Why exactly do high interest rates dissuade VC investment?

It's more complex than you think

So we’ve all heard it: VC has dried up. And if you listen to the media, it’s due to high interest rates. And for the most part, that’s correct.

What’s odd about this though is that in 2022, VCs actually raised a record amount of capital.

To understand why it’s not being deployed, we have to take a deeper dive into what raising capital means, how VCs work, and how high interest rates have changed the market.

First, when VCs raise capital, they don’t just go and get checks from investors. Limited Partners (LPs) commit a certain amount of capital to the firm for later investment. Then, as the VC invests, they make “capital calls” to the LPs requesting money. Now, the VCs want to maintain friendly relationships with their investors so if making capital calls will make their investors unhappy, they won’t make them.

So, second, with high interest rates, the risk/reward calculus of Venture Capital investments has changed. You can now make 5%+ on your money risk free. So LPs have other, less risky investments and are less interested in investing in VC. Due to the time value of money and compounding interest, this makes other investments significantly more attractive than VC at the current moment.

In addition, many LPs borrow money when called upon for capital and the cost of this borrowing has skyrocketed. So their allocation of money they now want in VC investments is less so they do not want to be called on for capital. So despite all of this supposed capital raise by VCs, Venture Capital firms are very hesitant to call upon LPs for it since it’ll upset them and prevent them from investing in the future. And as long term investors, VCs are very concerned with maintaining long term relationships with their LP clients.

Perhaps most importantly is how interest rates affect valuations and eventual exit value of startups. The valuation of a company is, in general, determined by the sum of its free cash flow across the future discounted by the risk free rate of investing capital. Since interest rates are high, the risk free rate is high, and exit valuations are thus lower, depressing returns on VC and VC investments, again making it a less attractive investment class as potential returns are lower than ever before.

All of this creates a perfect storm not only where VC funding for startups has dried up, but also an existential threat to Venture Capital firms themselves. If interest rates remain high, they won’t be able to raise future capital, which will prevent them from funding both existing portfolio companies and their ongoing operations through management fees. VCs know this and are in preservation mode.

Honestly, as someone who lives in the startup ecosystem, it’s quite frightening. There is significantly less capital flowing through the system, the job market is rough, and finding funding has never been more difficult. However, there is still capital being deployed into good companies and I for one am glad to see more due diligence being applied with a focus on cash flow and profits. A return to fundamentals is a good change rather than “Airbnb for dogs” raising a $400 million round. This is a healthy shift away from your usual Silicon Valley unprofitable ideas towards real businesses than can generate revenue and profits. There are so many startups funded in the last decade that never not only had a path to profitability nor even were designed to have one. Many IPOed as astronomical valuations only to later crash.

Thanks to high interest rates and tighter VC funding, those days are over. I know many readers may lament it as free money made a lot of people rich. Don’t be upset. You can still succeed. You just need to come up with a profitable idea this time, which in the end is a good thing for capitalism.

I firmly believe the days of cheap capital will return but Silicon Valley is probably permanently changed as has VC's investment thesis and considering some of the dumb ideas that got funded that crashed after IPO (see chart below), in the end, that’s a good thing.