Venture Capital in Flux: Navigating New Trends and the AI Investment Wave of 2023

Published by BSAI on 14 Feb 2024

Current overview

The function of venture capital funds is to provide the capital to startup firms and small businesses showing potential for long-term growth. As is the case for hedge funds and private equity funds, venture capital funds must be careful in the deployment of capital in order to hedge risk while chasing positive returns. Hence, it is crucial to analyze the current investing landscape, and identify the latest trends and their impacts in the venture capital space in 2023.

 

VC funding has been falling overall since 2021. We saw a 43 percent fall in only one year in global seed and angel investment volume: from $12,2 billion in Q1 2022 to $6,9 billion in Q1 2023. In the same period, global early-stage investment dropped by 54 percent from $55,8 billion to $25.5 billion. Global late-stage and technology growth investment firstly collapsed for 63 percent from $93,4 billion in Q1 2022 to $34,4 billion in Q4 2022, but rose to $43,0 billion in Q1 2023.

 

The reason for these complications is largely a result of global economic uncertainty with high interest rates and inflation. However, in spite of tthis, some sectors were able to retain strong interest from investors and a promising future trajectory.

 

At the forefront of VC discussion recently is the technology sector, namely software production. The main reason for this is that tech companies often have possibilities for rapid growth, so many venture capital funds bet on this potential. The sector is constantly evolving, so there are always new opportunities for companies to grow and succeed. Moreover, technology companies tend to focus on innovation in order to undermine their opposition in this highly competitive industry. In the first quarter of this year, startup SandboxAQ stood out with total VC funding round of $500 million. Headquartered in Palo Alto, the startup deals with AI and quantum computing solutions.

 

The next industries to note are health care and biotechnology. These directly influence people’s lives on a daily basis, and recent innovations have been substantial. As global perspectives shift, the startups in this field more easily attract investors’ money. In 2023, startup Monogram Health, specialised in evidence-based in-home care and benefit management services for polychronic patients, raised an impressive $375 million in Series C funding. 

 

Following this, we look to the energy sector. Energy is, in general, an essential component of our lives and every industry, and finding cleaner, more efficient energy sources is paramount to a more environenmentally sustainable future. As global warming poses an ever larger threat, the areas to watch are renewable energy, battery technology, and smart grid firms. Also, the presence of natural monopolies in the energy business, while creating potentially high barriers to entry, means those that succeed can expect significant growth and large market shares. Our Next Energy, a developer of energy storage technology to expand access to sustainable power, exemplifies this through its $300 million series B round.

 

Navigating the AI Investment Surge

The above are globally some of the most topical areas, but delving deeper into the “new kid on the block” everyone is talking about, the Artificial Intelligence (AI) sector has experienced an unprecedented influx of investments from venture capital firms. This heightened interest is driven by the transformative capabilities of AI, spanning industries such as healthcare, finance, transportation, and entertainment. However, amid the optimism, concerns about a potential 'dot-AI bubble,' reminiscent of the infamous dot-com bubble of the late 1990s, are gaining traction.

 

The enthusiasm of venture capital for AI is well-founded. AI technologies hold the promise of revolutionizing data processing, decision-making, and automating intricate tasks. This progress has incited a fervent competition among investors to support the most promising AI startups. According to data from Ernst & Young (EY), funding for AI startups has surged, with billions of dollars being injected into the sector annually. In Q3 2023 alone, VC-backed companies secured $29.8 billion, sustaining the momentum from previous quarters. This surge in investment targets startups encompassing AI technology in various sectors like healthcare, finance, and e-commerce, as well as Deep-tech startups focused on developing cutting-edge AI technologies.

 

However, the robust market momentum for AI startups has prompted venture capital firms to aggressively seek exposure to this sector. Consequently, VC-backed AI startups have witnessed soaring valuations, raising concerns about whether these high funding levels and questionable valuations align with their actual market potential or revenue-generating capabilities. Additionally, the proliferation of startups poses a risk of market saturation, where numerous companies vie for the same space, potentially leading to failures and consolidations.

 

Examining the trajectory of AI startups that went public during the 2021 SPAC boom reveals a concerning reality. Many venture-backed companies, championing artificial intelligence technologies, have faced closures or substantial declines in valuations in recent quarters. A notable example is Babylon Health, a U.K.-based digital health startup that, despite raising over $600 million in venture funding, filed for bankruptcy in August after once being valued at over $2 billion. Similarly, Embark Technology, with a pre-revenue status and an initial market cap of over $5 billion during the SPAC boom, experienced a significant downturn, with shares plummeting over 98%, leading to the subsequent shutdown of operations.

 

These instances underscore the risks of an AI bubble, potentially resulting in severe financial losses, bankruptcies, job losses, and a reluctance to invest, all while impacting AI innovation.

 

To avert the emergence of a new dot-AI bubble, venture capitalists must refrain from allowing current market sentiment to unduly influence their decision-making processes. Adopting a balanced approach that emphasizes due diligence, innovation, and realistic, careful valuations can help navigate the complexities of the AI investment landscape and unlock the full potential of this transformative technology.


The rise of pre-seed investment

Having discussed the types of industries seeing strong VC interest, one must also consider the evolution of funding across the various investment stages, from the conception of an idea through to funding across series A, B, C, and further, and we have seen significant movement in one area; pre-seed investments. This strategic shift in the VC sector is a global phenomenon, with Europe seeing a rise from $385 million in 2012 to over $1.3 billion dollars recently, and US firms including Greylock, Catalyst Fund, The House Fund and Bee Partners all announcing pre-seed funds also totalling above the billion dollar mark. We also note that the average size of pre-seed rounds has grown significantly from $400k-$500k in 2019 to current estimates of $2 million.

 

Why this switch of focus to such early stage investing, and what does this mean for the VC space? We can thank the ever increasing pace of technological innovation, as emerging startups are able to demonstrate concepts and scalability with less initial capital, notably in areas such as AI, fintech, and biotech, where possibility for disruption and growth is very significant. This record breaking potential pushes competition up between investors, inciting races to find promising startups at the earliest possible stages, taking higher risks for the next big success story. The democratisation of entrepreneurship also plays a crucial role, with greater diversity in founders than ever before coming to the forefront of business creation, requiring a more accessible funding landscape provided by pre-seed funding.

 

While this trend spans various sectors, we can inspect a few cases where this funding is helping shape a more promising future. Xerataus IQX, a healthcare startup, has made a significant impact in the field of personalized cancer therapies. Securing a strong $25 million in pre-seed investment, the firm has been able to accelerate its research and development in its goal to identify the most effective personalised treatment options, through the refinement of its machine learning algorithms, clinical trials and the development of a strong intellectual property portfolio.

 

On the other end of the spectrum, Leighton Avant-Garde Haus is looking to better the world one sustainable item of clothing at a time, revolutionising the fashion industry with their innovative materials and production methods to reduce waste and promote an eco-friendly mindset. Its equally large pre-seed round is enabling them to building their sustainable supply chain, expand their market reach and gain access to industry networks from the VCs, and such an investment sets an important precedent in a sector where a green focus is often foregone.

 

Such a shift towards greater investor involvement at earlier stages has several implications for the future of venture capital. Working with such small companies, there is likely to be a greater focus on supporting founders (in areas such as business model development or market analysis), as they are the basis of the firm and crucial for long-term growth and success. We are also likely to see an increase in VC funding to different geographical regions, as developing economies become increasingly globally connected.

 

While the capital and mentorship VCs bring is welcomed by burgeoning entrepreneurs around the world, pre-seed investment is inherently riskier than a Series A or B round. Therefore, it may come at the price of more rigorous due diligence processes delaying new investments, and leaving out the firms with less potential for immense and immediate scalability. There may also be greater control on the founder’s actions or ideas in order to recuperate initial injections and increase returns for the VC.

 

In summation, while there has been somewhat of a slump in venture capital recently, certain industries including tech, biotechnology, healthcare and energy, as well as firms in the pre-seed stage have seen strong investment and growth, the most notable of which is the buzz surrounding AI. It remains to be seen if this is warranted or if a market correction is due in the near future, with growing concerns about valuations, due diligence, and true potential of some of these firms.

 

Deep-dive of the effects of Russia-Ukraine

Amidst ongoing military and political conflicts, including those of Isreali-Palestinian and Russo-Ukrainian wars, the need to innovate in and attract funding to the defense sector is at an all-time high. Despite the obvious moral controversy in investing in this industry, many experts believe that VC firms will turn to defense tech more and more in the future. The recent initiative of NATO is a perfect example of such a shift in the space of VC, which also uncovers exogenous drivers such as China’s position in the field and an ununified approach of the US.

 

NIF counters China’s technological edge

NATO has recently unveiled a groundbreaking €1 billion venture capital fund, aiming at bolstering their technological capabilities and at challenging China's dominance in the defense sector. Launched last year and officially named the NATO Innovation Fund (NIF), the initiative seeks to address a funding gap for defense start-ups in Europe, particularly in the realm of deep tech. As a matter of fact, the NIF plans to inject financial support in areas like AI, biotech, energy, manufacturing, and space.

 

As concerns rise over Western start-ups lacking the financial backing enjoyed by their Chinese counterparts, NATO aims to ensure that these companies do not have to rely on Chinese investors for support. The move comes amid escalating worries about China's rapid development of sensitive technologies, prompting US President Joe Biden to announce a ban on US investments in critical Chinese tech industries. Investors' concerns also stem from fears of arbitrary political crackdowns, worsening geopolitical tensions, and a perceived lack of trust and transparency in the Chinese economy.

In this environment, the NATO Innovation Fund stands as a significant step in fostering innovation in critical defense sectors and it also ensures that Western start-ups maintain competitiveness and independence with respect to China’s technological rise.

 

US refuses to join the NIF

Worthy to be mentioned is the fact that, so far, the US has not joined the NIF. Indeed, despite being the country with the largest defense budget of the world (over $770 bn for 2022), US has opted for this wait-and-see path. Nevertheless, Washington has increased investment in start-ups producing military tech in recent years.

Data clearly show these recent changes: US venture investment in defense start-ups grew from less than $16 bn in 2019 to $33 bn in 2022.

 

The Russian invasion of Ukraine played as a “game changer”. Following this dramatic event more than 200 defense and aerospace deals were closed by VC firms. Those deals almost reached $17 billion, more than the sector raised in all of 2019. ShieldAI, which produces AI-powered fighter pilots and drones, has been one of the most successful and it is now worth 2.7 bn. Furthermore, in latest years, the U.S. start-ups has been seriously hampered by a lack of financing. Conversely, China has been investing in Chinese, US and European tech start-ups. The National Security Innovation Capital (NSIC) program was launched by the Congress; the latter focuses only in prototype contracts. While such a conservative approach is understandable, on the other hand a greater risk attitude is necessary to drive innovation, especially in the historic-economic period we are through.

 

NATO Innovation Fund will undoubtedly have a positive impact on the field of defense technology. With the abundance of funds, it is also likely that more innovators will come to the industry, which will weaken the existing position of China. While the US has not invested in the fund yet, its priorities still align with those of NIF - more funding is coming to defense technology to effectively navigate through times of global uncertainty.

 

By: Amos Appendino, Balthazar Munro, Costanza Calamita, Ferdinando Coda Danunziante, Lorenzo Moreno Postema, Marko Dimov, Paulius Steponkus.


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