For a decade, tech start-ups have flourished, raking in huge investment dollars, fueled in part by low interest rates. But the easy money may not be so easy anymore. After close to a decade-long pause, the Federal Reserve increased rates by 25 basis points in December. The repercussions from the hike may soon be felt by many private tech start-ups through a change in investor behavior.

In 2015, U.S. tech start-ups raked in more than two-and-a-half times the investment money that companies raised in the public markets with initial offerings.  

The last time the Fed decided to increase interest rates was in August 2006 and many tech start-ups had either not existed then or were in their initial phase. With the financial crisis throwing the economy into turmoil, the Fed adopted a "zero interest rate" policy in 2008 and kept the interest rates close to a zero until December 15, 2015. The central bank's policy in 2009 also increased the money supply by adopting quantitative easing until 2014. Quantitative easing was initiated to stimulate the slowing economy, re-establish investors' confidence and create a healthy investment environment by making loans cheap.

Private tech start-ups started enjoying the benefit of the huge money supply in the economy and within a short span, they grew exponentially. One reason investors chose to channel their funds into start-ups was because bank deposits and other financial instruments in comparison gave lower returns. This initiated a robust business environment that contributed to the growth of the economy, something the Fed was trying to achieve. The low borrowing cost and the huge flow of investors sent many start-up valuations sky high. According to TechCrunch, in 2015, there are 156 private start-up firms worth $1 billion or more, with a total valuation of $527.9 billion.

The Fed hike is the first experienced by many unicorns, like Uber (founded 2009), Pinterest (2010), Snapchat (2012) and Airbnb (2008), which are yet to operate in a high-interest-rate world. Funding could fluctuate when investors reposition themselves (for higher returns or due to more choices for investments) and there could be shrinkages in start-up funding. The tightening of the monetary policy by the Fed could force many to cut costs.

The hike will not only test the financial strength of many start-ups, but also the foundations of their business models. Many unicorns may have an established business model which are strong enough to face headwinds of an interest rate hike. But the hike may sift out the weak and incompetent business models from the competent ones.

As investors get more cautious about their funds, many start-ups may find it difficult to raise capital, making it even more difficult to hold an initial public offering. That said, not many tech companies are going public these days. The Wall Street Journal reported that in 2015, only 14% of U.S. IPOs were related to technology. Unicorns like Uber, Airbnb are still far away from the IPO radar and have little intention of going public anytime soon.

The effect of the Fed Funds rate on the tech industry may not be immediate and one reason is that an entire economy itself takes around 12 months to reflect the changes of an interest rate decision. Also, the Fed's stated method of increasing interest rates is a gradual process and it will only increase further after carefully analyzing the domestic and global economic environment.

Smart start-ups may have already gone public raised capital before the Fed decided to raise the interest rates in December. In 2015, the world's most valued transportation taxi company, Uber, raised $2.1 billion sending its total valuation to $68 billion. It's now valued higher than 80% of the companies in S&P 500. Similarly, Airbnb confirmed a $1.5 billion investment round that made it the third-highest valued start-up ($25.5 billion) in the world after Uber and Xiaomi, the Chinese electronics company. In the last quarter of 2015, payment technologies company Square went public, triggering debates about its valuation. The company raised $279 million.

With the Fed rate hike, many tech start-ups may find it hard to tap private markets for funding and may be forced to face the rigor and market discipline of going public. In such cases, it will be interesting to see the difference in the private valuations of start-ups and how markets value their worth.

 

 

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.