A few weeks ago, the Federal Reserve raised interest rates by .75 points.[1] With this being the fifth increase this year, the Federal Reserve remains focused on fighting inflation, or at least attempting to curtail it.[2] Simply put, raising interest rates makes it harder to borrow, which reduces demand and, subsequently, inflation.[3] Because raising interest rates can lead to a recession, reducing inflation is carries risk.[4] But at the same time, too much inflation can also lead to a recession.[5] On a consumer level, raising interest rates lessens the demand for goods by raising the barrier of entry.[6] Without raising the sale price, it becomes more costly to buy big-ticket items that usually require would-be patrons to take out loans.[7] But how do these recent increases impact business?
Intuitively, when there is less demand, businesses will sell less and reduce the price of their goods. As prices fall, inflation can too. But how should higher interest rates affect a business’s strategy? Consumers are not the only ones who have a harder time borrowing money—it also becomes more expensive for businesses to take out loans.[8] Consequently, it would not be surprising to hear that business transactions requiring a lot of capital—which would ordinarily be acquired through a loan or line of credit—could be put on pause as a result. Whether a transaction will be affected by an increase in interest rates often depends on the corporation’s capital structure.[9] The more a business relies on a debt-based capital structure to finance their projects, the more likely it is that the business will be affected by a higher interest rate.[10] A business might require financing to get the company off the ground, maintain operations, or scale the business.[11] So then why wouldn’t a business not just increase the percentage of equity in its capital structure? Though this can be an effective tactic, it is not necessarily a bullet-proof one; high interest rates impact the stock market too.[12]
Do increased interest rates render all economic activity at standstill? No.[13] If a deal still needs to get done, companies have the ability to pivot. After interest rates were raised earlier this year, the M&A market, experienced a slight slowdown.[14] But this slowdown was not absolute.[15] If a deal needs closing either party can adjust.[16] The seller can reduce the purchase price, or the buyer can offer an alternative pay structure.[17] For example, instead of acquiring a corporation in an “all-cash” transaction, a buyer can offer to pay under an earnout structure, which is a pay structure where the buyer tenders consideration after the seller hits certain targets.[18] Earnouts are used in a variety of scenarios but are especially useful when there is a disagreement between parties or the buyer lacks of confidence in the seller.[19] The use of earnouts rose dramatically during the 2008 financial crisis.[20]
For example, in 2017, OFI Global Institutional, Inc. agreed to acquire SNW Asset Management Corporation for $8,000,000 upfront with an additional $6,000,000 to be broken up into three separate earnout payments, each worth up to $2,000,000.[21] While earnouts carry risks, there are also benefits.[22] On the buyer’s side, the earnout structure means that the buyer may pay more.[23] However, at the same time, the terms allow the buyer to make the acquisition.[24] On the seller’s side, there is the potential for a greater overall payout that is, of course, contingent on the seller’s ability to satisfy the terms of the earnout agreement.[25]
But how do startups needing initial funding navigate around high interest rates?[26] Startups can purportedly outlast inflation by employing creative and targeted action plans.[27] For example, an equity-heavy capital structure, where a corporation sells its stock to investors, has been proposed as a viable solution for startups.[28] This makes sense because equity does not change as interest rates fluctuate.[29] At the end of the day, however, the financing options for startups are much less creative than those available for more matured businesses. Unless your interest rate is fixed—meaning that the rate your responsible for paying does not deviate from the rate at the time you took out the loan—a higher interest rate will cost you.[30]
By increasing interest rates, the Federal Reserve intended to stunt growth. And while it is almost without question that growth will be slowed as a result, corporations are not deadlocked. As access to capital costs businesses more, higher interest rates will likely make businesses pause to question whether a venture is really worth it. And if a business decides that a venture is worth pursuing, there are usually financing options available.
[1] See Rachel Siegel, Fed Raises Interest Rates by 0.75 Points to Fight Inflation, Wash. Post. (Sept. 22, 2022, 6:00 AM), https://www.washingtonpost.com/business/2022/09/21/fed-rate-hike-inflation/.
[2] See id.
[3] See Jeanna Smialek, Inflation is High. How Will Rate Increases Fix That?, N.Y. Times (Sept. 21, 2022), https://www.nytimes.com/2022/09/21/business/interest-rates-inflation.html.
[4] See id.; see also David Rodeck, What is a Recession? Forbes Advisor, https://www.forbes.com/advisor/investing/what-is-a-recession/ (July 12, 2022, 2:47 PM).
[5] See Rodeck, supra note 4.
[6] See Siegel, supra note 1.
[7] See id.
[8] See Sampson Quain, How do Interest Rates Affect Businesses?, Chron , https://smallbusiness.chron.com/interest-rates-affect-businesses-67152.html (Jan. 25, 2019).
[9] See Capital Structure, Corp. Fin. Inst., https://corporatefinanceinstitute.com/resources/knowledge/finance/capital-structure-overview/ (Jan. 30, 2022); see also Joseph DeBenedetti, The Capital Structure for a Multinational Corporation, CHRON, https://smallbusiness.chron.com/capital-structure-multinational-corporation-81741.html (last visited Sept. 24, 2022).
[10] See DeBenedetti, supra note 9.
[11] See id.
[12] See Niels Martin Brochner, What the High Interest rates Mean for Startup Founders, Forbes (May 4, 2022, 7:45 AM), https://www.forbes.com/sites/forbestechcouncil/2022/05/04/what-the-high-interest-rates-mean-for-startup-founders/?sh=3badc79e6691; see also Q.ai – Powering a Personal Wealth Movement, Do Higher Interest Rates Hurt the Stock Market? Here’s how Strategic Investors Adjust as Rates Go Up, Forbes (Sept. 20, 2022, 7:15AM), https://www.forbes.com/sites/qai/2022/09/20/do-higher-interest-rates-hurt-the-stock-market-how-do-smart-investors-adjust-as-rates-go-up/?sh=a13bdc7b0fd3.
[13] See Marc Saracino, Effects on Inflation on M&A Deals, Campolo, Middleton, & McCormick, LLP (July 19, 2022), https://cmmllp.com/effects-of-inflation-on-ma-deals/.
[14] See Brian Scheid et al., Inflation puts Dent in M&A After White-Hot 2021, S&P Glob. (April 4, 2022), https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/inflation-puts-dent-in-m-a-after-white-hot-2021-69551549.
[15] See id.
[16] See Ana Calves, The Potential Impact of Inflation on M&A, Mergers&Acquisitions (June 7, 2022), https://www.themiddlemarket.com/opinion/the-potential-impact-of-inflation-on-ma.
[17] See id.
[18] See Byron Egan & Zachary Ward, Jackson Walker LLP, Earnouts in M&A Transactions, 1, 1 (2020).
[19] See id.
[20] See id.
[21] See Leaverton v. OFI Glob. Institutional, Inc., No. 21 CIV. 5659 (LLS), 2022 WL 4133369, at *1 (S.D.N.Y. Sept. 12, 2022).
[22] See Tommi Koponen, M&A Vocabulary – Explained by the Experts: Earn-Out,
Rödl & Partner, https://www.roedl.com/insights/ma-dialog/2019-06/ma-vocabulary-explained-experts-earn-out (last visited Oct. 4, 2022).
[23] See Egan & Ward, supra note 18, at 2.
[24] See id.
[25] See id.
[26] See id.
[27] See Joshua H. Davidson, 4 Ways Startups Can Beat Inflation, Entrepreneur (July 11, 2022), https://www.entrepreneur.com/starting-a-business/4-ways-startups-can-beat-inflation/429118.
[28] See Brochner, supra note 12.
[29] See id.
[30] See Matthew Gillman, How Federal Interest Rate Hikes Will Impact Your Startup, StartupNation (Feb. 14, 2022), https://startupnation.com/manage-your-business/accounting-finance-funding/how-federal-interest-rate-hikes-will-impact-startups-gillman/.
