By Kristian Marquez, CFA Founder and CEO, FinStrat Management, Inc.
The fund-raising environment for startups has experienced a significant shift. The strategy of “growth at any cost” is under threat as the Federal Reserve has raised rates to a multi-decade high. As a result, startups that built their foundations on cheap cash and unsustainable unit-economics are witnessing a decline in their valuations and access to capital. And while some fear an impending economic downturn, not everyone views this as a bleak scenario. The market is seeing a move towards more conservative financial management, and focus on solid business fundamentals.
Understanding and Navigating the Impact of Higher Interest Rates
Interest rate decisions by the Federal Reserve have had a profound effect on startups. Higher interest rates have led investors to insist on higher returns and with less risk. In turn, this is putting pressure on valuations, and by consequence, early stage businesses’ ability to raise equity financing. And while many VC investors have money to invest, they're being more selective than before, as lower valuations on their existing investments, as well as their own ability to raise funds from limited partners, have made them reassess their own financial position.
Strategies for Early Stage Company in a Tighter Equity Financing Environment
With VCs becoming more selective, early stage companies need to be more thoughtful and deliberate with their financial management strategy. Those that can increase their cash runway, by focusing on revenue growth and profitability, will not only increase their appeal to investors, but afford more financing options, whether bootstrapping or debt financing.
Bootstrapping emphasizes a focus on profitability. Specifically, income is reinvested into the company to fuel its growth, rather than distributing it as profits. While bootstrapping can be challenging due to the inherent financial constraints, startups often develop a disciplined approach to operations and spending given their limited resources.
Debt financing refers to the practice of borrowing funds to finance a business’ operations or capital needs. With debt financing, the company commits to repaying the principal amount along with agreed-upon interest over a specified period. Note, in contrast to equity financing, where ownership shares are sold to raise funds, debt financing does not dilute the ownership of the company.
Debt financing has traditionally been provided by commercial banks or bond markets. However, they generally not geared to startups given their financial profile. Fortunately, today, there are a host of alternative lenders that provide revenue backed options, which better cater to startup needs to include Capchase, Founderpath and Novel Capital.
Regardless of the source, while debt financing provides an opportunity for businesses to leverage their operations and potentially increase returns on equity, it also carries risks. Companies that rely heavily on debt may face financial distress if they’re unable to meet their repayment obligations. Additionally, the interest costs associated with debt can eat into profitability if not managed prudently.
In Conclusion: Navigating the Evolving Startup Landscape
The startup ecosystem is in a state of flux, largely influenced by decisions from financial institutions like the Federal Reserve and their impact on investor risk / return requirements. Higher interest rates, more competitive VC funding, and an emphasis on sustainable growth have painted a challenging, yet potentially rewarding picture.
Startups need to be agile, exploring various funding sources, whether organic (i.e., focusing on top line, being judicious with spend) and/or external, all while adapting to evolving market conditions. While the landscape may seem intimidating, with the right strategy and an eye on both internal operations and external market dynamics, startups can not only survive but thrive.