In my last post, I discussed the challenges of investing in AI startups and how it caused hesitancy for investors. So, who will be investing in AI startups? Those who are very informed about artificial intelligence and those with enough capital to take the risk.
Who Will Be Investing in AI? The Experts
It seems that people who are very knowledgeable about artificial intelligence will be making many of the investments in this space. One example is the Open AI Startup Fund. It was the recent subject of an article on TechEDT called, “How OpenAI is shaping the future with its startup investments.”
The article is summarized by Emma Job at TechEDT:
“OpenAI’s Startup Fund has backed multiple AI-driven startups across industries, raising millions to support innovation in robotics, healthcare, and more.
Unlike other large tech companies, OpenAI does not invest in startups using its own money. Instead, the OpenAI Startup Fund is backed by external investors, including Microsoft, one of OpenAI’s biggest supporters, along with other OpenAI partners, according to the fund’s website.
Since its launch in 2021, the OpenAI Startup Fund has raised US$175 million for its main fund and an additional US$114 million through five special purpose vehicles—investment pools created for specific opportunities.”
The OpenAI Startup Fund is a good example of who will be investing in AI and a fund that will likely succeed in artificial intelligence. This is because its partners are knowledgeable in AI and have pioneered some aspects of it. They should be able to separate the good deals from the bad ones. They also have the skills to help build successful companies.
Other likely successful investors will have large, stable funds as well. I’ll explain why below.
Who Will Be Investing in AI Besides the Experts? Those with Large Funds
When trying to determine who will be investing in AI startups, my main concern about the fund is its size.
As you may know from my previous writing, I do not like small venture capital funds. How do we define small? To define small, we must look at what is required to succeed in the venture capital business.
The Problem with Small Venture Capital Funds
Irregular fluctuations in the IPO market heavily influence the venture capital industry. When IPOs are hot, and VCs have liquidity, the limited partners flood money into the industry. However, when the IPO cycle is depressed, and VCs have little or no liquidity, it is difficult for even the top-tier VC funds to raise additional capital. This IPO cycle is poorly understood, except by the VC funds driven out of business by it. This erratic cycle is the main reason the VC industry is so top-heavy.
The large funds that can protect their portfolios keep generating positive returns and attracting more capital, and the smaller funds get driven out of business. Here is a quick look at the IPO drop-offs over the past 45 years:
- 1988, caused by Black Monday, October 19, 1987, when the DJIA fell 22%.
- 2001, caused by the dot-com crash; recovery in 2007, although there were a few IPOs in prior years
- 2008, caused by the real estate crash; recovery in 2014/2015
- 2016, caused by market volatility and an excess of private capital; strong recovery in 2021
- 2022, caused by a drop in stock markets; recovery in 2024
So, suppose your venture capital fund is close to 100% invested when the IPO spigot turns off. As your portfolio companies require additional capital, the investors with dry powder will continue to support the companies. But if some of a company’s investors are fully invested and unable to continue their support, new shares will be issued at lower prices, the non-participating funds will be heavily diluted, and they may be unable to raise the next fund.
So, How Much Capital Does it Take to Survive One of These Low-IPO Cycles?
Studies have shown that a VC fund needs about 30 investments to be properly diversified and have a decent chance of making an attractive return. If a small VC fund plans to make initial investments of $5 Million in 30 companies, it needs $150 Million to begin. It should probably allow at least another $150 Million for follow-on investments to support its original investments. This means it needs at least $300 Million after subtracting its operating fees. This usually means 2% per year over at least 10 years, or, 20% of the fund’s total. In other words, the fund would have to start with $380 million.
Now $380 million may sound like a pretty sizeable venture capital fund, but suppose that one of the IPO doldrums occurs when the fund becomes fully invested. The fund may have to continue funding some of its portfolio companies for 6 or 7 years, with no remaining capital. So, it will likely get heavily diluted, making it difficult to raise another fund. By this logic, a small fund is probably one with less than $500 million in capital.
Therefore, when determining who will be investing in AI, despite the challenges, we can safely assume it will be larger funds.
I suspect that the OpenAI Startup Fund will have enough access to capital to survive, but their best hope is to create a couple of AI Unicorns before the next dip in IPO activity.
Expertise and Large Funds is A Winning Combination
A greater source of venture capital for AI startups is likely to be some of the more strategic, traditional top-tier Silicon Valley venture capital funds that will recruit partners with expertise in artificial intelligence. I would not be surprised if some of these funds are building AI teams or even establishing separate AI-focused funds.
Here is an interesting article from Forbes: “Venture Capital’s New Era: AI’s Journey From Enhancing Operational Efficiency To Alpha Generation”.
According to this article, some traditional venture capital firms are developing strategies for dealing with Artificial Intelligence. Having invested in two of the early Sequoia funds and worked closely with them some years ago, I think they have always been one of the most creatively strategic venture capital funds.
It also states that VCs are using AI to identify potential founders of AI companies rather than waiting for the companies to come to them. This makes enormous sense to me and solves the problem of determining “Who wrote the business plan?”
Ultimately, it is an exciting time for Artificial Intelligence and those who will be investing in AI. But the challenges and rewards will be different than those we have seen in the past.
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