What Is ZIRP And How Did It Poison Startups?

Uhoh, one of the sinkholes, so to speak, that the money could go into is the asset class known as venture capital. And sinkhole it is.

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All right. This is Dalton plus Michael, and today we're going to talk about what is ZERP and why did it mess with the startup world?

I love the term ZERP! Explain to everyone what ZERP is. The actual term ZERP is one of those words that I find myself using a fair amount, that I often will be asked to pause and explain, “What was that word you just said?”

Yes, and so we are saying the word ZERP. ZP.

Yeah, you gotta say it like that. You gotta say it like that. You gotta say it like that. ZP.

Yes, and that is an acronym, right, for zero interest rate phenomenon? Yes, that's the period we lived through that ended as COVID was F.

Yeah, so in this time, the interest rate set by the Federal Reserve in the United States was zero.

Yes, some banks in Europe, you had to pay them. Yes, they had negative interest rates.

Yes, and so look, we're not economists. We're not bankers. I think sometimes people think venture capital is the same thing as banking and private equity. I don't even think I'm a venture catalyst. I'm definitely not an economist.

Well, our industry is pretty like, we don't know anything about this stuff. We are not Wall Street people. We worked on building websites, basically. Um, was what we did.

Let's explain ZERP to you now.

Yeah, so we don't know anything about this, so we're going to explain to you this is YouTube, right? Um, that's how this works.

Exactly how this works. Well, I'll say this, you know why we know about this? We've been victims.

Yeah, we've seen the downstream effects. I can confidently tell you we've been ZERPed on quite a bit.

All right, so how did ZERP affect the startup world?

And then we can talk about... let me say this would you been before?

Oh, please. Let's talk about the flow of money.

So let's talk about the flow of money. Wiser.

Okay, yes. So there's money from the Federal Reserve and banks could basically get it for free again.

You can, if you're interested, you research this from someone much smarter than me on this topic. Banks had to put it somewhere, and it was hard to find a place to get yield, which was higher interest rates.

Everyone had to, and so they dumped it into stuff like mortgages. This is why mortgage interest rates were so low.

Um, for banks like First Republic or SVB and all these people were searching for yield, like the money needed to find a place to go.

Yes, and by yield you just mean like I want to make more money. 0% which is what you get from a bank, which is zero.

Yes, okay. And so what happened is a lot of this money ended up in alternate strategies, which include things like real estate, I'll uh, WeWork, yeah, or buying wacky stuff, again, that has nothing to do with us.

But one of the sinkholes, so to speak, that the money could go into is the asset class known as venture capital. And sinkhole it is; it will consume any amount of money it is presented with.

Ex. And so what happened is all of this money floating around in the world ended up going to VC funds or family offices, who suddenly dramatically ramped up their rate of investing.

Yes, because they had access to it because the money had to find a place to go.

Yes, and so, you know, the spice must flow. Like, it found it found a place to go.

Well, and let's be clear, their motivations are that the more money they're managing, the more money they make.

Yeah, so the more money they're distributing out to investments, the next time they can raise the fund, they can management fees, stack those fees.

And so there was a whole downstream effect of this money coming from wherever directly into people at demo day.

You know, not just people. D. Just the whole… you know, I was thinking as you said this, I was thinking about an analogy: America subsidized corn, and then suddenly everyone was motivated to figure out, like, what can we do with corn?

Like, can we use corn to make this? Can we use corn to make that? High fructose corn.

Yeah, like we can find, if you have a problem, we can find a corn-based solution.

Hey, you guys want some corn? We got corn.

Yeah, that was money.

You want money? Money.

That was money! Hey, there's— I see a problem, let's put some money on it.

Do you not have product-market fit? What if we throw some money at it?

Like, are your margins negative? What if we threw money at it?

Like, do you not know what you're working on? Money.

Well, again, what's fascinating is a lot of these folks had not done startup investing before either.

And so a lot of—imagine someone that all they've done is run like a hedge fund, trading stocks.

Yes, where they're like, “Oh, go buy 50 million of Google stock,” or whatever. They were treating investing in startups like investing in stocks.

Well, I loved it because there was one firm we interacted with, who was like, “Well, you would value, you know, public market companies using this rubric, you know, companies generating like 500 million plus in revenue but often billions.

We will just downsize that rubric to companies generating a million dollars in revenue because they're both companies. Why wouldn't we just analyze them the same?"

I don't know if your argument will be self-evident to our viewers. Okay, to us, that is crazy.

Explain why that is crazy.

Because, needless to say, like the failure rate of companies that are at 1 million revenue today getting to 500 million revenue ever is massively high.

Yes, like there aren't as many publicly traded companies that just like die.

No, whereas million-dollar revenue companies are dying out minutely.

Yeah, minutely. So, you know, this investor was like, “Wow.”

And I remember we were talking to them, and I remember just being like, “So, you’re just going to give these folks that don’t know what they’re doing a lot of money?"

And they were like, “Yes.”

Well, because they were running their own arbitrage. Because they had hot money from other people, they're basically middlemen.

But they were a good sinkhole for money.

Yeah, and again, what's fascinating to kind of complete Michael’s story—

Yes, is once the market turned and interest rates went back up, they got out, done! They got out of the business. They’re gone.

They don’t do venture anymore. They were just out of town, blew out of town.

But hey, during this time, it was amazing. Like we had founders who would ask for introductions to these people, but this is how the founders would go.

This is how the founder would say it: “I heard if I talk to these folks for 30 minutes, they’ll just give me a like, and then like in multiples of 10 million dollars.”

And I remember because like other VCs were trying to kind of compete and they were just like, “How do we compete with this? Like 30 minutes? $40 million?”

Well, and Michael, I bet there's a lot of people watching this saying to themselves, “This sounds great. Why are these guys laughing about it?”

Why wasn't it great, Michael? Or like, what was the downside of this?

It turns out that if money was the only variable to making your company work—one, startups wouldn’t work because all the incumbents have way more money.

It's true—Apple has a lot of money, like all the money. All the money, effectively, right?

Two, um, it turns out that like when you give money to someone, they stop innovating, and they start spending more money.

Why do we have to have better software? We can just hire more people to fill in the blanks.

Why do we have to do things better? It turns out when you give people more money, they start acting like the big companies they're trying to disrupt.

But also, it turns out the opposite is true. When they can’t afford, they figure out how to do without, and that often creates the innovation.

So it's just kind of like we’re going to give you money. It’s poison!

Like, would you like—how much poison would you like? You can drink as much as you want; we have infinite poison in the back.

Like, can I give you more poison? It’s shaped like money; it's going to kill you.

But hey, let's be clear, some founders, for them, the money wasn't poison.

Yeah, right, but that was a smaller percentage than you might think.

So that's also when we saw the explosion of the unicorns. Remember when unicorns used to be rare?

Mag, that was I think why they were called that. That was the— the name was it was meant to be a rare, infrequently cited thing as unicorns are rare and infrequently cited.

What that ended? Yeah, we would see them on a weekly basis, basically.

Again, I would have to get the exact numbers, but I seem to recall on a weekly basis it was a marketing thing, right?

It was like, "Well, I'll give you a billion-dollar valuation, and you can be a unicorn."

Yep! The second you name something, you like begin to destroy it.

I was like, what’s interesting is I remember during this time I was sitting in a board meeting and the founder was complaining that all the companies were too expensive.

This company had cash. They wanted to buy a company, and it was just everything was too expensive.

And he said something that, like, tricked me a little bit, got my thinking. He’s like, “The revenue to valuation multiple.”

And I was like, “Huh?”

You—that seems to make sense, right? The amount of revenue you're making versus your valuation, like that would be an easy way to tell whether something's cheap or expensive.

Like if your company’s making like a billion in revenue and it’s worth like, I don't know, 5 billion in valuation, that’s cheaper than if your company is making 5 million in revenue and it’s got a $5 billion valuation.

And then I thought I should just like look around at some of these startups that are raising unicorns.

I should kind of like check out Tech Crunch and see what is this revenue to valuation multiple.

When I saw that a company just raised at a 350X multiple, 3 million revenue, billion-dollar valuation, I was like, “Huh?”

I remember when Justin TV and Twitch had 3 million revenue.

Like I’m like, “Huh?"

Like, did we have—what percentage of things figured out did we have? Like 1%?

And man, and then suddenly it hit me; I was like, “Oh no! Like this is not gonna last.”

And remember like this was the start of the new YC standard deal when we were starting to think about this, right?

Like this is not going to last.

Yeah, I mean for what it’s worth, you know, uh, if founders that were in The Bachelor in those times or people we did office hours with could probably back us up here, but we were definitely advising founders that the music would probably stop.

Something about what was going on felt like ZERP again, which is the tile— you know it was like this is—there's a lot of side effects of this zero-interest rate thing going on.

Yes, let's not count on it lasting.

No, and so make some smart moves now to prepare for the winter that will be coming.

Yeah, right, and I can't tell you how many founders were just like, “No, this isn’t winter. This is just—we’re just getting started. This, we’re ZERP. We’re just—this is great! It’s GNA, go! I don’t know what you’re talking about.”

Crazier than this?

And it's weird, 'cause I don’t—you know, I didn’t live through the '90s, right?

The '90s in my life, the tech boom was just like a story other people told.

And it is so effed up that like we saw it—wasn't an exact replica, it happened in the private markets, not the public markets, but damn near!

It was wacky.

I mean, just to give a concrete example for folks, because money was so cheap, so to speak, yes, lending companies made a lot of sense because when you're doing lending, you need a lot of capital to lend out to people, and then they pay an interest rate, right?

Yep.

And so if your cost of capital is very low and you just lend it a lot, boom, it works.

And as it would turn out, money has product market fit always, and lots of companies were like, “Oh, we’re just going to do lending for X,” you know, you name it.

Yeah, and they're like, “Wow! We got product market fit, a lot of people want this thing called money.”

We—anywhere, we're product geniuses!

Unbelievable that people want this money thing that only we have, and it’s very defensible.

And then what happened is when interest rates went back up, the cost of capital for these businesses went up, and it was hard for them to pass that along to their customers.

And so, kind of like overnight, there was a whole class of types of businesses that became very challenging.

Well, it was sad too, because I think that it also screwed with the people who were observing this and thinking about doing a startup.

Everything got so inflated that you started seeing founders coming into YC being like, “Oh, well, my seed round should be $10 million.”

And it’s like, what are you g going to do with 10 million?

“Well, I just raised a $10 million seed!”

Yeah, they were entirely keeping up with the Joneses!

Like, the entire conception of startups is to like read articles about what other companies are doing and being like, “I want that,” and “I want to top it.”

Yes, and there was a lot of trying to top everyone else going on.

And it was sad too, because I would say I observed two types of VCs during this period of time.

Uh, three types, let’s say three types of VCs.

Type one was like, “There isn't a problem; this is Tech Heyday, and we're just—we’re providing very real valuations to these companies. We just understand that Tech is going through a Heyday.”

Interesting.

Group two, “I know this is screwed up, but I’m going to do it anyways.”

Right?

Like, like, like, like, you know, it's the game we play.

Like, if you get me in a room in private, I'm going to be like, “Eight of the last deals I did, I priced really dumb, but you know, my LPs are cool.”

And then there was a third group, and this group was small, and we know some of them, who were just like, “Count me out. I’m GNA, hold on to my capital.”

Um, in the investment game, you invest when things are undervalued, and you don’t so high.

Yeah, that’s— I heard that somewhere. I'm not an economist.

And there were some of them who did that, and who were rewarded for it. People who knew it was a problem or still participating.

But Michael, here’s a question I imagine someone might be wondering.

Yeah, weren't you guys part of the problem?

Yeah, yeah! And it's tricky, right? Because like on the early stage, one of the things that insulated us is we have a standard deal, right?

So we don’t have to deal with this valuations, valuations.

Um, but we had a growth fund, yep, and yeah, like that demo day auction during those PR times, they were crazy.

Well, and I think we always suggested to folks that the key to greatness is to build a great business.

Yes, makes so mil people want— we really believe this stuff.

Yes, and so we're advising people even at the height of the stuff, “Hey everyone, like don’t pay attention to all this noise.

Yeah! Try to build something enduring.”

Yes, because the waves of the larger economy go up and down, and it's going to take a long time to build a startup.

So if you’re in the batch, trying to time the market is like the silliest thing of all time because you need 10 years.

What will the market look like 10 years from now?

Different! Different!

And so it was always like, “Yeah, you know, yeah, it is unlikely that anything going on now in the wider world will affect your current batch startups.”

And that was a very consistent message, a very consistent we had for folks.

I think though that, um, the bigger lesson though happened when the market corrected and we started to see what people did with that money.

Yep, and I will say, like, some companies they took that capital, and like, they can run their business profitably. They don't have to raise another round until they IPO.

Those founders were very smart!

Other founders, they spent that money.

Yep, and then when they tried to get more, and it’s sad because, um, if you build your business around an unsustainable phenomenon, and then that phenomenon goes away, what happens to your business?

You know, move fast, you don’t have anything!

It's like platform risk!

This is like platform risk on the Fed!

Yes, yes! Your business only worked when there was nowhere else to invest in the universe.

The second there’s anything better to invest in, immediately all the money will come out!

Yeah, it's like, so I think that like, you know, in this aftermath, you know what’s interesting is there are still some industries that maybe are, uh, have some ZERPy qualities, right?

How do you think about that?

Like there are hype industries right now. I think as a founder your job is to just balance optimism with realism.

Yeah! And be exactly on the right balance level, and the folks that even at the height of this stuff, they were always optimists!

They’re like, “Hey, my company could be great!”

Yes, and they took advantage of some of the stuff on offer, fair enough, yes.

But they knew that this wasn’t going to last, and they planned.

They were such a great balance of optimism and realism, and I think regardless of what the time period is, that’s where you want to be.

Yeah, and if you’re too— you know if you're too negative, if you're too, like, “This is a bubble; you know, the U.S. government’s going to collapse,” or you know—
Okay, good luck with that!

Um, but that’s—that’s an extreme over here on the negative side.

But if you're like too optimistic, that’s bad too!

Yeah!

I like that! Optimistic but real, and like understanding that you have to build your business in many different economic climates.

Or like, hell, like why not?

Why not build your business so that it works in bad economic climates so when times are good, it’s even better?

Yep, so there you go! So that’s ZERP, zero interest rate phenomenon.

And here are two highly trained economists who now we could build you a website!

I don’t know.

You need a website?

This is like The Big Short movie, where like they have all these actors explaining to you like how like the '08 crisis happened!

I could write some Python code if anyone—

I can, I can make you—

I can write Python! Anyone out there that wants, we can make really good box!

All right, Dalton! Great!

CH, thanks!

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