How Rising Interest Rates Could Affect Tech Valuation
by Timothy BernsteinMr. Bernstein is an analyst with NewOak, an independent financial services advisory firm built for today’s global markets. Led by a team of experienced market and legal practitioners, NewOak provides a broad range of services across multiple asset classes, complex securities and structured products for banks, insurers, asset managers, law firms and regulators. Visit NeOak.com.
Lost amid recent news coverage of the stock market tumult, China’s struggles and oil’s plunge was a short piece from Re/code on a possible sea change in technology company valuations. In it, prominent venture capitalist Jeremy Levine expressed deep skepticism that the industry’s dramatically inflated valuations are sustainable:
“Prices — especially for late stage deals — have been extraordinarily high for a while now and demand flawless execution and a lot of luck,” Levine said in an email following an in-person meeting. “The former is extremely hard to achieve, and the latter is obviously outside anyone’s control. Therefore, I believe a lot of the private deals that have [been] getting done recently are providing very poor risk-adjusted-returns for investors.”
Levine’s warning, as Re/code’s Jason Del Rey points out, comes on the heels of a similar alarm bell rung by investor Bill Gurley, who cautioned recently on Twitter that “we may be nearing the end of a cycle where growth is valued more than profitability.”
Levin and Gurley are hardly the first two industry professionals to warn about the bursting of a valuation bubble—fellow venture capitalist Kevin Kinsella and Snapchat CEO Evan Spiegel have also raised concerns. However, at a moment when market volatility is surging and an imminent rise in interest rates is a strong possibility, it is worth examining the connection between the money flowing into Silicon Valley and the bigger economic picture.
Low Rates Boon to Tech Startups
Probe any tech valuation skeptic on their reasoning, and it won’t be long before you hear the phrase “low-rate environment.” The Federal Reserve has not raised interest rates since 2006, and it has kept many of its key benchmark rates near zero since 2008, when companies like Uber, Snapchat, and Xiaomi did not even exist. The ripple effects of the Fed’s low-rate policy extend both to the return on bonds as well as the cost of borrowing money from banks. Investors looking for higher returns seek out higher-risk alternatives to “safe” investments like fixed income, while companies looking to raise vast sums of money to expand their operations quickly can do so at a lower cost. Both of these developments, unsurprisingly, benefit tech startups.
Another word you might hear next, and more frequently now, is “profit.” Profit has been secondary to growth and market share in Silicon Valley for some time, with the emphasis on a company’s potential, not its performance, fueling speculation on the potential windfall from either an IPO or a buyout.
Rising Rates Blur Tech Picture
A rate increase could potentially hurt promising tech companies on both fronts: a potential drop in investment off the increase could force firms to look for a buyer, which in turn might be scared off by a perceived over-valuation. Additionally, the stock market volatility that often accompanies a rise in rates could make it harder for companies to hold public offerings. As a result, firms can either accept a lower valuation or face the daunting prospect of having to show they can turn a profit.
Either way, a rate increase looks to create complications for young tech firms grown used to a free-flowing money spigot that never turns off. The question going forward is whether a higher-rate environment will be what finally cools the market off, and have an appreciable effect on valuation figures going forward. On this, opinions seem to be divided. Some, such as an anonymous venture capitalist cited in Knowledge@Wharton, the school’s online business journal, believe that there is a bubble, and that it could burst within the next 12 months. At this point, he argues, firms will try to raise another round of money and find that it won’t be so easy in a higher-rate environment. “Then,” he said, “everyone will begin to question the fundamentals.”
Conversely, the same article quotes an adjunct professor at Wharton, Dan Wessels, suggesting that the good times may not be nearing the end for the large percentage of startups that are still private companies. According to Wessels, higher rates “will affect valuations of [public] markets, no question. However, the valuations of [private] companies are based on fundamentally different economics. It’s more based on what these companies are promising for the future.”
To Wessels, the fact that the lion’s share of the money for these private start-ups comes from hedge funds and mutual fund companies, where “there is more flexibility and complexity to the contracts,” could allow the cash inflows to Silicon Valley to continue despite more traditional sources of funding drying up post-rate increase.
At the same time, the complexities of the private marketplace do not necessarily insulate its participants from the notion that rising yields on lower-risk instruments (for example, government bonds) will inspire a renewed flood of cash that will have to come from somewhere. Whatever pressure is currently on startups to show profit-making potential, however negligible, will undoubtedly increase when the alternatives to the alternatives start to look like better investments.
 Del Rey, Jason. “One of Tech’s Best Investors Keeps Passing on Deals Because Valuations Are Too Damn High.” Re/code, 23 August 2015. http://recode.net/2015/08/23/one-of-techs-best-investors-keeps-passing-on-deals-because-valuations-are-too-damn-high/
 Bill Gurley on Twitter, 20 August 2015. https://twitter.com/bgurley/status/634572713168793600
 Witkowski, Wallace. “VIX ‘Fear Index’ more than doubles on week, biggest weekly jump ever.” MarketWatch, 21 August 2015. http://www.marketwatch.com/story/vix-fear-index-sees-biggest-weekly-jump-ever-2015-08-21
 “Of Unicorns and ‘Decacorns’: Is a Tech Start-up Bubble Forming?” Knowledge@Wharton, 22 June 2015. http://knowledge.wharton.upenn.edu/article/is-a-tech-start-up-bubble-forming/