AI Funding Frenzy: Beyond the Headlines

The past year has witnessed an insane frenzy in AI venture funding, grabbing headlines with eye-watering figures. From Microsoft's initial $1 billion injection into OpenAI (creator of ChatGPT) in 2019, ballooning to a potential $13 billion by 2023, to Google's $500 million bet on Anthropic (creator of Claude) in late 2022, with promises of further investments, the cash flow is undeniable. Amazon wasn't far behind, pouring $1.25 billion into Anthropic in September 2022, followed by an additional $2.75 billion this March.

2023 alone saw tech giants like Amazon, Google, Microsoft, and Nvidia backing over 75 AI start-ups, a staggering 57% increase compared to 2022 funding over two-thirds of the $27 billion raised by fledgling AI companies in 2023, with Microsoft taking the lead through partnerships with Open AI and Inflection.

While the funding figures are impressive, a deeper look reveals a more strategic story unfolding. Here, we delve beyond the headlines to explore the "why" and "how" behind these investments.

More Than Just Money: Building a Secure Future

These investments go beyond mere financial backing; they're strategic business development deals aimed at securing valuable business units. Companies like Anthropic and Open AI require immense computing power to train their models – a challenge the cloud giants can address. These "strategic collaborations" often include clauses requiring the AI company to leverage the investor's cloud services, sacrificing the freedom to shop around for potentially better deals elsewhere.

In essence, the cloud providers are strategically investing in their future success by integrating the AI tools across their offerings. This strategy involves essentially transferring funds internally, utilizing their balance sheets to drive future income statements. While the initial cash outflow seems significant, the partnerships ensure a return on investment as these AI models are adopted and cloud consumption increases. The quality of this future revenue stream can be debated, but the long-term goal is for these initial "low-quality" revenues to transform into high-quality returns.

These deals are often presented as partnerships for developing AI computing systems, with AI companies declaring the cloud providers as their "preferred cloud provider." In return, the cloud providers showcase their intent to offer AI models and tools for developers to integrate into their applications.

Considering the immense cost of cloud services required for AI development, deployment, and refinement, these partnerships become crucial for funding operating expenses. Venture capital funds often lack the capacity for such massive investments. Additionally, AI companies likely benefit from discounted cloud services through these partnerships, fuelling their growth at a lower cost of capital compared to traditional venture funding. Conversely, the cloud providers gain access to valuable technology for themselves and their customers, allowing them to integrate AI into their product suites.

Beyond the Numbers:

The headline-grabbing billion-dollar figures often mask a key point: these aren't simple cash injections. Unlike traditional venture capital investments, they are intricately structured deals involving a mix of:

??? Equity Investment: Traditional cash investment for ownership stake.

?? Cloud Service Credits: Cloud service credits valued as investment dollars.

?? Convertible Notes: Debt instruments that convert to equity upon meeting certain conditions.

?? Revenue Sharing: Agreements to share future profits.

Reports suggest Microsoft's investment in Open AI involves recouping their investment through a significant portion (75%) of Open Ai's profits until the debt is settled. Only then does the ownership structure shift to reflect a 49% stake for Microsoft, 49% for other investors, and a remaining 2% for Open Ai's non-profit parent organization. Additionally, there's a profit cap in place for each investor group, a unique feature compared to traditional venture capital models that typically seek returns exceeding 20 or 30 times their investment.

Google's investments seem more straightforward, with reports indicating their half a billion Anthropic investment was a convertible note that later converted to equity during an investment round led by Menlo Ventures (conducted through a special purpose vehicle instead of direct fund investments).

Amazon's investment structure is more complex. A portion ($1.25 billion) was deployed in September as a convertible note, with an agreement to invest an additional $2.75 billion through a second note expiring in early 2024.

Mezzanines and warrants

These structures e of a mix of cash and cloud service credits, necessitating flexible investment structures to accommodate variable investment amounts. Convertible notes offer additional returns to investors through interest rates, which have doubled from 5% in 2019 to nearly 10% in late 2023. This, combined with the average 20% discount rate, can be a flexible way to structure an investment with a business partner before they convert through a QFE.

Despite AI's potential to revolutionize every facet of society, its initial impact has been disrupting Silicon Valley's venture capital landscape. Traditionally, start-ups secured funding every 15 months or so, demonstrating business growth. However, since the late 2022 emergence of generative AI, capable of creating text, images, sounds, and videos, the funding game has changed. Investors are now fiercely competing to back the most promising developers in this red-hot field, abandoning the established rhythm of venture capital deals.

The massive funding rounds might grab headlines, but discernment is critical, the real story lies beneath. The necessity of shared challenges drives crucial partnerships combined with the fear that if you don't pick a winner in this space you're out of the game.