Removing The Kool-Aid? How The Federal Reserve Shrinking Its Balance Sheet Could Hurt Startup Valuations

For startup founders, the Federal Reserve’s declared intent to end quantitative easing and shrink its balance sheet could mean the party’s over when it comes to venture capital funding.

The Fed’s balance sheet, a weekly report that lists its assets and liabilities, has increased sevenfold since the 2008 financial crisis. Fed officials put plans into motion at their most recent meeting to shed trillions of dollars in bonds on the balance sheet, according to minutes released Wednesday.

At Wednesday’s Fed meeting, “Participants observed that, in light of the current high level of the Federal Reserve’s securities holdings, a significant reduction in the size of the balance sheet would likely be appropriate,” the meeting summary stated.

The consumer price index rose a higher-than-expected 7.5 percent in January 2022 compared with a year ago, surprising some investors and sending stocks lower. That’s the highest CPI reading in 40 years, exceeding the Dow Jones inflation gauge estimate of 7.2 percent — confirmation that inflation is getting worse and that investors are expecting as many as six interest rate hikes this year.

Valuation multiples in the public markets have contracted more than 50 percent, wrote Tomasz Tunguz, a managing director at the Silicon Valley-based venture capital firm Redpoint Ventures.

A valuation multiple is a ratio that reflects the valuation of a company in relation to a specific financial metric, allowing for comparisons of value among companies with different characteristics such as size.

“Startups have enjoyed a phenomenal decade. The confluence of low interest rates and flat costs enabled a thousand $1 billion flowers to bloom,” Tunguz wrote in a column for The Information.

From 2010 to 2020, startups benefited from low inflation of less than 2 percent. The cost of capital dropped. In 2010, the typical Series A company raised $4 million at a $16 million post-money valuation. Today, the same business receives $21 million at a $77 million valuation, according to Tunguz. “That’s more than 5x the capital for roughly the same dilution.”

Startups shouldn’t fear inflation, according to Tunguz. Inflation has a positive correlation with round sizes and total dollars invested. “The greater the inflation, the more dollars startups stuff in their coffers,” he wrote. “Nor should the actions of Jerome Powell and the Fed instill trepidation—the federal funds rate bears effectively zero relation to average startup round sizes over the last decade (although it does have a modest negative correlation with total dollars invested).”

It’s the Nasdaq, not inflation or Fed interest rates fears that are the barometer of health in private capital markets, he wrote: “The Nasdaq’s dramatic slide beginning in late 2021 is likely a sign that high summer is over in private financing markets—and if autumn is here, then winter may not be far behind.”

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The Fed relaunched quantitative easing or QE in response to the economic crisis caused by the covid-19 pandemic. It purchased massive amounts of debt securities in an attempt to reduce interest rates, increase the money supply and drive more lending to consumers and businesses. The goal was to stimulate economic activity during a financial crisis and keep credit flowing.

The end of quantitative easing doesn’t bode well for startup founders, according to Tunguz. The upcoming reduction in asset purchases is unprecedented in the 60-year history of venture capital “from which we might be able to analogize or extrapolate,” Tunguz wrote.

Early-stage markets should remain relatively sheltered, he predicted, but later-stage IPO and M&A markets, not so much. Labor and capital costs are expected to increase more than they have in a decade. A Department of Labor analysis shows a 4-percent increase in labor costs in 2021, the most in 20 years.

“The more resilient the Nasdaq, the stronger private capital markets will be. But that shouldn’t come as too much comfort—the Nasdaq has never been tested like this before,” Tunguz wrote.

Photo: A board above the trading floor of the NY Stock Exchange shows the closing number for the S&P 500 index, Oct. 30, 2019. (AP Photo/Richard Drew)

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