Interest Rates and Startup Valuations

I recently read Matt Turck’s article, The great VC pullback of 2022.

One sentence that particularly moved me was:

“… venture capital is still a tiny part of the world economy. Macro changes like interest rate hikes move trillions of dollars, and we’re just a trickle in that overall flood.”

My immediate knee-jerk reaction to this was that this must be a wrong assessment. A very wrong assessment. Since interest rates have a large impact on asset allocation (e.g. by LPs), my idea was that higher interest rates would significantly disfavour investments in VC (where cash flows are far out into the future).

I quickly modelled this with a P&L for a B2B startup at series B (roughly modelled on Point9’s B2B Marketplace Napkin that they released this week) and compared it to a theoretical established company. The established company’s P&L was built to give more or less the same valuation from a DCF at a WACC of 8% (amazon’s current Weighted Average Cost of Capital).1

The two lines show the companies’ valuations for different WACCs. The blue line is the startup. The red line is the traditional company. 

The difference for a 3% change in WACC was significantly smaller than I had anticipated. Only about a -12% delta in valuation comparing the two companies for a WACC of 11% vs. 8%. I would assume that a delta of -12% would have an effect on capital allocation, but not one that would significantly change the nature of the VC business.

This is the corresponding chart:

Startup ValuationTraditional CompanyDelta

Next, more in an exploratory mode, trying to understand what the relevant WACC would be that a VC fund would use at the series B stage.2 I looked at some pitch book RRR data. The 15 year average RRR for the growth stage seems to be 14.3%.

So now, I am thinking whether I am looking at the data in a wrong way and that maybe it isn’t so much about comparing asset classes and more about comparing the startup’s valuation with itself at two different WACCs.

In this case comparing the valuation at a WACC of 14% with 17%3, leads to a drop in DCF valuation from $209m to $ 128m. This is a pretty significant drop and would significantly reduce the startup’s ability to absorb capital (without a very large increase in dilution).4

This in turn would significantly drive down the startup’s ability to grow as fast and would compound the above effect.

Closing thoughts

My current thought model is that the $209m -> $128m step is the right thing to focus on in terms of effect.5

I would assume that the dilution per round will just go back up to 40% per round (vs. the 20-25% that we currently see.). This would mean that the total capital available to the venture would not decrease as much, but founders’ share would shrink and (maybe) also the amount of early secondaries. It also clearly means pretty nasty down rounds for many companies.

Writing this has helped me shape my thoughts on Matt’s article. I am currently in a weird mental position, where my US VC twitter bubble is on fire (in a bad way), but my local Berlin VC (IRL coffee) bubble seems pretty calm and confident.

Happy to hear your thoughts.

Link go Google Sheet with DCF.6

Foot Notes:

1 I understand from my friend’s in VC (N=2) that they don’t typically model startup’s value with a DCF at the series B stage, but I feel this is a relevant tool for comparing the two assets, since at a higher level of aggregation, this is how LPs or Funds of Funds will think of this. Even if at their level of aggregation the DCF comprises 100s of startups that their GPs have invested into.

2 My friends in VC told me that it is uncommon to use DCF at series A/B stage and multiple valuations are more common.

3 A 3% increase in risk free rate is my (absolute gut feeling) prediction for where rates will be in a year or so. IMHO while technology continues to be anti-inflationary, I am seeing (anecdotal) trends of re-localisation of supply chains, mainly due to covid, but also due to the realisation that war is a new reality and global supply chains are brittler than assumed. So I predict we will see a significant undivision of labour in manufacturing on a global scale in the next 5-10 years or so. For me this is more fundamental trend than high commodity prices, which may (hopefully) be temporary.

4 Even worse if you also assume that Exit Multiples are probably 25% down compared to six months ago, but I wanted to purely focus on the WACC effect. The overall current effect is probably larger.

5 (but maybe this is just because I want to be right)

6 It is very high-level/simplified DCF (e.g. EBIT-Tax = Cash Flow). Which is probably more or less true for a debt free SAAS business. It has probably been more than 10 years since my last DCF, so happy to get your input on my typos/mistakes 😉