Q2 2024 State of Venture Update
AI Uncertainty, Software Undervaluation, and the Defense Tech Renaissance
Having some time to reflect with a clear mind, I've been contemplating how the unique optimism and rapid expansion of AI capabilities we've witnessed over the past year and a half are juxtaposed with danger and uncertainty in the investment world. In my view, amidst this breakthrough technology, we are at the peak of uncertainty regarding where investors will profit from AI. As I mentioned last time, AI valuations are fully priced, but the value capture remains uncertain. Will it be at the application layer (probably), the foundation model layer, the infrastructure layer, the AI services layer (we think so), multi-agent systems, hardware, or with incumbent ISVs? Perhaps all of the above? It's really not clear.
Investors are now tasked with navigating an environment where nearly every layer mentioned is priced for high value-capture, without many proof points on where value will actually accrue. Revenue is being generated, but it's not sufficient. What's uniquely missing is gross margin and defensibility. Many companies in AI are operating with low gross margins in highly competitive spaces relative to near-term demand. How will this all resolve? I don't think most VCs will admit it (there may be a 'Google' out there!), but they don't know either.
It's phase shifts like these that distinguish good investors from great ones. It's common for an investor's success to be limited to the initial macro-regime in which they performed well. Consider investment management as a large-scale model overfitting exercise. In any sustained bull or bear market, the most convicted investors in that trend will outperform. The large population of investors ensures that some will have conviction in the current regime and outperform. However, like most overfit models, they are unlikely to continue to perform well when variables change. Only the greats can persist through multiple cycles. (This, in my view, is why hedge funds have performed so poorly over the past 2 decades). I hope it goes without saying, but my singular goal is to make the transition.
Software seems cheap
In my last update, I discussed how incumbent ISVs will capture a significant portion of AI value and then subsequently contradicted myself. The reality is likely to be more nuanced: some value will be captured by Devin-like multi-agent systems, while incumbent ISVs integrating AI into their product workflows will capture other portions—especially as the models improve. The exact division of value capture is uncertain and will likely depend on the complexity of the multi-agent systems. However, I believe both approaches will ultimately be successful.
The market, however, seems to price the view that cloud software companies will benefit from AI at nearly zero. I've shown this chart many times, but cloud software revenue multiples are trading close to near-term lows. This stands in contrast to a huge boom in AI stocks like NVIDIA, ASML, PLTR, etc.
I think this is wrong, and it's probably the only part of the public and private market that is mispriced today. If you believe AI models will improve significantly over time, ISVs will capture a lot of value. I think that it's very possible that LLMs will resemble 'query processors' more than true platforms. A query processor itself is useful, but it's the tooling and data gravity around it that are defensible (at the limit, LLMs can be just an API call with relevant context). ISVs that are systems of records (SORs) have that data gravity and own the enterprise workflow screens. They are best positioned to benefit from providing a unified, industry-specific AI outcome, which could lead to the LLM layer becoming commoditized over time.
The market isn't pricing in this data and workflow gravity at all! I think public and private cloud software SaaS companies are very undervalued, and I'd love to invest more in them (I've initiated a position in $WCLD from my PA).
AI, the Capabilities Gap & GPU Oversupply
In the past, I've talked a lot about the AI capability gap, and we see it more and more every day. Things you'd hope would work, like structured 'Text-to-SQL,' don't quite work yet. It's baseline functionality like this that is missing—things often work 'most of the time' but not quite 'all of the time.'
The issue to closing the gap is that it seems we are approaching a ceiling on performance with current architectures. From my perspective, we have three major sources of scaling law improvement left before fundamental architectural changes are needed, but these improvements come with diminishing returns. The areas of improvement are: a) better use of synthetic data in various forms, b) the introduction of multi-modal data in training, and c) scaling of compute (we see people building 5-10x bigger clusters and addressing network congestion limitations). Will these improvements push us past the capability gap? I'm not sure, but I hope so; otherwise, we will need a breakthrough in architectural research and that's not deterministic.
At present, and especially if the above scaling methods don't produce sufficient performance gains, I think we're at a point where there is an oversupply of GPUs in the market. We've already stopped hearing companies complain about GPU access—GPUs are plentiful. This will serve as a good litmus test for AI adoption in the market. If inference workloads don't scale, we'll have seen a lot of CAPEX for demand that doesn't materialize. Famous last words, but I think a) we're close to a peak for NVIDIA ($NVDA) in the near future, and b) we're approaching (maybe within a year?) the trough of disillusionment for AI.
Very weakly supporting my disillusionment call is the fact that AI labs continue to shut down, with the latest news being that Adept was acquihired by Amazon. However, the reason my call isn't imminent (one year out) is that new labs continue to form at a faster pace than they shut down, with H raising $220 million, x.AI raising $6 billion, and famed researcher/pioneer Ilya Sutskever starting Safe Superintelligence Inc. Ilya is a legend, but basing a company on safety seems like losing the prisoner's dilemma from day one. How can a model that is more restrained in terms of power compete with those that are less so?
I should remind non-regular readers that I am extremely bullish on AI. However, I believe that, like most technological cycles, we are currently a bit ahead of ourselves in terms of capability versus potential, and the current exuberance is built on potential. AI will be transformational for society, but perhaps not just yet!
Will the impact be similar to that of cryptocurrencies, where the promise was large but the long-term impact has been shallow? Or will it be more like mobile/internet technologies, which, after an initial period of disillusionment (especially with the internet), experienced a long and consistent slope of enlightenment? I tend to think it's more of the latter.
Macro
I don’t have time for a full macro analysis, but it does seem like inflation is abating in the short term, with the CPI falling to 3% in June compared to the expected 3.1%. Looking at monetary indicators, we are likely heading into a period of monetary contraction in many major markets. In the US, money is expected to get tighter in the second half of the year (money can be disconnected from the fed policy rate). Japan seems poised to tighten soon, and China also appears likely to follow suit. Markets could face challenges in the second half of this year, especially given the equity risk premium, which, as I’ve mentioned before, remains at 20-year lows. Monetary flows are key drivers of asset performance, and equity valuations seem extended amid worsening economic data.
I still believe inflationary pressures will return in 2025, especially given the likely political landscape where both parties are expected to increase spending.
Defense Wave
I haven't written about it before, but I'm very excited about the revolution in defense innovation over the last ten years. We've been pioneers in creating defense investing as a viable venture category, and I'm thrilled to say it's finally having its moment. I've decided it's time to write about what has been working and the changes that have enabled startups to succeed in such a challenging area.
There have been a myriad of exciting updates in the past two years, both within our portfolio and beyond, that have cemented defense tech as one of the most exciting and profitable areas of venture investment. Here are a few great companies in the space I'd like to start by showcasing:
Anduril: We participated in the Series A, and since then the company has gone on to raise capital valuing it at over $8bn. The company has made a ton of progress, but recently they cemented their leadership by being selected to move forward on the Collaborative Combat Aircraft (CCA) program (autonomous unmanned aircraft to augment 5th and 6th generation manned fighter aircraft). This is the first time in recent history a critical aircraft project has gone to a non-Prime!
Anduril is also the youngest company since the Korean War to win a Program of Record with their Autonomous Surveillance Towers (AST) program!
Saronic: A company we co-founded at 8VC that designs and manufactures autonomous surface vessels (ASVs) for the Navy. They just raised $175m at a $1 billion valuation.
Epirus: A company we co-founded at 8VC that creates long-pulse high-power microwave (HPM) technology for counter-drone and drone swarm protection. They recently raised $200m at a $1.35b valuation and shipped four systems to the Army as part of a $66.1m award.
Chaos Industries: A portfolio company founded by several ex-8VC employees came out of stealth raising $70m to build advanced sensing solutions.
ShieldAI: A non-portfolio company. Developing AI for unmanned aerial vehicles (UAVs). Won a $198m ceiling contract with the Coast Guard for Maritime Unmanned Aircraft System Services.
The zeitgeist in the defense startup ecosystem today looks drastically different than it did for early pioneers of this space, such as Palantir, SpaceX and Anduril. When we discussed investing in the Anduril Series A at 8VC in 2018, there was significant consternation in the tech ecosystem on doing work in defense. It was around this time that Google famously dumped their Project Maven DOD program due to employee unrest, which gives a sense of the strong sentiment against supporting defense innovation in Silicon Valley at the time.
Since then, we’ve been able to witness firsthand the complete shift in perception of defense tech. We recently threw a Defense Hackathon in LA this year and had a great turnout:
A series of changes in government, commercial industries, and culture has shifted defense to a viable venture investment category. The first and most important event leading to change has been the proven success of the vanguard companies; Palantir, SpaceX, and Anduril did what was seemingly impossible -- getting their foot in the door and disrupting decades of defense prime regulatory capture. All three have all shown that startups can compete to build superior products that are more affordable for the government with a compelling investor return profile. Success does a lot to change minds and shows a viable path forward, drawing much more talent into the area.
As part of forging the way, the defense vanguard helped to drive reform that is enabling the entry of smaller innovative companies to further succeed in defense innovation. Palantir did a good job of recently outlining the waves in their defense last supper article:
The current landscape of innovation bucks the trend that emerged due to the incredible consolidation in the defense industry following the end of the Cold War. The government encouraged this consolidation, which effectively reduced competition and created the modern bureaucratic primes. This consolidation, combined with the regulatory capture of these primes, exploited previous defense acquisition methods (like FAR contracting along with large and long bureaucratic PPBE processes, which exist ironically to ensure tax dollars are being spent efficiently and without corruption) to create a “valley of death” for any company that wanted to compete.
The first major breakthrough in the last 15 years that bucked this trend occurred with SpaceX. NASA made a big bet on SpaceX for the Falcon 9 Development, Commercial Orbital Transportation Services, and Commercial Crew Program, where SpaceX ran circles around incumbent primes like Boeing and ULA on firm fixed-price (FFP) Other Transaction Authority (OTA) contracts. Since then, the success of SpaceX, along with companies like Palantir and Anduril, and concerns from Congress that reform is necessary to access the best technology to deter modern foreign aggressors, have led to procurement and funding reforms that make it easier for new entrants to compete.
The relevant changes and reforms to defense procurement for startups, as I see them, are:
The creation and growth of the Defense Innovation Unit (DIU): The DIU was established in 2015 to give meaningful contracts explicitly to commercial and early-stage businesses with the goal of fielding and transitioning tech to DOD partners. They've been a crucial supporter of startups in the ecosystem and Congress recently increased their budget to $1b.
The growth of Other Transaction Authority (OTA) contracting rather than FAR contracting: OTA contracting, which innovation partners like DIU heavily rely on, is a very flexible method of acquisition which allows federal agencies to engage in research and development, prototyping, and production activities without adhering to the more rigid regulations and requirements of traditional FAR procurement methods. This flexibility is designed to attract non-traditional defense contractors, foster innovation, and accelerate the acquisition process by reducing bureaucratic hurdles and allowing for more tailored agreements that can accommodate the unique needs and capabilities of private sector partners.
A push for Firm Fixed Price (FFP) contracts: FFP contracts are contracts where the government and contractor agree on a set price for the work to be performed, regardless of the actual costs incurred. This contract type shifts the financial risk of cost overruns to the contractor, incentivizing them to control costs and work efficiently, as opposed to more traditional Cost Plus contracts (costs are covered and a margin is added on top) which incentivize increasing costs to grow profits from a fixed margin. Startups have been more competitive in securing FFP contracts compared to traditional Primes due to their leaner cost structures and ability to rapidly innovate. Certain branches like the Air Force and Space Force have explicitly stated their support of FFP contracts, while others still remain stubborn supporters of Cost Plus. By placing the risk on the company, FFP contracting has been particularly advantageous for startups, as many Primes have publicly stated they are reluctant or flat out won’t bid on FFP contracts due to the financial risks involved and massive losses some have incurred in recent years from them. The continued push for FFP contracting helps ensure a level playing field for startups to provide the best capabilities at the best prices to government customers, particularly relevant for programs like CCA.
Introduction of the Adaptive Acquisition Framework (AAF) and the Middle Tier Acquisition (MTA) pathway: the AAF is a new and streamlined approach developed to modernize the acquisition process for defense technologies and systems passed in 2020. It features multiple tailored pathways to accommodate different types of programs, particularly those that need to move faster than the traditional bureaucratic process now known as Major Capability Acquisition, allowing for quicker deployment of critical capabilities. Of particular relevance is the MTA pathway, which allows for Rapid Prototyping and Rapid Fielding of novel technologies, which is more in line with how innovative companies quickly iterate and test prototypes to achieve cutting edge results.
STRATFI, OSC, APFIT, and other sources of funding from the DOD to help survive the Valley of Death: In addition to changes like OTA/FFP contracting and MTA acquisition to make it easier to acquire tech from innovative startups and in some ways “shorten” the valley of death, the DOD has stood up multiple programs to ensure these companies receive funding to survive the valley of death. Strategic Funding Increase (STRATFI) awards provide funding to startups after SBIR Phase II awards to facilitate the commercialization of innovative technologies. It requires matching funds from defense or industry partners, which typically aligns itself well with large Series A or Series B raises (you can get a maximum of $60m from a STRATFI award with $30M needing to come from private investors). In addition, the Office of Strategic Capital (OSC) was recently spun up to provide affordable loans to support 14 Critical Technology areas for national defense. Other funding sources like Accelerate the Procurement and Fielding of Innovative Technologies (APFIT) can provide $10-50m to accelerate procurement of systems ready to be fielded. These various sources of funding complement earlier reforms to help startups survive the long procurement times involved in the valley of death.
With these reforms, we have witnessed a shift from a transactional, exclusive process to a more inclusive community of mission-focused players. Organizations like the Defense Innovation Unit (DIU) open channels between startups, investors, end-users, and program managers. The Department of Defense (DoD) has moved from often waiting twenty years for a single solution that fit the traditional mold to engaging with the country's most talented technology players in iterative processes. The established players that once controlled the market are now experiencing shocks of disruption (e.g., Anduril CCA).
It is this preponderance of factors that has recently solidified defense as one of the most exciting areas of venture. From the doldrums to the forefront!
We're fortunate at 8VC to have been involved early with many of the best companies paving the way forward in defense technology. We hope to continue partnering with great founders to employ the most innovative technologies in defending this great nation. As an Easter egg, here's a photo of me with the first-ever Anduril tower!
Interesting things to read/watch
Francois Chollet, Mike Knoop - LLMs won’t lead to AGI
Dario Amodei CEO of Anthropic: Claude, New models, AI safety and Economic impact
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Great summary. I think your point about building a company around “safe AI” being a prisoners dilemma is spot on.