1. Tourists go home
An inability to find yield in the fixed-income markets along with turmoil in many foreign countries has led big private equity shops, hedge funds and mutual fund companies to seek returns in alternative areas. Couple that with all the hype in start-up land and it's no surprise that a crop of big money institutions from New York, London and Singapore are circling San Francisco, writing nine-figure checks.
According to CB Insights, only two U.S. venture-backed companies have gone public this year, raising $250 million, while VC-backed tech companies have raised $9.8 billion in private capital. That's a startlingly large gap caused by a flood of new money.
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Rising rates typically translate into increased yields across the fixed income landscape. Borrowing costs for companies rise, sending rates on corporate and junk bonds higher.
That's not to say that all the new late-stage money will hit the exits (far from it) but firms that have no loyalty to tech and have been overpaying to get in will surely be pleased to find attractive options elsewhere.
"If the Fed tightens its interest rate policy, yields in traditional assets will go up, as will the cost of borrowing," said Shriram Bhashyam, founder of EquityZen, a site that helps connect investors with start-up employees who want to sell some of their shares. "That means there would be less money chasing start-ups, lowering valuations."
Companies that have been spending wildly with the expectation that mega-financing rounds will be available in the future may be forced to turn off the spigot. For others, it may be too late.
Benchmark's Bill Gurley has gone so far as to predict "some dead unicorns this year," referring to billion-dollar start-ups that are unprepared for a change in market conditions.
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2. The dominoes fall
Once the big money starts to depart, the rest of the capital structure can start to normalize, and this market has been anything but normal. In 2014, U.S. start-ups raised over $48 billion from venture investors, compared with an annual average of about $30 billion going back to 1995, according to the National Venture Capital Association.
Traditional VCs, no longer forced to compete on price with hedge funds to get in deals, can go back to valuing businesses on more reasonable metrics and fundamentals and with more rational multiples. Investors can be more discerning, leaving the off-the-wall ideas or unappealing founding teams with nowhere to turn.
How could it all play out?
"A lot of companies that could raise that were sort of marginal companies can't raise and go out of business," said Kevin Mahaffey, co-founder and chief technology officer of mobile security provider Lookout and an angel investor in tech companies. "Everything slows down a little bit and start-ups tend to fail at a slightly higher rate, particularly early-stage ones that haven't proven a revenue model."
And then there's venture debt, which as CNBC.com reported in October, has been soaring thanks to a handful of commercial banks getting into the mix. Start-ups have taken to referring to venture debt as free money, because rates are commonly in the neighborhood of a typical mortgage. As banks have to pay more to borrow cash, they're naturally going to charge more to lend it.
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3. Corporate wallets fold up
When earnings are on the rise and stock prices are touching record highs, corporate America has money to invest and an open checkbook from shareholders.
Rate hikes mean higher borrowing costs, leaving companies spending more to service future debt. For companies with expectations of generating a certain amount of earnings per share, higher debt costs mean cutting expenses elsewhere. Remember that new billing system we were going to install? Maybe now isn't the best time.
Similarly, consumers paying more on their mortgages and credit cards may be less inclined to buy that smartwatch or hot new app.
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That's one reason why so many software start-ups talk about the cost of their products in the context of return on investment, or ROI. If a customer is spending now to save later, the purchase makes sense in good times or bad.
But even if the ROI is obvious, getting the meeting with prospective customers becomes more challenging as belts tighten. Will the chief information officer or head of marketing still take your call?
Bullpen Capital's Martino isn't so worried about this piece, because big tech companies in particular are sitting on mountains of cash that have been earning nothing.
"We've never seen balance sheet quality like this in our lifetimes," Martino said. "I can't see a minor change in the Fed funds rate, which is kind of window dressing, really spurring a change."
In other words, start-ups that have real businesses shouldn't worry about spending drying up.