The Fed And Valuation

In case you missed it, the Fed raised rates another quarter point.  In case you missed it, unemployment rates are at record lows all around the country and with all ethnic groups.

What’s that mean for startups?

Supply and demand effects from interest rates going up are going to filter through a lot of different parts of the economy.   They will affect things that are not just quantitative.

Great startups are often created in times of duress.  Resources are cheaper.  Problems are laid bare.  In good economic times the tide is in and everyone looks pretty good.  Customers might not be as focused on cost cutting or finding new solutions to problems.  That’s not to say we should always be in duress or hope for periodic downturns just to get great startups going.  But, it’s a fact.

It’s gonna be tougher to recruit.  Founders are going to have to make a more persuasive case to get people to work for them.  They have distinct cost/opportunity costs as the thirst for talent is unquenched.  It’s always been that way, but in a poor economy a person is more likely to take more risk.  What have they got to lose?

I think that valuations are going to change.  As interest rates go up, it changes the risk/reward ratio of investing.  Capital allocators might look to the safety of US Treasuries to get a guaranteed return.

Corporate acquisitions are going to change.  You might or might not know how corporates calculate “internal hurdle rates” but in their corporate finance departments they look at the weighted actual cost of capital.  It’s different for all companies.  Here is a rudimentary formula.

The “i” is interest rates. As they go up the hurdle rate goes up.  For an acquisition, a startup is going to have to demonstrate that they have the ability to really perform post-acquisition.  The good news is if valuations go down, another input into the equation goes down.

The Federal Reserve is generally behind the curve when it comes to changing policy given the macroeconomic environment.  They lower rates too slowly on the way down, and aren’t aggressive enough on the way up.  Because our economy is running on lots of cylinders, it’s raise rate time.  Going slow could be inflationary.  On the flip side, no one knows what the tariff policy Trump’s economic team has structured will do to economic growth.  In theory, it should slow it and raise costs.  In the short term, protectionism might create all kinds of scarcity inside the country which could make the economy appear like it is humming when it really isn’t.