Interest rates have been at historic lows for a number of years now as the Federal Reserve’s loose monetary policy has tried to stimulate investment and greater economic activity. While the economy has been slow to recover, the stock market has been climbing to all-time highs. With the risk-free interest rate near zero, investors looking for at least some kind of return have been bidding up stock prices, but they have also been throwing money into new startups.

This increased investment in venture capital has led to high-flying valuations of these fledgling companies. If this uptick in startup investment is partly due to the historically low interest rates, the looming question is how these new companies will fare if the Fed follows through with a projected hike in the federal funds rate. Considering that there are few funding options for startups looking for quick growth, any policy that causes investment to shrink poses real threats to sustaining a business that may not be profitable for years into the future.

Funding a Startup

There are few viable options for funding a new business. Unless one is independently wealthy or has a rich relative, personal savings may prove insufficient as seed capital. Using what little capital is available in an attempt to bootstrap the new business may work for some businesses, but many take years before they earn enough revenue to cover costs. Without external financing, waiting years for a business to become profitable is just not viable.

One option is to obtain a loan, but again, unless the business is likely to be profitable in the near future and its prospects have great certainty, banks will be unlikely to take the risk. For such startups, the only potential source of funding may be from venture capital.

Supply of Venture Capital

Investors generally care about two things: expected returns and risk. Higher expected returns pose greater risks than investments with lower expected returns, meaning investors must try to maximize their returns while limiting their exposure to risk. While there is no investment that does not pose some level of risk, the rate on the three-month U.S. Treasury bill is generally used as the risk-free rate.

As the three-month T-bill rate has been essentially at zero for a number of years, investors have had to turn to high-risk investments in order to earn at least some kind of return. Borrowing costs are also cheaper, making leveraging to finance investments significantly less costly. For these reasons, low interest rates are considered to correlate with greater investment in venture capital and higher valuations on new startups. However, excessively low interest rates may lead to investment bubbles in venture capital. On the other hand, higher interest rates may lead investors to pull money out of venture capital as they can finally earn decent returns with significantly less risk. (For more, see How Venture Capitalists Make Investment Choices.)

Venture Capital Bubble?

The ultra-low interest rates that have led to significantly lower returns on many investments have fueled a boom in venture capital investment. In 2014, American venture capital funds raised over $30 billion,which is almost double the previous year’s total. The first three months of the current year saw $13.4 billion invested in American venture capital, the highest level since early 2000 – before the bursting of the dotcom bubble.

This increased funding has led to excessive valuations on new companies as certain tech startups without any revenue or profit are receiving hundreds of millions of dollars in financing while being valued in the billions. One prominent example of the craze is the $19 billion acquisition of Whatsapp by Facebook Inc. (FB). Whatsapp’s revenue is miniscule compared to this takeover price, and the deal makes the $1 billion buyouts of Tumblr and Instagram only a couple of years ago seem relatively reasonable

Many analysts warn that these extreme valuations are indicative of a bubble as three of the previous booms – the late 1960s, early 1980s, and the dotcom bubble of the 1990s – coincided with increased venture capital investment. The very nature of a bubble is that at some point it pops, and it often doesn’t take much. An interest rate hike by the Fed may be just the catalyst for such popping to occur. (See also, Who are Venture Capitalists?)

Fed Predicted to Raise Rates

If low interest rates make it cheaper to borrow money, then any increase in those rates necessarily makes borrowing more expensive. Like any other commodity, generally when it becomes more expensive, people demand less of it. With less cheap money floating around and more reasonable returns on risk-free investments, venture capital investment will begin to dwindle.

Despite the fact that, among other things, cloud computing and smartphones have made starting a business significantly cheaper and easier, it is extremely expensive to keep a business going in big markets. Hence, companies that still have yet to earn profit or revenue will find it very hard to finance their business operations if venture capital investment begins to dry up due to higher interest rates.

Such a rate hike by the Fed could come as early as September with another increase in December predicted Federal Reserve governor Jerome Powell. It may all depend on how the economy performs but two other Fed policy makers have made similar predictions indicating that the economy could support at least one 0.25 percentage point increase in the interest rate this year. After its policy meeting last week the central bank affirmed its plan to increase interest rates by the end of the year.

The Bottom Line

Any new business takes an initial capital investment to get started, and many take years before they begin to earn profit and revenue. Gaining access to venture capital thus becomes imperative for many of these startups.

With interest rates at historic lows and investors looking to make some kind of return, entrepreneurs are reveling in the availability of funding and have seen their companies valuations grow to disproportionate sums. Yet, with interest rates having nowhere else to go but up, the Fed’s impending interest rate raise will likely begin to reverse the flow of funding. As venture capital funding dries up, only the most promising startups will survive as investors will look for higher expected future returns to compensate for the risk of financing not-yet profitable businesses.

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