While many investors do not know, inflation plays a very important role in the success of startup investments and is a key element that venture capital firms should not ignore. It has a huge impact on the returns of VC firms and without favorable market conditions and controlled inflation, even the most promising startup investments can falter. While many firms focus on factors like total addressable market (TAM), product-market fit, and scalability, inflation, and interest rates often don’t receive the attention they deserve.
To analyse the impact of Inflation and its impact on business, the European Investment Bank (EIB) recently carried out a study that highlights how inflation affects business investment, with high inflation and price uncertainty posing significant challenges. Today, we understand the importance of inflation, why VC firms should factor it into their plans, and how can they safeguard themselves from inflation risks.
The Concept of Inflation
Inflation refers to the rise in prices for goods and services within an economy. But what causes these price hikes? We can illustrate this with a simple equation:
MV = PQ
In this formula:
M represents the Money Supply in an economy
V stands for the Velocity of Money
P indicates the Price Level
Q refers to the Quantity of Goods and Services Sold
The relationship between inflation and the money supply is clear: when central banks print more money, it enhances consumers' purchasing power, which subsequently boosts demand and leads to inflation. The Velocity of Money describes how quickly money circulates through the economy, whether through spending or investment.
Pandemic Impact on Inflation and Money Velocity
During the pandemic, the money supply in the economy was high, driven by the large stimulus packages by the government along with the high amount of money printing by the government. Despite the high money supply, inflation remained low due to reduced consumer spending as consumers were staying at home and had limited spending options. This shows that a higher money supply doesn’t always lead to inflation
As markets reopened, increased pent-up demand stimulated spending and accelerated the velocity of money, resulting in significant inflation, particularly for essential items such as groceries and food.
Navigating Inflation: Essential Considerations for Venture Capital Investments
Historically, low interest rates have created a positive environment for VC Investments as investors get access to cheap capital and can easily invest in high growth startups, earning superior returns in the process. According to a study by the European Financial Management Association, a 1% increase in interest rates led to a decline in venture capital fundraising by 3.2%.
VC firms should play close attention to inflation as it impact their returns severely. During periods of low inflation and interest rates, everything seems stable, but rising inflation shifts investor focus to safer government bonds. Higher interest rates raise the cost of capital, making it harder for startups to raise funds, slowing growth, and lowering valuations—Klarna’s valuation, for instance, dropped from $46 billion in 2021 to $6.7 billion in 2022. Inflation also dampens market sentiment, prompting companies like Instacart and Stripe to delay IPOs or accept lower valuations. Additionally, startups face a higher risk of closure as rising inflation increases cash burn, with European startup closures rising by 20-25% in 2022.
Inflation-Proofing Your Venture Capital Investments
● Enhanced Due Diligence: Conduct thorough due diligence to evaluate how inflation impacts target companies’ cost structures and revenue streams
● Maintain Cash Reserves: Ensure enough cash reserves to support portfolio companies during inflation
● Portfolio Diversification: Invest in inflation-resistant sectors like real estate, commodities, and healthcare, and focus on startups with strong competitive advantages
● Adjust Valuation Models: Incorporate inflation into financial models to account for rising costs and margin pressures
Conclusion
In conclusion, inflation presents a formidable challenge for venture capital firms and their portfolio startups, influencing investment strategies and overall market dynamics. As evidenced by recent data, rising inflation and interest rates can lead to decreased valuations, delayed IPOs, and increased business closures. Therefore, it is crucial for venture capitalists to integrate inflation considerations into their decision-making processes. Ultimately, staying proactive in the face of inflation will allow venture capitalists to capitalize on emerging opportunities while safeguarding their investments.