Effect Of Interest Rate Hikes On The Valuation Of New Businesses

By Author: Mary Rose Somera
Total Articles: 94
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Inflationary pressures continue to mount with each passing day. A small group of Fed members make an official statement promising to take whatever action is necessary to bring inflation under control. The stock market always reacts negatively, and media sites covering the startup industry trumpet the reduced access to funding and lower values.

But how exactly do interest rates, startup funding, and business valuation relate to one another?

The Federal Reserve has been raising interest rates to slow the economy and curb inflation in accordance with Modern Monetary Theory (MMT). With all the talk about interest rates, it’s inflation and the government’s response to it that will have the biggest impact on startup valuation and the public at large.

Your clientele, suppliers, and investment capital are all vulnerable to inflation.

As a result of inflation, the advice given to startups is to reduce costs as much as possible, become cash flow positive as soon as possible, slow down the employment process, and limit spending. The problem is that some of these initiatives, while helpful in a recession, ...
... are too broad to be truly effective. Instead, you should familiarize yourself with the effects of inflation on your company.

Customers, providers (including staff), and capital are the three pillars on which every business rests. To what extent is inflation affecting these various elements?

Your clients are other businesses, therefore their worries will mirror your own. Putting yourself in their position, do you think inflation is a good thing or a negative thing for them? Will they have more freedom to spend money, or will they be restricted more?

If you’re selling a consumer good or service, what impact has inflation had on your target market? Would they struggle to make ends meet as a result of rising prices? Is purchasing your product a luxury or a necessity?

Inflation could be helpful for business if it helps your customers, and this is rather likely. But, when your consumers win, your service providers typically lose.

In the early stages of business, the team is often the most expensive asset. As the cost of living rises, the team will demand a raise in pay from the corporation. Yet again, though, the details matter. Consumer prices fluctuate greatly from one location to another and from one commodity to another. The inflation rate can vary greatly from one country to another and even from one city to another. Furthermore, inflation has a varying impact on various occupations and income brackets. A successful strategy can only be determined after careful consideration of these details.

Capital is the final topic. As inflation encourages the investment of money that would otherwise lose value at a greater pace, it should enhance the availability of capital. There is a heightened expectation that investors will use their money wisely. That this is happening at a time when VC firms are stocking up on cash in anticipation of future inflation makes it all the more remarkable. Eventually, one of these things will have to give.

But here’s where the thread comes together: governments and the monetary institutions that strive to curb inflation have problems of their own.

Government responses to inflation and its impact on new businesses

To curb inflation, central banks will raise interest rates and tighten access to credit. Thus, it is more difficult to borrow money and more appealing to put money away. Bringing down the economy’s temperature and inflation this manner will be the least unpleasant option. The resulting rebalancing of supply and demand dampens price inflation. Overall economic growth will decelerate as a result, but the trade-off is seen as positive.

The government’s efforts to curb inflation, then, would have the same effect as a general slowdown in the economy. Using the aforementioned framework, please explain the impact of the current downturn or impending recession on your clientele, your suppliers (including your staff), and your resources.

If your service is something people splurge on occasionally but can go without now that they have less disposable income, sales are bound to drop. Workers and other service providers anticipate an economic downturn, which will lead them to agree to lower pay and longer contracts. The effect here is counter to inflation’s, therefore the two might cancel each other out.

It’s a little trickier to dissect the situation in terms of cash flow. The capital, on the one hand, is feeling the effects of rising prices. Investment, on the other hand, is done so with an eye toward earnings afterwards. It’s possible for both to occur when this expectation drops, especially with respect to long-term investments like startups. It’s possible that the investor is taking a long-term view of the investment and has decided that the negative prospects for the future are more important than the inflationary pressures.

The most important thing to remember is that, just like consumer prices, startup valuations should go up during an inflationary period. Yet, government action to prevent inflation may reduce the future potential of startups, resulting in reduced valuations. But, each organization sees vastly different outcomes. Each new business owner needs to evaluate their own firm, clientele, vendors, and funding requirements to choose the best course of action.

Feel free to reach out to our Credo CFOs to learn more about valuation of new businesses.