Interest rates and startup cash: How the central bank rate impacts your runway

You may be wondering how interest rates affect your startup. While it may seem unrelated, a central bank’s adjustment of interest rates has a direct impact on your cash flow, especially for later stage startups and SMEs that have multi-million dollar deposits. Interest rates also affect the availability of both equity and debt capital which is mission critical for cash flow management. As a founder, by understanding economics 101 you will be able to more strategically manage cash flow for your business. 

Interest Rates Explained 

Before we examine the effects of interest rates on cash flow, it is important that we explore some key context about how interest rates actually work. Interest rates in both America (set by the Federal Reserve) and Australia (set by the Reserve Bank of Australia) determine the cost of borrowing money and the return on savings. These central banks will use interest rates as a tool to control inflation while managing economic growth. When interest rates are raised, borrowing becomes more expensive, discouraging spending and investment. Additionally, it becomes more attractive to save because of the higher yield. As a result, there is less demand in the economy and inflation should theoretically decrease. Central banks target an inflation rate of 2-3% and will generally increase rates when inflation is outside of this target. For example, inflation peaked at 7.8% by the end of 2022 so the RBA aggressively raised interest rates from 0.1% in May 2022 to 4.1% by June 2023. High interest rates reduce demand in the economy, thus lowering inflation. 

The opposite is true for lowering interest rates. Borrowing becomes cheaper, and it is more attractive to spend as there are lower returns for keeping money at the bank. This will increase demand in the economy, driving economic growth. When inflation is within its target, and economic growth is not, central banks will generally lower interest rates. After the Global Financial Crisis (GFC), central banks around the world lowered their interest rates to nearly 0% to increase economic activity. This decade-long low interest rate environment had multiple effects on the startup ecosystem which we will examine in greater detail. 

Impact on Deposits 

The most obvious impact of interest rates are on your deposits. In exchange for giving the bank capital, you receive interest on this money. The yield you receive is impacted by the interest rates that the central bank sets for the economy. In a low interest rate environment, the impacts can go unnoticed as you only receive a small percentage, oftentimes yields can approach 0%. These low rates are common if you are a small startup and you manage your deposits with a large bank who offers non-competitive rates. You should consider using a cash flow management platform that can give you access to the most competitive yields for your deposits. At Primary, we generate millions of dollars for our customers by giving them access to exclusive institutional products with some of the highest yields available. When interest rates are high, this is even more important as founders can miss out on millions of top line revenue by storing deposits in low yield business accounts. 

Impact on Equity Fundraising 

While less obvious, interest rates will have an effect on the ability for your startup to raise equity capital from venture capitalists. However, this can sometimes have a lagging effect of twelve or more months so you should monitor accordingly. Venture capitalists also need to raise funds, they do this by fundraising from sophisticated investors. These sophisticated investors usually invest across multiple asset classes, and make their decisions based on the relative risk and reward profile of different assets such as venture capital, private equity, debt and public equities. When interest rates are high, venture capital becomes less attractive as its risk to reward profile decreases. It’s easier for fund managers to get higher returns in safer investments like term deposits. This means that venture capitalists will be able to raise less money, so there is less availability of equity capital for startups. 

When interest rates are lower, the opposite is true. More investors give money to venture capitalists because the risk to reward profile has improved. This effect has been seen over the last 10 years with near 0 interest environment fueling a record growth of the venture capital industry.  In 2011, venture capital investments in the U.S. totaled around $30 billion, while by 2021, the figure had skyrocketed to $329.6 billion. Now there has been a contraction in the market, as investors leave the asset class for lower risk returns, making it harder for founders to raise equity rounds. 

This is why it is so important to monitor interest rates and macroeconomic activity as it allows you to plan a fundraising strategy. When interest rates are low, you should consider taking advantage of this with a capital raise. Conversely, if interest rates are increasing, you should ensure that you have enough runway to survive a drawn out capital raise as equity fundraising will be more difficult. The key is to have good visibility to your runway, which our cash flow management products can help you with. 

Impact on Debt 

Founders can also raise venture debt, but it is very important to consider the interest rate environment when you do so. Venture debt is a type of debt financing that does not dilute your ownership of the business, and must be repaid with interest. Oftentimes there will be special terms such as covenants that the lender holds over the borrower. When interest rates are low, venture debt can be an appealing option, but founders need to consider more than just this. Good visibility into your cash flow management will allow you to determine if it is the right fit. Generally speaking, venture debt isn’t a good fit if your cash flow is volatile and hard to predict. Cash flow management software provides the visibility to see whether venture debt is a good option. This is particularly important as interest rates increase, and the burden of servicing the debt could harm your businesses financial health.  

Impact on Consumer Spending 

Finally, interest rates will have a big impact on consumer sentiment in the economy. This is especially important for founders in a B2C business. As mentioned before, when interest rates increase, so does the cost of borrowing. For households with a mortgage, their monthly interest repayments will increase, and their disposable income will decrease. This means there will be less consumer spending. Founders should consider the effect of interest rates on top line revenue and consumer demand when modelling their cash flow management. While it is difficult to model with precision in a multivariate world, it is helpful to be more conservative with cash flow management when economic conditions are worsening. 

Summary 

Every founder knows that managing cash flow is mission critical, but understanding economic trends is often neglected. We believe that good treasury management is about understanding the macroeconomic market and how that will affect your business. Using our platform, we make that easier for you. You can be confident that you are getting the best yield on your deposits, and complete visibility into your cash flow position that allows you to react dynamically to changes in the market.