How An Interest Rate Hike Could Deflate The Tech Boom

Silicon Valley’s era of easy-money is due for a test.

The technology industry has benefited from low interest rates, contributing to the creation of more than 100 startups valued at more than $1 billion. Now that economists predict a rate hike as soon as September, investors question whether the move will do what seemingly nothing else has been able to accomplish -- cool off the sector.

“Once valuations get high, you’re kind of loading the gun, and it may not take much for it to go off,” said Charles Lee, a Stanford University economics professor, who has studied the impact of interest rates on the technology industry.

The U.S. central bank has kept benchmark rates near zero since 2008, before companies such as Uber Technologies Inc., Snapchat Inc. and Pinterest Inc. even existed. That means most of today’s startups haven’t been tested in an economy in which borrowing costs fluctuate. Young companies may find it harder to raise capital. It also could add stock-market volatility, making it harder to hold an initial public offering.

That would be a dramatic shift for startups operating in a world where raising money is easy, giving them a cushion to refine products, attract users and figure out a business plan. If money becomes harder to come by, executives at young companies will be under pressure to trim spending, turn a profit, be acquired or raise funds at lower valuations. Absent that, some will go bust.

Market Correction

Underscoring the rally in valuations, Uber, Slack Technologies Inc. and other startups worth more than $1 billion are being funded at more than 20 times annual sales, according to CB Insights, compared with a price-to-revenue multiple of 1.8 for the Standard & Poor’s 500 Index.

“We know a correction in the market is coming,” said David Golden, managing partner at Revolution Ventures, who expects an interest rate increase to contribute to a shakeout. “We see the signs that it’s coming.”

A key reason why Silicon Valley is paying more attention to Fed policy is because of its effect on the behavior of hedge funds, mutual funds and other investors that have poured money into startups. Young companies have become popular investments because they’re among the few bets with the prospect of a big return, according to Stanford’s Lee. Case in point: Fidelity Investments, T. Rowe Price Group Inc. and Wellington Management Co. and hedge funds Coatue Management and Tiger Global Management took part in at least 37 pre-IPO funding rounds totaling $5.55 billion from 2012 to 2014, according to Pacific Crest Securities.

Risk, Reward

“In a low-interest and low-yield macro environment, private tech companies have the potential to grow faster and yield more than many other alternative investment opportunities,” said Mike Maples, a venture capitalist who was an early backer of Twitter Inc. and ride-hailing service Lyft Inc. “A lot of the large pools of capital in the world tend to gravitate to private tech startups.”

When rates are higher, investors often look for more predictable returns in fixed income or dividend-paying stocks, according to Lee. Even without a Fed hike, the 10-year treasury rate has been increasing, offering modest, safe returns for investors -- and providing an alternative to riskier bets.

Business Models

Still, rates remain near all-time lows, and borrowing costs will probably remain low for a while. The impact of higher interest rates on Silicon Valley will depend on the size and pace of the Fed’s moves. If they’re slow and modest, as most economists predict, many venture capitalists don’t expect a cataclysmic event like the burst of the dot-com bubble more than a decade ago. Unlike the earlier crash, many of today’s companies have more clearly defined business models and aren’t publicly traded, limiting the damage. Many also raised more cash than they needed, in anticipation of a slowdown

“A chilly fall/early spring frost, versus a nuclear winter,” said Matt Ocko, a venture capitalist at Data Collective, which backs data and science startups.

A rate increase also indicates that the broader economy is improving, fueling more spending by consumers and businesses -- be it for an Uber ride, or for new business software. Silicon Valley is also less vulnerable to higher borrowing costs than other industries because young technology companies don’t have a lot of debt. Aside from interest rates, several factors are contributing to surging technology boom, including the proliferation of mobile devices, tumbling costs of creating a company and the rise of non-traditional investors funneling money to newer companies.

Bad Deals

Yet even the biggest beneficiaries of the boom see a shakeout coming. Chris Sacca, an investor in companies including Twitter and Uber, said too much money is flowing to technology startups that will fail in a coming industry slowdown.

“Bad deals are being done,” Sacca said in a Bloomberg Television interview. “It’s kind of inevitable that the funds right now that are putting a lot of this money to work here aren’t going to see it all back.”

Evan Spiegel, co-founder and CEO of messaging app Snapchat, said this month that an increase in interest rates may cause the market to cool off.

“People are making riskier investments,” he said at the Code Conference. “There will be a correction.”

Rate hikes could also increase stock-market volatility, making it harder for technology companies to hold IPOs. While the Nasdaq Composite Index hit a record this year, IPOs haven’t been common. Some 15 technology companies went public last year with valuations of more than $40 million, while more than 200 startups were able to raise $40 million or more in private backing, according to an analysis by Tomasz Tunguz, a venture capitalist at Redpoint Ventures, a Silicon Valley fund.

Easy Money

A dried-up IPO market, coupled with a drop in investments from hedge funds and mutual funds, could leave many companies with nowhere to go, said Barry Kramer, a partner at Fenwick & West LLP, a law firm that represents startups when they raise money. Many startups have been valued so highly they scare off potential buyers. he said. So if a company can’t hold an IPO or be acquired, it will have to either become profitable and self-sufficient, or try to raise more money at a lower valuation.

“If the stock market goes down and people are a little less anxious to invest in IPOs, and big companies are a little less anxious to do acquisitions, that is not great for the liquidity of these companies,” Kramer said.

Scott Carter, a partner at Sequoia Capital, a venture capital firm that’s backed Airbnb Inc. and Dropbox Inc., said he’s been warning companies to be more financially disciplined and spend wisely in case the market turns.

“You’ve had an unbelievable opportunity to build really exciting companies at the same time there’s a lot of money available at really attractive terms,” he said. “There may be a moment in time when it’s not so easy.”

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