The Federal Reserve Board voted Wednesday to raise interest rates, ending close to a decade of virtually free money--and that could mean financing challenges for startups and small businesses.

Although the move itself is minimal, with the Fed saying in a statement that it would lift its benchmark rate by a quarter of a percent, to between 0.25 percent and 0.5 percent, it has a huge symbolic value. The central bank is essentially signaling that the economy is on strong enough footing to begin a return to more normal monetary policies.

The impact of the adjustment is likely to be mild on most parts of the economy--for instance, slightly increasing borrowing costs for consumers and small businesses that rely on more traditional bank-loan financing. However, it could have an outsize influence on private company valuations and limit the size of startup funding rounds. 

"The Federal Reserve raising interest rates will have a chilling effect on late-stage investments, and it will bring down valuations across the board," says Venky Ganesan, a managing director of Menlo Ventures, of Menlo Park, California.

Impact on Startups

Many of these late-stage companies are known as unicorns, as their valuations exceed $1 billion, and they include car-share service Uber and apartment-share service Airbnb, which are currently valued at more than $50 billion and $13 billion, respectively. Unicorns have been direct byproducts of the low-interest-rate environment, financial experts say. More specifically, investors have sought the potential for higher returns from riskier assets like private company stocks, as safer investments like T-bills and bonds pay out next to nothing. 

As interest rates for these seemingly safer investments increase, they become more attractive to investors, and as such, the incentive for investors to plow funds into high-risk opportunities decreases. As a result, late-stage growth companies are likely to encounter more difficulty raising financing in the years to come.

Another reason the Fed's action will more likely to affect later-stage companies is that capital isn't invested in them for long periods of time, says Ganesan. Mutual funds, for example, have to determine the value of their holdings on a daily basis. Further, late-stage financing typically involves more debt, which by its nature is affected by interest rates, he adds.

To tweak interest rates, the Fed adjusted the federal funds rate, also known as the interbank lending rate, which is used by financial institutions to set the prime rate, or the base rate upon which other interest rates are set. The interbank rate has been at its lowest level, near zero percent, for the longest period in the history of the Fed.

By keeping interest rates artificially low, through a program called quantitative easing, the central bank tried to mitigate the negative effects of the recession by promoting investment in other asset classes. This has worked, to a large degree, with a seven-year runup in stocks that lasted until just this summer.

"The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective," the Federal Reserve said in a statement on Wednesday, suggesting other interest-rate increases are likely, but it would leave the new rate as it was for some time.

The Risks of Hiking Rates

Nevertheless, the Fed's maneuvering, economists say, is a tricky calibration, aiming to get its benchmark interest rate back to more historic levels of around 2 percent. If the central bank increases interest rates too quickly, it could risk tipping the economy back into recession.

And small businesses could feel the pain more acutely if interest rates go up too rapidly, says Thomas Cooley, professor of economics and former dean of the New York University Stern School of Business.

"A lot of new jobs are generated by small and midsize businesses, and if the interest rate increases dramatically, it could slow investment to this sector," Cooley says, adding that the increase in interest rates is also likely to further strengthen the dollar. That in turn could hurt exports.

One business for which this entire discussion is more than theory is Dymax of Wamego, Kansas. The company, which has 50 employees and about $10 million in annual revenue, manufactures custom-made equipment for the rail, mining, and forestry industries.

The low-interest-rate environment has allowed it to borrow to fund operations at levels that are about half the 10 percent interest rate the company paid for its financing more than a decade ago, says Clark Balderson, the company's chairman and chief financial officer. The cheap money has allowed Dymax to increase revenue and employees by about 50 percent since the recession, Balderson says.

But about 35 percent of the company's business is in exports, primarily to Australia.

The strong dollar, in addition to the recent rout in commodities markets, has caused overseas clients to take their time placing orders. And that lag could be exacerbated with the recent rate increase, Balderson says. To alleviate the impact of rising interest rates, going forward, and with credit assistance from the Export-Import Bank, Balderson says he will consider giving his customers more generous repayment terms, to ease their cash-flow issues.

"Do I wish [the Fed] would not do it? I think there are other ways," Balderson says. "But a quarter of a percent in interest is not going to be the end of the world."

Published on: Dec 16, 2015