The Bank of England has raised interest rates by 0.75 percentage points to 3% in a bid to tackle inflation. It’s the highest interest rate since the 2008 global financial crisis, the biggest hike since 1989 and will have ramifications across the entire British economy. For tech startups, it underscores that the era of cheap money is well and truly over.
The historically low rates of the last decade have meant investors, such as pension funds, turned to comparatively riskier bets like venture capital funds in pursuit of returns.
This reached a crescendo in 2020 and 2021, leading to record levels of tech startup funding, inflated valuations and a bumper year for IPOs.
But what goes up must come down. Central banks globally have been raising rates to bring down inflation. Higher interest rates mean low-risk investments, such as bonds, hold more appeal to limited partners. The Bank of England’s latest interest rate hike could shrink the volume of capital being deployed in VC funds and, ultimately, startups.
“Investors will likely favour companies with more predictable profits and cashflows over riskier startups and business models,” Patrick Kavanagh, co-founder of fintech startup Atlantic Money told UKTN.
“While VCs are in the business of making bets through various economic cycles, they may be less enthusiastic about investing at high valuation multiples.”
This trend is already in full swing, as evidenced by significant down rounds earlier this year in the likes of buy now, pay later company Klarna. While VCs still have plenty of cash to invest, data shows they have been deploying it more cautiously and in a smaller pool of startups.
Last quarter the number of VC deals completed in the UK plummeted to its lowest level since 2016, according to a KPMG report, as investors take a ‘wait and see’ approach to the global economic downturn and impending recession.
Interest rate hike means more expensive debt
A higher interest rate also means debt will become more expensive for businesses, making debt-based fundraising a less attractive option.
“The rate rise makes debt more and more expensive for earlier and growth stage companies, so equity remains an important way to fund growth and expansion,” said Matt Cooper, CCO of the crowd investment platform Crowdcube.
“That can only happen if the founder and investor expectations on valuation align. That alignment between ‘bid’ and ‘offer’ has to happen eventually as companies will not put off raising funds indefinitely.”
Niels Martin Brochner, founder and CEO of contractbook.com, wrote in May that should interest rates increase to the levels seen now, “companies founded five to 10 years ago will struggle to raise new capital, as most venture funds will deploy at a much slower rate than in the past few years”.
Navigating this new economic environment will require a change of strategy from both startups and VCs. Tech companies launched in the last few years have only ever known cash to effectively be free thanks to near-zero interest rates.
Martin Warner, an entrepreneur and Tech London Advocate, told UKTN that government must step in with “favourable incentives” to encourage investment into UK tech.
Warner, founder of British flying taxi startup Autonomous Flight, added there needs to be “far more cooperation between the startups on the ground and the government to create policy that has real-time effects”.
He said the central government must “look beyond simple tax breaks” and that “regulation, infrastructure and law-making all need to be specifically tailored to the tech industry within the cluster you are trying to create” to build confidence.
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