ARK Venture Commentary, 2/22/2023

Artificial Intelligence (AI) Infiltrates Megacap Tech

Both Alphabet and Microsoft announced new AI-driven search engine upgrades.[1] Microsoft is building off its $10 billion investment in OpenAI while Alphabet reportedly invested almost $400 million into Anthropic, an OpenAI competitor.[2]

ARK’s take

Language model-based AI systems do pose a competitive threat to Google’s search engine business, a high margin $160 billion per year near-monopoly.[3] At the very least Bing’s entry into the market should pressure margins given the expense of querying an AI language model. The larger threat to Google, however, is the potential for a structural shift in user behavior as AI begins to natively integrate into endpoint software. Why go to a search engine to find a stock photo for your graphic design, when you can ask your graphic design software to source or generate that image directly via a natural language interface?

Venture Capital[4] Assets Begin to Reflect Market Reality

Stripe is reportedly raising $2.5 billion in new equity at 40% off the valuation it commanded when it raised money in 2021.[5] Over the same timeframe Adyen, a comparable publicly traded company, traded down a similar amount.[6]

ARK’s take

Stripe’s high-profile down round[7] is indicative of valuation markdowns sweeping across the venture landscape. This is true even for companies that have sufficient cash reserves to avoid raising additional money as reflected by secondary market transactions occurring at a discount to previous rounds. We believe valuations that reflect current market conditions are healthy for venture as they allow investors to put new money to work and should increase deal flow liquidity throughout the first half of 2023.

Do Capped Upside Rounds Reflect a New Fundraising Strategy?

Microsoft’s $10 billion investment in OpenAI was heavily structured. Microsoft enjoys a disproportionate share of the profits upfront but reportedly can not reap more than a rough 10x return on its capital.[8]

ARK’s take

Though for Microsoft and other strategic investors structured investments that cap the ultimate upside could make sense, venture funders will need to think carefully about how they underwrite these deals. The venture capital model relies on high returns concentrated in a very small number portfolio companies. According to ARK’s research, uniformly capping upside potential at 10 times across a large sample of individual venture investments with measured exit or bankruptcy outcomes could have potentially reduced gross returns by 20%. This return reduction can be accommodated within the venture framework, but it requires careful diligence to do so.

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