Originally published in The Information on November 2.
For the past nine months, nearly every investor with a Twitter account, blog or board seat has been beating a unified and constant refrain: The go-go days are done. Founders were being pushed to build 36 months of runway, whether or not it was actually feasible to cut costs that much. Time and again, investors told me due diligence was back. I watched as fundraising rounds that a year ago would have produced a term sheet in a few days stretched across a full month and dozens of pitches.
And then came Dall-E 2’s public release, quickly followed by a flood of wildly cool technology. (edit 12/8: And now ChatGPT!)
These events triggered a craze now ripping through venture capital land. We’re seeing billion-dollar valuations for companies peddling products based on generative artificial intelligence algorithms with less than a million dollars of revenue and no proven business model. Not long ago, the same behavior was held up as a cautionary tale about the excesses of VC over Web3 and instant delivery. Now we have a whole new era of exuberance on our hands.
The first thing to remember is that this ability to pivot from dark depression to fall-over-yourself excitement is at the core of the startup world’s future-building powers. Seen from another angle, the whiplash looks like optimism, and VC would have vanished decades ago without it. The entire venture model is about funding failure until you find success. There have been times where the entire industry seems to implode, only to come roaring back.
I won’t argue that every investor or founder is a walking example of this kind of stoic hopefulness. There are plenty of cynics puffing themselves up by tearing down other people’s ideas (something I—regrettably—did quite a bit of early in my career), and plenty of others who have no particular view on the future other than wanting to make money. The best investors and founders, though, are optimistic realists of the purest sort. This might come across as ignorant or naive, but sooner or later they usually end up being right.
Optimism is the key to understanding what’s happening on the frothy edge of the investing world. It would be easy to write off the generative AI craze—after all, there was an AI and machine-learning craze just a few years ago that didn’t lead to much of anything. Add to that the ongoing collapse of several waves of exuberance at once—crypto, fast delivery, public markets in general—and it’s difficult to believe that optimism will actually win out.
That said, I see four major reasons why generative AI has venture capitalists acting like it’s Q1 2021 all over again.
- It’s rooted in an archetypal category of futuristic technology, aka AI.
- There are any number of plausible paths that end in fat returns.
- The press has already thoroughly hyped the space as a whole and a handful of companies in particular.
- Most importantly, there are no public generative AI companies. As a result, there are no visibly crashing multiples or valuations to weigh down private valuations.
Coming out of the stock market crash at the beginning of the Covid-19 pandemic, the world did in fact change. Work shifted, shopping habits morphed and the value of venture bets hit astronomic highs. Companies that had been private for a decade decided the time was right for blockbuster initial public offerings, and Wall Street said, “Hell, yes.” That meant big payouts for all the venture investors who’d been patiently waiting for their exit opportunities. As returns surged, new fund sizes surged, and the FOMO cycle kicked in all along the chain.
Suddenly it was easy to be optimistic—too easy. Wherever there was software, or even just the idea of software, there was the promise of quick wealth. Then many of the equities that went public to great fanfare quickly fell off a cliff, taking a whole lot of optimists with them.
By spring this year, pessimism seemed to have set in. On its face, this was more than a bit baffling. It’s not as if much value has been destroyed—sure, the valuation of, say, Coinbase has dropped more than 80% since its public trading debut, but a market cap of $15 billion is still incredible. Plus, as I’ve already argued, investors are sitting on huge piles of money and they have an obligation to invest.
What’s become clear in the last month is that the ancient optimism wasn’t dead, it was merely hibernating. Maybe you could have seen this from the ongoing drumbeat of new fund closes. If you’d talked to the right investors, you’d have discovered that they were still doing deals, just quietly. The market was waiting for a catalyst, and now it has one.
It’s important when thinking about how VC works over time to remember that venture investing is driven by narrative more than it is by data. Early-stage companies are valued on their promise, not on what they’ve done. On top of that, an awful lot of venture capitalists devoured science fiction as kids and now, as adults, they fixate on how new technologies can shift humanity. Even if we haven’t yet figured out a positronic brain or proton micropile, AI always tickles that old childhood fascination.
Generative AI especially offers tantalizing possibilities. If this new stuff can write marketing copy, is it good enough to topple the world’s largest advertising agencies? It’s possible that image generators will soon remove the need for commercial photography. Maybe we will finally get a conversation engine that makes customer service less awful and renders the call center business obsolete. Each of these is a giant opportunity, and we’ve barely scratched the surface.
With the narrative pieces in hand, investors have another hurdle to overcome: peer pressure. Some investors seek out genuinely novel bets, but many want the safety of going with the crowd. Generative AI satisfies both desires, having both whiz-bang appeal and enough press attention to give timid investors cover.
It’s all good news for venture capitalists and founders in the generative AI world right now. That won’t last, but right now, it’s easy to argue that the future is bright and golden. Even more, it’s difficult to tie these new companies to the types of public assets that have been hammered of late. Generative AI isn’t software as a service, so SaaS multiples are irrelevant. It isn’t a token, so crypto winter doesn’t matter. For the moment, at least, nothing can spoil the party.
All of this is great for the tech ecosystem, including for founders not currently building generative AI companies. That’s not to say companies should start adding random image generators or copywriting features to, say, payment processors. That would be foolish, though I’ve seen worse (not every videogame needs non-fungible tokens!).
The lesson for founders is that investors are looking for reasons to be optimistic. Sometimes that means cutting back on hiring or reining in growth plans, but the really savvy founders will find ways to convince investors their companies are the ones that can swim against the current.
Let’s all hope generative AI fulfills at least a quarter of the promises people are making in its name. In the meantime, optimism is contagious, which is good for everyone.