Most people expect the Fed to lower interest rates soon. But if they don’t, startup valuations will shrink more than you expect: probably lower by 50%+ from where they were just 2 years ago.

Paul Krugman recently wrote an article called “Are Bonds Going to Party Like It’s 1999?”. In it, Krugman offers a mea culpa on interest rates. Until recently, he was convinced that higher rates—currently 5.3%—were a temporary post-COVID phenomenon.

Now, though, he’s not so sure. Like the economy of the late 1990s, higher than expected inflation and population growth due to immigration could force the Fed to keep interest rates above 5%+ indefinitely.

While this would have huge economy-wide effects, I’m more interested in what this potentially means for the venture ecosystem specifically. Obviously, it wouldn’t be good.

It’s important to be precise. If interest rates are high because due to technological progress there are many opportunities for profitable investment, that’s great for everyone including the venture ecosystem. In this scenario, rates are high because investors need a higher return to convince them to invest in a bond rather than a profitable technology company.

Conversely, if rates are high because of inflation, there are fewer dollars available for non-productive, money-losing investments (like most venture-backed companies). Because venture investors have to earn a return above the risk-free rate (or else why invest in risky companies when you can earn 5% risk-free?), a higher risk-free rate means even fewer companies will achieve returns sufficient for a venture investor to make a profit, and even fewer ventures will get funded.

But, how much? Let’s quantify. We learn in Finance 101 that the value of a business is based on the total value of its future discounted cash flows. The discount rate is a function of many factors but long-term interest rate expectations is the biggest one.

If long-term interest rates end up at 1% vs., say, 5%, I think a reasonable discount rate for those cases would be 8% and 12%, respectively. How much does the value of a dollar of cash flow differ in these two scenarios?

In 10 years, in the higher discount rate world, a dollar of profit is worth 30% less. In 20, it’s 52% less. 30, 66% less. 40, 77% less. 50, 84% less.

The overall discount rate difference is a function of the expected long-term growth of a company, but it’s safe to assume companies with profits far in the future are worth at least 50% less with 5-1% difference in rates. This is the magic of compounding in reverse.

I keep hearing from friends in the startup world that the VC environment will improve when the Fed cuts rates. It certainly would if that happens. But the path of interest rates is notoriously difficult to predict.

If rates end up staying around where they are today or land higher than previously expected, the VC landscape will likely settle in a very different place than a few years ago.