
What happened
Last week the Federal Reserve cut interest rates for the first time since the pandemic. The larger-than-expected 0.50% reduction in short term rates marks the beginning of a new cycle that will impact all financial assets, including the shares of privately held businesses.
In this note I’ll review what this new cycle could mean for entrepreneurs who want to raise capital or sell their companies. While these are very different transactions, they both involve the sale of shares in a business. The value of these businesses will likely change as a result of the evolving interest rate environment.
Gravitational pull
Warren Buffett once said “Interest rates are to asset prices what gravity is to the apple”.
According to financial theory the value of an asset equals the sum of all future cash flows generated by that asset. To bring that value to present moment dollars, the cash flows must be discounted at a chosen rate. The lower the discount rate the higher the asset value because it’s less painful to wait until cash flows materialize. So as rates decline, the estimates of value increase.
On a more practical note, when interest rates are higher investors can get decent returns from risk free short term US treasury bonds. If an investor can get 5% on a 1-year loan to the US government, the safest bet in the world of finance, she might not be inclined to risk her capital by buying equities.
When interest rates decline, as they probably will for the next couple of years, the appetite for risk increases because those attractive risk-free rates are no longer available. Investors have to migrate to riskier alternatives to get the returns they desire.
To summarize, lower interest rates are good news for anyone who owns risky assets like the shares of a private business.
Market psychology
"No one ever made a decision because of a number. They need a story". Daniel Kahneman
While financial theory and practical investment decisions play a role, markets are not moved by spreadsheets, they are moved by animal spirits.
As you can see from the graph above, the dot com bubble of the late 90s took place in a period of 5% interest rates, the same level we now consider excessive. Our changing views on interest rates are probably the result of getting used to zero percent short term rates for most of the past 15 years.
As author Daniel Kahneman points out, we need a story to make sense of the world. Finance is no different.
The story now is that rates are going down, which is a good thing. This new narrative gives market participants a reason to take more risk or get left behind.
The slow cycle of private capital
Unfortunately for entrepreneurs and business owners, private market participants move more slowly than investors and speculators in public markets.
The three main sources of capital for private businesses are:
Venture capital
Private equity
Corporations
The first two groups -venture and private equity- have long fundraising cycles themselves, which implies that they don’t change their investment strategy in a sudden way. Corporations also adjust gradually to changing conditions.
This means that while declining interest rates will move investors towards greater risk appetite, you as a startup founder or business owner will not notice the difference in the short term.
So why am I writing this article then?
Good question.
If you want to raise capital from either venture or private equity funds, I’d argue that this is a very good time to do it.
Why?
Because it’s still very tough to access new capital, which means that your competitors will also struggle to get it. If you are successful, you will have a competitive advantage in the form of additional capital.
Also, labor markets are softer now relative to the past 3 or 4 years. This means that successful fundraisers will have an easier time attracting world class talent.
Sales and marketing investments will also be more effective in a world where capital is scarce.
My argument could have been made at any time since 2022, when things got ugly for fundraising. The big difference now is that the cycle has changed. Timing is everything.
As for the sale of a business, I would not rush at this point. Valuations are still modest except for AI-related companies. If you own any type of technology or services business, you have a good chance of finding better terms in the next few years, once the cycle really gets going and buyers become more aggressive.
Cycles always turn
The last cycle for early stage capital started in the aftermath of the 2008-2009 Great Recession. The cohort of companies that were started during that recovery period include Airbnb, Uber, Slack, Instagram, Whatsapp, Coinbase and Zoom. That cycle ended with the 2021 bubble that included NFTs, SPACs and meme stocks (I recommend the movie Dumb Money about that period, it's entertaining and educational).
We are now in a period that is comparable to 2010-2015, when those businesses were raising capital and growing. Those founders probably struggled to get some of those early rounds closed. But it was worth it.
And the benefits go beyond just the capital.
The investors who will speak with you today are of much higher quality than what you would have gotten -on average- during the 2020-2021 bubble. These investors have probably built stable asset management businesses, which makes them better long term partners for you.
In summary, if you are thinking of raising growth capital this is a great time to start talking with smart investors. It will not be easy, but it never is. The difference is that now the wind is in your back.