Recently a four-week-old startup Mistral AI, that is yet to develop its first AI product raised over $100M in venture funding in midyear 2023. Another three-month-old AI startup founded by former Salesforce co-CEO Bret Taylor and ex-Google executive Clay Bavor raised its first funding round at a valuation of over $100M and another early-stage startup Inflection grabbed $1.3B at $4B valuation despite only being a year old. AI startups have defied the decline in VC funding of the past 18 months, collectively raising $16B this year. Even excluding Open AI's $10B round, the AI VC funding in 2023 has surpassed 2022 total and deal pace has remained steady with median post-money valuation is up >100% from 2022. It is true that most VCs have become cautious in executing deals in the current macro environment, the enthusiasm level of some investors to plow capital into early-stage AI startups reminds the exuberance of Crypto, Remote Work, Rapid Grocery Delivery, and Metaverse in 2021. In 2021 we saw herd mentality across the tech industry but right now we're seeing it in AI. Experts can argue that the scale of AI opportunity justifies the investor hype. At Service Ventures, we believe that a herd investment mentality among VCs has taken hold AI that is really the nature of the VC business - when a technology gets hot, there's a massive push to be involved and own a piece of the activity.
VCs cannot afford to miss out a technology cycle
Investing in isolation is difficult in the world of VC where quality deal sourcing relies on networks. VC as an asset class takes many years to see the real outcome of an investment. VC business runs in step changes in operating conditions, unlike a traditional business where incremental projections are carried out carefully on top of past performances to create future business perspectives. Unlike other investors, a VC must take a “high degree of calculated risks” to create that outsize return. Missing out on a big wave of innovation trend like AI carries a lot of risk to their fund performance and the net return to LPs. The key that differentiates great VCs from mediocre VCs is “high degree of calculated risks” outside of a typical herd approach. To be truly authentic VC in a herd climate, it takes a certain degree of psychological stamina. Pounding your fist on the table to advocate for a startup that other VCs don't see, is a tough ask. We see that VCs having convictions on AI plays are lacking to some extent today. Whether the hype around AI is froth like those in 2020/2021/2022 (rapid grocery delivery) or if there is something more, needs to be evaluated carefully.
DNA of Mediocre VCs
When a big technological leap like AI comes along, it's safer for mediocre VCs to follow the herd as investing outside the technology trend becomes risky - if the investment outside the flavor does poorly, you will not be able to raise the next fund. We have observed that the temptation to follow a hot trend blindly is strong with inexperienced VCs who seek validation from peer VCs. For quality deals, VCs must have close sources in the ecosystem that inherently influence their investment decisions. As a mediocre VC, being part of a deal that includes quality VC firms offers validation. If the investment does well, you are in 30 Under 30 list. If you make the wrong call as a herd, LPs won't catch up with you for a few years. But at the same time, seasoned VCs take a deeper look at the technology and scale of value it could create across various aspects of the ecosystem to make truly differentiated investments. Such investments might come as off the rail investments, but only a VC that has carried out the necessary analysis with acumen and facts could back such a startup. Following technology hype could overcrowd deals leading to inflated valuations, as most VC got into in 2020-2022.
Herd Mentality on Both Ends
Herd mentality becomes stronger in a downturn than it is in the upturn, as upturns offer more avenues to invest that have a greater chance of succeeding, regardless of quality of the startup – even a blind monkey finds a banana from time to time. But in tough economic environments, only having conviction on a play and writing checks rather than taking a wait-and-see approach could provide outsize returns. Under the current environment, lack of liquidity and fundraising challenges have slowed the pace of dealmaking, but we think now is the best time to invest given the valuations are investor friendly. On the other end of the herd mentality, we also see some VCs just focusing on their portfolio w/o investing in new deals.
The Right Investment Approach
We think the right investment approach for VCs in AI is to be in the herd (as you don’t want to miss out on a trend) and define/lead an aspect of the AI technology trend by creating several convictions about AI capabilities in the value chains. Differentiated VCs know that having a conviction play can generate outsize returns, but alone a single investor cannot build a successful startup. Startups need follow-on capital to scale, and a set of VCs are needed to be convinced of the business potential and the sector. A pool of collective capital into a new sector is also required to push forward the technology and increase the number of startups and attract the best talents to that area. That’s why top VCs play inside the trend by defining an aspect of the trend, getting in early, having other investors come in later to push up valuations that lead to superior outcomes. We are keeping a watch on AI startups as we are aware of the current market dynamics of technology defensibility and category-defining businesses models. While hype persists in AI, and almost certainly will, we think it's okay to follow the herd, as long as one does not follow blindly.
/ServiceVenturesTeam
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