Rate cuts are coming
At TDK Ventures, we’ve been talking internally about how the Fed’s meeting next week is likely to be an inflection point. Next Wednesday, after two and a half years in this rate-hike cycle, we’ll find out whether we’re on the descent side of the mountain.
Given that Fed chair Jay Powell himself, as well as interest-rate futures, believes the time has come for policy to adjust, a rate cut seems all but certain.
Everyone wants to know whether it will be 25 or 50 basis points, but the most important feature of this week’s decision is the direction a first cut would signal. (You don’t want to see aggressive cuts anyway – that would likely mean the Fed is battling a recession.)
The down-ramp will take months or even a year or more while the Fed continues to eye its 2% inflation target. The Fed has often been noted to take the escalator up in hiking rates (although not in this cycle) but the elevator down in cutting.
If you’re a founder, you’re going to want to position yourself as this landscape shifts. Interesting times lie ahead.
What will happen to liquidity and funding?
We’re not going to see near-zero interest rates again anytime soon. Even if the economy falls into recession, the Fed will be reluctant to revisit its ZIRP era – and that’s a good thing for startups in the long run.
More likely, we’ll see a gradual easing that will start to unlock capital and liquidity for consumers, businesses, investors, and startups. Markets that tend to be more reliant on debt – such as automotive – will see a pickup as borrowing costs come down. Consumers and businesses will be able to refinance their mortgages and other debt at lower rates, freeing up cash.
As fixed-income yields come down, investors will look towards other opportunities. Already, in Q2 2024, we’ve seen an uptick in venture deal volume and fundraising, and a notable decline in downrounds. (In part, this was due to a cohort with less inflated valuations in their prior round.)
Eventually, deal-making will be revived and the IPO markets will return (probably next year). If startups can exit and capital is finally returned to limited partners, LPs will become less leery of the venture asset class – and especially recent vintages with more moderate valuations.
The largest private equity and venture capital firms still sitting on record amounts of dry powder will shift into more of a “risk on” posture. It’ll take some time before the venture “middle class” fills back in, after many smaller firms fell out of the market over the past few years and became “zombie funds” unable to raise new capital.
For startups, valuations will start looking better and terms will become more founder-friendly. In Q2 2024, median interest rates on convertible notes ticked down from a high of 8% in Q1 to 7.5% in Q2. Of course, startups will want to steer clear of zombie VC firms that are no longer actively investing (which may not always be obvious, by the way).
For now, founders should take a close look at their runway and consider paving the way for their next round. They may want to tee up diverse sources of capital that include debt as well as equity. A runway that looks reasonable in a belt-tightening environment may look scant if you need to reorient capital towards growth and capacity-building.
The impact of rate cuts on startups
In general, most startups stand to benefit from rate cuts. Technology and growth companies are generally more sensitive to interest rates, as we’ve seen over the past few years. Higher interest rates eroded the value of future earnings – the source of much of growth companies’ valuations.
Some companies, however, will benefit more than others from the easing capital environment. These might include:
- Capex-intensive businesses (e.g. climate tech) that need substantial capital for infrastructure and scale-up
- Lending fintechs that benefit directly from lower borrowing costs
- Ecommerce brands selling discretionary and large-ticket items to consumers
- Startups adjacent to sectors that are heavily reliant on consumer loans (e.g. cars, furniture, home renovations, real estate)
- Investing platforms that will see higher trading volume
- Startups in hot categories like AI and automation or bolstered by government support (e.g. Inflation Reduction Act, defense tech), which will continue to capture a disproportionate share of capital
- Companies that have emerged as winners in their space (e.g. micromobility, robotaxis) while their rivals have struggled or shut down
- Other “risk on” sectors such as cryptocurrencies, space, quantum computing, nuclear fusion, and other deeptech
On the other side, startups with a short runway and limited access to capital may have a hard time waiting out the down-ramp. This is especially true for those that are well downstream of the immediate positive impact of the rate cuts. These startups have some tough choices ahead, to cut, pivot, sell off, or shut down.
The big X factor is whether the economy falls into recession. If it does, it will likely mute the upside of the rate cuts for most players across the board.
Framing the narrative in terms of efficiency and growth
The “year of efficiency” has now percolated throughout the economy. Last month, tech layoffs hit their highest level since Jan 2024, as companies cut costs and freed up capital to invest in AI initiatives.
The US is now seeing a productivity boom, driven by a combination of belt-tightening and technological investment. This is particularly true in knowledge-intensive industries such as information services and professional services, which are seeing higher productivity growth of 15-30%.
While new businesses are still being launched at a good pace, they are getting smaller on average. Startups are running leaner and doing more with less, tapping into automation tools, generative-AI APIs, smaller open-source models, and overseas contract workers.
After being burned during the last cycle, venture investors will continue to be wary and do their diligence. Startups with a business model and/or an operating model that ride upon these waves – for instance, helping companies become more productive or reskill their labor – will be better-positioned to tell a compelling growth story, no matter how the macro environment shakes out.
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Nicolas Sauvage is the president of TDK Ventures, a technology-focused venture fund investing globally in early-stage startups that use material science to unlock a sustainable future for the world.
This article was a collaboration between TDK Ventures and 6Pages, a market–
intelligence startup focused on far-reaching market shifts.
Views expressed are provided on an “as is” basis for educational purposes only and subject to revision at any time. TDK Ventures, TDK Corporation, and 6Pages do not make any warranties about the completeness, accuracy or timeliness of information provided, or endorse any service or product mentioned. Any action taken based on information provided is strictly at your own risk.
