Why the startup party is coming to an end

2020 and 2021 have been great years for startups. According to the Census Bureau, applications to form new businesses in 2020 totaled 4.4 million — a 26 percent jump from 2019. And new business applications continue to climb this year, with 3.2 million filed from January to July.

There are many reasons for the surge. Lots of people had to start businesses because they lost their jobs. Many corporate employees – those who are always so “slammed” – found themselves not as slammed as they claimed and took the extra time while working from home to start a business while still collecting their paycheck. Others simply launched side gigs selling crafts on Etsy, delivering food or consulting.

Most importantly, capital has been inexpensive, which has allowed investors and venture capitalists to provide lots of it to lots of entrepreneurs. According to financial services firm Ernst & Young (EY), through the first half of this year almost $140 billion has been invested in U.S. based venture-backed companies, a pace that is estimated to exceed last year’s record of $150 billion.

“Investors in 2020 were ‘defensive,’ meaning firms were deploying capital because they weren’t sure if there would be another chance,” Jeff Grabow, EY’s venture capital leader for the U.S., told Quartz. “This year we’ve gone from a defensive funding mode to a growth mindset and that is driving a lot of activity.”

It’s no secret that American startups have and continue to create products, services and technologies that have changed the world countless times over. They’ve only been able to do this over the past 10 to 20 years thanks to the trillions of dollars of capital received from the venture capital and investment banking industry. And those investors, in their endless pursuit of unicorns and multi-baggers, have turned to startup funding to beat the markets and make them billions.

So yeah, it’s been a startup party. But unfortunately, that party will soon be over. Why? Two words: interest rates.

Despite what officials are telling us, it appears more and more likely that today’s inflation is not transitory. Consumer prices aren’t going to go down anytime soon. They are rising at triple the rate we’ve seen over the past decade or so and will continue. Producer prices are increasing at an annual rate that exceeds 8 percent, and if you look at the breathtaking rise in the cost of core materials (iron and steel, industrial chemicals, freight, plastics and resins), you’ll see prices surging anywhere from 20 to 90 percent.

Our economy is awash in cash. The government has spent trillions in pandemic aid and is on the cusp of spending trillions more on “social infrastructure.” Banks are sitting on $4 trillion more in liquidity than they had a year ago. Our national debt is at levels never seen before and projected to rise to amounts that will make our current levels look prudent.

All of this creates a vast pool of unspent money that will, over the next few years, ultimately cause continued, long-term inflation for the simple reason that when you have too much supply of a product the value of that product decreases.

So, what’s next? To combat inflation, the Federal Reserve will step in and increase interest rates. Does anyone doubt that interest rates are going to rise, and that this increase will happen in the not-so-distant future? Ask any of the hundreds of owners of small and midsized businesses that are my clients and you’ll find that all – I mean all – expect this to happen and are already taking defensive steps like converting their short term variable debt into longer term commitments with fixed rates.

Rising rates means a higher cost of capital. A higher cost of capital means less capital available for small business and startups. Less capital available means fewer opportunities for entrepreneurs. All of this is coming in the next few years.

As rates rise, capital will leave equities and find respite in interest-bearing securities. It will flee to inflation-hedging options like real estate. It will turn away from investments that are riskier and more costly in a higher cost-of-capital environment. Venture capital firms will be pickier with their funding choices because there’s more to lose. Their investors will back away from the kinds of speculation they’ve done in the past because it will become too expensive. Investment bankers will gravitate towards options that will more likely keep up with these inflationary times, and those options will include fewer and fewer startup and early-stage businesses.

Of course, capital won’t disappear, and some startups will still get funding. There will always be later-stage businesses that can produce the collateral needed for bank financing, even at higher rates. But those firms and businesses will be fewer and further between than what we’ve been seeing these past few years. Capital will no longer be the commodity it’s been. And because of that, the startup party that we’ve been having over the past decade will come to an end.

Gene Marks is founder of The Marks Group, a small-business consulting firm. He frequently appears on CNBC, Fox Business and MSNBC.