The tech giants' massive investments in AI are skewing the VC market.

• Unlike previous tech booms, this one is being financed by tech giants such as Microsoft, Amazon, and Nvidia, instead of traditional venture capital firms.
• The IPO drought, which has been ongoing for almost three years, is making it even more difficult for the venture industry, which is already facing challenges.
• According to Chip Hazard, co-founder of Flybridge Capital Partners, VC funding is moving "up the stack" and companies that will endure will be constructed at the application level.

The venture capital industry is facing challenges three years into a sluggish IPO market.

Despite the presence of highly valued AI startups in the private market, including those referred to as generational companies, venture firms seeking exits won't find relief from AI anytime soon.

Unlike previous tech booms, VCs are not the main players in this one. Instead, the largest companies in the industry, such as Microsoft, Amazon, and Google, are investing billions of dollars to support the growth of capital-intensive companies like OpenAI, Anthropic, Scale AI, and CoreWeave.

The lack of profitability metrics and the absence of pressure to go public make it unlikely for these well-capitalized companies to showcase their generative AI startups to public investors.

Tech giants offer more than just money; they also provide tangible benefits such as cloud credits and business partnerships, which VCs cannot match.

"S&P Global Market Intelligence analyst Melissa Incera stated that the AI startups they interact with are not facing any difficulties in raising funds at high valuations. In fact, many of these companies are still receiving an overwhelming amount of unsolicited investor interest."

The U.S. VC exit value this year is projected to be $98 billion, a 86% decrease from 2021, according to a report from PitchBook. Additionally, venture-backed IPOs are expected to be at their lowest since 2016. While traditional VCs are actively investing in AI, they are mostly putting money into startups building applications that require less capital than the infrastructure businesses powering generative AI.

In 2024, generative AI companies have already raised $26.8 billion from investors, surpassing the full-year total of $25.9 billion in 2023, which was a 200% increase from 2022.

In 2023, AI accounted for 12% of total fundraising, but this year it has increased to 27%. Additionally, the average round for AI companies has grown by 140% compared to last year, while the increase for non-AI companies is only 10%.

According to Chip Hazard, co-founder of Flybridge Capital Partners, the allocation of investment dollars is shifting towards the application layer, and enduring companies will be established in this layer.

The market turn that started in early 2022, caused by soaring inflation, has led to the Federal Reserve raising interest rates, which has forced investors to shift from risky assets to more conservative investments that provide yield.

Since their decline, tech stocks have rebounded, mainly due to Nvidia's chips, which are used in AI model training, and other mega-cap stocks such as Microsoft and Amazon. The Nasdaq reached a new record in July but later experienced a slight dip. However, there have been few IPOs and expensive acquisitions, resulting in minimal returns for venture firms' limited partners.

PitchBook's August report stated that managers are facing challenges in raising additional funds without providing LP returns, as more liquid, lower-risk investments now offer attractive yields due to high interest rates.

Cerebras, a chipmaker founded in 2016 and backed by traditional VCs, is the only pure AI company that appears close to going public. Despite being a semiconductor company, Cerebras never reached the high valuations of AI model developers and other infrastructure players, topping out at $4 billion in 2021 before the market downturn.

Cerebras confidentially filed its IPO paperwork with the SEC in late July, but has not yet filed a public prospectus. A spokesperson for the company declined to comment.

According to Jeremiah Owyang, a partner at Blitzscaling Ventures, the astronomical valuations of foundational model companies put them in a different league, beyond the reach of VCs.

According to Owyang, it is very difficult for VCs to guarantee any exits at the moment due to the current market conditions. Early-stage investors may not see returns on their newer investments for seven to 12 years, only if their companies ultimately succeed.

Elbowing into big rounds

Firms like Menlo Ventures and Inovia Capital are taking another route in AI.

In January, Menlo announced the creation of a special purpose vehicle (SPV) called Menlo Inflection AI Partners as part of a $750 million funding round for Anthropic. Since Anthropic's launch in 2021, Amazon has been the company's primary investor, while Microsoft has poured billions of dollars into OpenAI and is reportedly part of an upcoming funding round that will value the ChatGPT creator at over $100 billion.

Menlo invested in Anthropic in 2023 at a valuation of about $4.1 billion. To invest more money at a higher price, Menlo had to go outside of its main $1.35 billion fund that closed last year. In raising an SPV, a venture firm typically asks for LPs to put money into a separate fund dedicated to a specific investment, rather than a portfolio of companies. Menlo filed for $500 million for the SPV.

In July, Cohere, a startup that specializes in generative AI for businesses, raised $500 million in funding from investors including AMD, Intel, and Nvidia, valuing the company at $5.5 billion, more than double its worth from the previous year.

CNBC confirmed that part of the financing for Cohere was obtained through an SPV, with Inovia, a Montreal-based company, organizing the latest SPV and CEO Tobias Lutke being one of the participants.

Representatives from Menlo and Inovia didn't respond to requests for comment.

Morgan Private Venture, an investment bank's unit, has allowed clients to access several leading AI investments by pooling capital through special purpose vehicles (SPVs).

To obtain a return, investors must wait for an IPO, as the regulatory environment restricts big tech companies from making significant acquisitions. Companies such as Microsoft, Alphabet, Amazon, and Nvidia have a combined $280 billion in cash and marketable securities on their balance sheets, allowing them to be patient with their investments.

IPO pipeline will 'continue to build'

Another option for liquidity is the secondary market, where shares can be sold to another investor.

Elon Musk's SpaceX, valued at over $200 billion in a recent employee tender offer, has allowed investor shares through secondary transactions. Similarly, Musk's 18-month-old AI startup, xAI, valued at $24 billion after raising a $6 billion round in May, may eventually enable some investors to sell their shares through secondary transactions.

VCs typically rely on IPOs to generate returns, while founders and early investors view secondary transactions as a means to cash out a portion of their stock in high-valued companies. SpaceX, however, is an exception to this rule.

Michael Harris, the global head of capital markets at the New York Stock Exchange, stated that the NYSE is currently conversing with several AI-centric companies and anticipates that this collaboration will grow as the industry progresses.

A select few AI companies have hit the public market this year, including one that sells data center connectivity to cloud and AI infrastructure companies, which debuted on the Nasdaq in March. The company is valued at about $6.5 billion, down from $9.5 billion after its first day of trading.

In June, a health-care diagnostics company backed by Google went public. The stock is currently up around 50% from its debut, valuing the company at $8.6 billion.

Despite anticipation, the IPO floodgates did not open, and prominent AI companies are not discussing going public.

According to Incera of S&P, it is unlikely that these AI startups would go public unless there is a significant change in market sentiment. She believes that going public would increase the pressure to demonstrate profits or cut costs, which may not be feasible for many of them at this stage of their development.

The potential for generative AI to create significant returns at the application layer is viewed positively by most venture investors, as it has occurred in previous notable tech cycles. For instance, Amazon, Google, and others were built on top of internet infrastructure, while apps like Uber and Airbnb were successful on smartphone platforms.

John-David Lovelock, a Gartner analyst with 35 years of experience in the IT industry, believes that generative AI presents a significant opportunity for businesses. However, he predicts that in 2024, only 1% of the trillion dollars spent on software will come from companies investing in generative AI products.

"While some GenAI tools are being funded and a few applications exist, a widespread implementation of GenAI within the enterprise software product catalog has not yet been achieved, according to Lovelock."

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