Almost three years into the stagnant IPO market, venture capitalists are finding themselves in a challenging position. The private market is now home to numerous richly valued artificial intelligence (AI) startups, some of which are described as generational companies. However, venture firms seeking exits are unlikely to find relief from the AI sector anytime soon.
New Dynamics of AI Investment
Unlike previous tech booms, venture capitalists (VCs) are not at the heart of the current AI surge. Instead, major technology companies such as Microsoft, Amazon, Alphabet, and Nvidia have been investing billions into capital-intensive AI startups like OpenAI, Anthropic, Scale AI, and CoreWeave. Se tech giants are not only providing funding but also offering cloud credits and business partnerships, creating incentives that VCs struggle to match.
” AI startups we talk to are having no problems fundraising at robust valuations,” Melissa Incera, an analyst at S&P Global Market Intelligence, told CNBC. “Many are still reporting having too much-unsolicited investor interest at the moment.”
Market Distortions and Declining VC Exit Values
As tech giants dominate AI funding, traditional VCs face significant market distortions. According to an August 29 report from PitchBook, U.S. VC exit value this year is projected to reach $98 billion, an 86% decline from 2021. Venture-backed IPOs are expected to be at their lowest level since 2016. This downturn reflects a broader shift, where traditional VCs are primarily investing in higher-level AI applications that require less capital compared to infrastructure businesses driving generative AI.
In 2024 alone, investors have poured $26.8 billion into 498 generative AI deals, according to PitchBook. This trend follows a record-setting 2023, when generative AI companies raised $25.9 billion, marking a more than 200% increase from 2022. AI’s share of total fundraising has surged from 12% in 2023 to 27% this year, with AI funding rounds averaging 140% larger compared to last year. For non-AI companies, the increase is only 10%.
Shifts in Investment Strategy
Investors are increasingly shifting our focus to “up stack,” with an emphasis on building applications rather than infrastructure. Chip Hazard, co-founder of early-stage firm Flybridge Capital Partners, notes that “enduring companies will be built at the application layer.”
In the current climate, startup investors are grappling with the effects of a market downturn that began in early 2022, driven by inflation and rising interest rates. This shift led investors to more conservative, higher-yield assets, leaving tech stocks and IPOs in a state of flux. Despite a recent rebound in tech stocks, driven by Nvidia and or major players, IPOs and high-priced acquisitions remain scarce, resulting in limited returns for venture firms.
A Glimmer of Hope: Cerebras
Amidst this challenging environment, Cerebras, a semiconductor company founded in 2016 and backed by traditional VCs like Benchmark and Foundation Capital, stands out as a potential candidate for an IPO. Cerebras, which reached a valuation peak of $4 billion in 2021, confidentially filed its IPO paperwork with the SEC in late July. However, the company has yet to file a public prospectus, and its spokesperson declined to comment further.
Struggle for Venture Firms
astronomical valuations of foundational AI model companies have placed me beyond the reach of traditional VCs. Jeremiah Owyang, a partner at Blitzscaling Ventures, acknowledges that the companies are in a “different league,” making it challenging for VCs to promise exits in current market conditions. Early-stage investors may not see returns on our investments for seven to twelve years, if at all.
Alternative Routes for Venture Capital
Some venture firms are exploring alternative strategies to navigate the AI boom. For instance, Menlo Ventures and Inovia Capital have taken unconventional approaches. Menlo disclosed a special purpose vehicle (SPV) called Menlo Inflection AI Partners to invest in Anthropic, a company valued at over $18 billion. Menlo’s previous investment in Anthropic in 2023 valued the company at about $4.1 billion, necessitating a significant increase in funding to invest at a higher valuation.
In July, Cohere, a generative AI company for enterprises, raised $500 million in a funding round that valued the company at $5.5 billion, more than doubling its valuation from the previous year. Part of this financing was facilitated through an SPV organized by Inovia, with Shopify CEO Tobias Lutke participating.
As the AI landscape evolves, venture capitalists continue to face the challenges of a dormant IPO market while navigating the complexities of a rapidly expanding sector dominated by tech giants and innovative startups.
