest rates then startup valuations shouldn’t drop too far. If inflation proves tougher to control, central banks will be forced to crank rates up even higher. In effect, this will put the brakes on broader macroeconomic growth and some economies could tip into recession. That’s bad news for startup valuations, but there are things that founders can do. 

Fundraising and revenue challenges

One of the reasons that so much capital has come into VC in recent years has been that, with historically low interest rates, the likes of pension funds and investors needed to find higher returns and therefore took more risk.

As interest rates rise, it will be easier for investors to find returns that beat inflation in “safer” asset classes. If funds find it harder to raise capital, they’re likely to be slower to invest it too. Startup founders should prepare for an environment where fundraises are harder to come by. 

👉 Read: Can the European tech ecosystem withstand the inevitable downturn?

Also as inflation rises, there will be pressure on business and consumer spending. That could result in slower revenue growth for startups. Many companies prepared for such a shock at the start of the Covid pandemic, but almost the opposite happened. There was sudden and rapid spending on tech and software, with a subsequent leap in public market valuations — just think of all those Pelotons and Zoom accounts.

This time around founders may not be so lucky. The startups that survive this new environment need to think carefully about how to navigate yet another new normal. 

Founders, raise longer runways and prepare for more dilution   

Founders will need to raise longer runways. While there is lots of committed capital for VCs still to deploy, and funds are incentivised to deploy that capital, in such a difficult economic climate most founders would be well advised to do what they can to extend the runway. Now more than ever, you need plenty of cushion when assessing your cash. We have already seen, for example at Stripe-backed fintech Fast, what happens when you run out of cash and are trying to raise in a difficult and fast-changing environment. The last thing you want is to be forced into raising and risk a down round.

Founders may also need to take more dilution. While the past few years have seen founders at Series A to C able to hold a fairly hard line on dilution in financing discussions, we expect that this will become a growing point of negotiation, especially given the growing fund return hurdles that most GPs face. There is already good thinking out there on what this means from the seed perspective

This will truly be a time to test the often-repeated mantra of “founder friendly”

Sadly, we anticipate that investor behaviour might not always be the best. This will truly be a time to test the often-repeated mantra of “founder friendly”. Now more than ever, founders need an active and engaged board, rather than passive investors who are no longer particularly invested in the success of the business.

Finally, dry powder is still in abundance — but crossover funds like Tiger Global, whose dealmaking sent European investment to record levels in 2021, will be behaving differently. Crossover funds are disproportionately exposed to private investments and given the scale of their public market markdowns, they are likely to be far more price sensitive. There are already market rumours around the changing behaviours being seen at later stages. 

An essential skill: learning to live in the new normal

As a startup founder, you can’t control these macroeconomic forces, which are global and down to the huge fiscal and monetary stimuli that the global economy has been enjoying for the last decade or so. 

But founders can take some steps to protect their business from some of the impacts of the changing monetary regime. For some companies, their primary focus will need to shift from growth or unit economics to cash preservation. When things are better they can return to growth again.

To do this some startups will need to eliminate all discretionary spending — such as experimental marketing or projects with too long a payback period. Difficult decisions may need to be taken about new hires — although for others this will become a hiring opportunity.

Learning to live through a new fundraising environment is an essential part of an entrepreneurs’ skill set. Founders need to be open with their board members, who are likely to have experience with cycles like this. 

Lily Shaw is investor at OMERS Ventures. She tweets from @lilymshaw

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