How the Fed and Interest Rates Impact Startup Operators
How the Fed and Interest Rates Impact Startup Operators
Translating interest rates to startup world
The Fed meets again this week to wave their wand over the economy. In anticipation of the occassion…
Three observations:
Money is real, but also, like, not real
It can kind of be created out of thin air by the government
The efficient market hypothesis is far from real
“The market is human emotions packaged into money and tickers” - Kyla Scanlon
Changes in interest rates impact startups in tangible and non tangible ways
There can often be a disconnect between consumer sentiments and the economic reality - aka a “Vibecession”
Last go around the fed hinted they wouldn’t cut rates again until the spring… (checks watch)…Well, here we are!
Last time around I didn’t really know how to square their voodoo magic, so I’ve dug into how the Fed and Interest Rates impact startup operators. If you have cash in your company bank account, or want to raise more to put in it, here’s an overview on how the wizard behind the economic curtain alters the playing field you operate on.
(This newsletter issue relies heavily on a great conversation I had with
on The Run the Numbers Podcast (links below).)How are the interest rates my company is subjected to determined?
The fed is the money wizard
They have dual mandates of price stability and maximum employment
Make sure inflation is not ripping people’s faces off
And if you want a job, you can get a job
So they influence rates in the economy to achieve those goals
Let’s check their toolkit:
The Federal Funds Rate
The Fed's most direct impact is through its control of the federal funds rate, which indirectly influences interest rates throughout the economy.
While the Fed directly sets the federal funds rate and discount rate (more on that below), its actions indirectly influence other interest rates, such as mortgage rates, car loans, and business loans.
The rates your company faces on loans are often closely tied to these broader market rates.
When the Fed raises rates, it becomes more expensive to borrow money.
This can affect startups significantly, as they often rely on external financing.
Higher interest rates mean higher costs for borrowing, which can slow sales and hiring.
The Discount Rate
This is the borrowing window between banks and the fed.
What’s a “borrowing window” you ask? Well, having learned this exactly three minutes ago, it’s a fancy term for how much the Fed charges commercial banks for short term loans
The discount rate is applied at the Fed's lending facility, which is called the discount window (how neat!)
And if it’s higher, banks won’t lend as much
Reserve Requirement
This is how much money from deposits banks need to keep on hand
If it’s higher, they won’t lend as much out to your company
Open Market Operations
This is when the fed buys or sells different securities
The econ 101 term for this is Quantitative Easing (or Tightening)
Easing: The Fed buys securities like government bonds to inject liquidity into the economy, thereby lowering interest rates.
Tightening: Conversely, quantitative tightening involves selling these assets to reduce the money supply, potentially leading to higher interest rates.
How does fractional banking influence my startup?
Reserve Requirements: Get adjusted based on economic conditions.
For example, during economic downturns or crises like COVID, central banks lower reserve requirements to stimulate lending and economic activity.
It’s a calculated risk - the economy sucks, so they say, hey, let’s try something to kick this thing back into gear
As a result, banks are required to hold less cash on hand, and can lend more of their deposits out to people who will spend it.
This is done with the understanding (hope?) that not all depositors will withdraw their money at the same time.
Government Guarantees: The government puts the “trust” in the banking system.
By guaranteeing deposits through agencies like the FDIC in the U.S., the government ensures that even if a bank fails, depositors' funds are protected up to a certain limit.
Random tangent: I’ve never understood why the FDIC’s $250K limit is the same for Joe Smo’s like you and me as it is for businesses… shouldn’t it be a bit higher for Walmart?
This assurance helps prevent bank runs and maintains stability in the financial system.
More Lending: In a fractional-reserve banking system, banks lend out most of their deposits while keeping only a fraction as reserves.
This system significantly increases the money supply and is a key method for creating new money in the economy.
More Borrowing: Tracing the impact through, this lending model directly affects the availability of credit for businesses, including startups.
An increased money supply typically means more loans are available, which is vital for startups needing capital for growth and operations.
Money Multiplier Effect: The money lent to businesses is often spent and then re-deposited in banks, creating a multiplier effect in the economy.
This cycle of lending, spending, and depositing stimulates economic activity and growth…using the “same” money!
Beware of Bank Runs: While fractional-reserve banking is efficient, it's not without risks.
A bank run, where many depositors withdraw their funds simultaneously, can cause chaos. See: SVB.
Realizing the $250K limitation I mentioned above, with some creative solutions, the best business accounts diversify and protect their cash from a bank run with FDIC insurance of up to $6M.
Dynamics at play for startups when rates rise
Venture Capital Funding: VCs have a harder time raising money when limited partners (their investors) have higher interest rate options in safe securities (like bonds…boring!)
And if VCs don’t have as much money to invest in startups, it creates a more competitive environment for startups to secure funding
Yield on Savings: On the other hand, higher interest rates increase returns on savings and cash reserves, potentially allowing for additional hires or investments.
Woop dee doo! Suddenly you can hire one and a half more developers a year from your increased interest rate!
Valuation Impacts: The value of a company is predicated on the sum of it’s future cash flows.
And when rates go up, Discounted Cash Flow (DCF) models get slammed with higher rates, which drives startup valuations lower.
A revaluation of labor takes place: The cost of labor changes with interest rates.
When rates were low and the economy was ripping, higher priced labor received a premium, as there was more money from VCs given to startups, who bid up the cost of the same engineers and tech employees.
When rates are high and the economy is not doing as well, lower priced labor may get a premium because we don’t have people who want to work the counters.
This bleeds into the price of goods an services - like Uber and DoorDash.
This can also bleed into end consumer prices, which drives down demand, and therefore revenue, for startups (especially B2C companies)
Impact on Exit Strategies: Changes in interest rates can influence exit strategies for startups.
M&A and IPOs are slow when rates increase, as it’s harder for buyers to get good debt terms to make purchases
And the appetite for IPOs dries up when less risky securities provide good yields
Control what you can control
Trying to change the Fed is like trying to change the weather.
A solid strategy when the cost of borrowing is high is to optimize the cash you do have. The best operating account for startups are free, have a high yield, keep you liquid, offer an interest-free card option that extends your working capital at no cost, and enable global payments. These features help you preserve optionality.
Some other cash management best practices to help you optimize cash flow:
Align your allocation strategy with your priorities
Automate your balance maintenance (don’t get sexy with manual sweeps and stuff)
Create separate accounts for financial functions
Leverage financial tooling and integrations (visibility!)
And try to keep it super simple. Afterall, you’ve got a company to run.
A word from our sponsor - Brex
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Check out the IDC report and automate your AP today.
Run the Numbers
Also available on Spotify and Apple.
Quote I’ve Been Pondering
“That’s all right,” Marvin told Tony Petronelli. “He can’t take them all into the ring with him. It’s just going to be me and him”
-Marvelous Marvin Hagler to his Trainer and Coach Tony Petronelli before his fight with Tommy Hearns