As the US economy emerges from the severe economic dislocation of the pandemic, early indications point to a strong recovery in 2021, with GDP growth poised to exceed 6% based on annualized first quarter data. Expansionary fiscal and monetary policy, healthier household balance sheets, and pent-up consumer demand are likely to significantly boost economic activity. Concurrently, limitations in the availability of materials and labor are restricting the pace at which productive capacity can return to pre-pandemic levels. This confluence of factors is likely to result, at least temporarily, in a spike in the inflation rate. Indeed, as of the latest reading in May, Consumer Price Index headline inflation rose 5% year-over-year.
The jury is still out on whether the upsurge in inflation will become prolonged enough, or dramatic enough, to warrant quick action by the Fed. This is especially true considering the central bank’s recent policy shift toward average inflation targeting, whereby the Fed seeks to achieve 2% average inflation over time rather than committing to a 2% ceiling. However, at least directionally, evidence points towards a phase shift in the business cycle, with higher growth and higher interest rates on the horizon. In this context, it would be worthwhile to review some best practices and some key considerations that can help successfully navigate an inflationary environment.
Early-Stage Companies and Inflation
Companies in the early growth stages are in the business of converting investor cash into value enhancing innovations. Revenues are either non-existent or insufficient to cover business expenses without jeopardizing growth, thereby necessitating a continued ability to fundraise successfully and at reasonable terms. Management teams, as a result, work to optimize their capital raise plans by forecasting the cash needed to reach the company’s next value inflection point. An inflationary environment can disrupt this process, creating the risk of a shorter than planned cash runway, and a need for additional capital infusions before reaching planned milestones. To mitigate such risks, management teams might consider the following:
Plan conservatively, act early, and build in a buffer. Forward visibility and advance notice can go a long way in alleviating future cash flow pressures. Maintaining a detailed cash flow forecast of at least two years into the future is a good way to stay ahead of potential issues both when raising capital and planning expenditures. Nevertheless, a cash flow forecast remains just that, a forecast. Maintaining a cushion above the expected cash needs is therefore advisable.
Protect your cash. Inflation, by definition, erodes purchasing power. While business bank accounts might offer some yield, it is usually too low and has historically lagged far behind other capital market instruments in keeping up with market rates. As a result, management teams are faced with the choice of sacrificing liquidity for purchasing power, and in turn exposing their cash to investment risk. Some considerations to help manage these additional layers of complexity include sound financial planning and a solid understanding of management’s capabilities. A detailed forecast of future cash needs can play an important role in identifying an appropriate investment policy, while in-depth and ongoing due diligence on investment portfolios is paramount to controlling investment risk. For smaller management teams with limited time and resources, the investment management function is best outsourced to a qualified investment advisor.
Higher inflation doesn’t always mean higher inflation. It’s important to keep in mind that high headline inflation readings don’t necessarily mean the same applies to individual corners of the economy. Business managers and operators are best equipped to identify rising input costs and plan accordingly. Nevertheless, headline inflation remains important, if indirectly so, to the extent where it foreshadows rising interest rates.
Early-Stage Companies, Rising Rates and Borrowing
Over the last few decades, the Federal Reserve has been very successful at controlling interest rates to keep inflation in check. Rising inflation will ultimately lead to higher interest rates, which indirectly impact businesses through their dampening effect on economic growth. Higher interest rates can also have direct effects in the form of higher debt service expenditures and changes to capital availability.
Rising interest rate environments are known to skim the froth in financial markets as valuations return to more fundamentally justified levels and some over-levered companies may find meeting debt service obligations increasingly more difficult. Many early-stage debt or venture debt structures are provided with floating rate structures (i.e., Prime or LIBOR + a stated rate and a floor below which the total rate cannot fall). Therefore, as the index rates rise, debt service costs will rise accordingly. As business are forced to reserve a larger portion of available capital to service debt, cash runways are shortened. At the same time, higher debt service costs can result in an increased risk of violating debt covenants, which may necessitate paring back business investment to ensure compliance. Nevertheless, there are mitigating factors. Investors, cognizant of their narrower margin of error, may tighten their investment criteria, thus rewarding more prudent and conservative management teams as their investment universe shrinks. Some important considerations for early-stage companies in the context of a rising rate environment are as follows:
Identify and stick to a target leverage. There are a variety of reasons, some even unrelated to the borrower, why a lender may be incentivized to put additional capital to work. However, just because the capital is available, that doesn’t necessarily mean taking it is a good idea. Management teams must ensure that a capital raise today does not preclude the company from future access to debt capital. Broadly speaking, venture lenders tend to coalesce around a 50% debt-to-equity leverage ceiling. There are of course no hard and fast rules for what degree of leverage is appropriate for a company at any given time, but companies must be strategic about the amount of capital they need to increase value versus seeking maximum leverage. That determination should be made by taking a through-the-business-cycle approach.
Negotiate terms. The utility and cost of a loan are driven by the terms of the loan agreement. Negotiating terms that are satisfactory to the lender and appropriate for the borrower’s operating environment is critical in differentiating between a beneficial and potentially troublesome capital raise. As economic conditions change, one should ensure that covenant constraints are well within reach throughout the business cycle and that the loan facility structure and timing corresponds to company growth expectations and value creation milestones. Negotiating from a position of strength necessitates a sound balance sheet at the time of the fundraise, a solid knowledge of market terms, and a competitive bidding process.
Pick the right partner. Even in the best of forecasts, there always remains an element of risk that expectations may not be met. Since the future is unpredictable, it is highly important to engage with capital providers that are appropriate, supportive, and understanding, and take a long-term view when making investment decisions.