Let’s face it: Generative AI is the belle of the ball in the tech industry and investment circles alike. Its potential to revolutionise various sectors has captured the imagination of entrepreneurs and investors. As a result, a new trend has emerged in the buzzing world of venture capital – the mad rush to invest in generative AI startups. 

The only problem when it comes to investing in these generative AI startups is the return on investment (ROI). While some sceptics argue that since there is no immediate ROI with generative AI, it’s a risky investment, savvy VCs believe it’s a calculated gamble that could pay off handsomely in the future. 

Let’s look at this: There are 13 generative AI companies that have become unicorns since last year, with Cohere and Runway joining the club just this month. This is amid the funding droughts, layoffs, and investors demanding profit from companies. Moreover, according to data from PitchBook, around $1.7 billion was generated across 46 deals within the first quarter of 2023 with an additional $10.6 billion worth of deals announced. The generative AI market is expected to hit $109.3 billion by 2030, according to Grand View Research.

VCs have never been strangers to taking calculated risks and currently they are pumping money based on the hype around models like Google’s Bard and OpenAI’s ChatGPT. When it comes to this field, a lot of it is probably driven by predictions, ambitions, and probably delusions. Here’s why. 

Where is the profit in this hype?

Firstly, OpenAI is not profitable yet. The Microsoft-backed company is running a loss of around $540 million since it started building ChatGPT. It has only started generating revenue after offering its API, subscriptions, and licensing its products like GPT-4 to its customers through Microsoft’s enterprise and cloud services. 

The same is the case with NVIDIA. The company that was banking on the gaming industry for money, decided to provide its hardware for generative AI. Voila! The biggest generative AI name in the world, ChatGPT, is powered by the company’s hardware, reaping money.

The billions of dollars that companies such as OpenAI have raised, has driven startups to build products similar to ChatGPT. VCs falling into the hype cycle are pouring funds into similarly ambitious startups without realising and analysing what sets the company’s product apart – not every startup can build a ChatGPT and then sell it as well as OpenAI did along with Microsoft. 

Of course, not every generative AI startup will succeed. Some may fizzle out, while others may stumble upon groundbreaking breakthroughs. But that’s the nature of investment. VCs understand that they must place multiple bets to increase their chances of striking gold. By diversifying their portfolio and placing their chips on generative AI, they’re playing the odds and banking on the future, or are they?

Lu Zhang, the founder and partner at Fusion Fund, said the barrier to entry in this segment is still quite low. She further adds the firm has seen an 80% increase in the number of generative AI pitches in the last two months, since the firm invested in You.com. 

In the grand scheme of things, “the hype surrounding generative AI may be justified”, said Sonya Huang from Sequoia Capital. “If I was a founder in Y Combinator right now, I would 100% be pointing my guns at one of these models and seeing what I can do,” she added, explaining that the rising investments is planting the seed in founders’ minds to build something with generative AI, and she says that we are already seeing the impact of the technology in the current world, and will definitely see more adoption in the future in almost every sector. 

When will the rewards reap in?

While the immediate ROI might not be evident, the long-term potential is too significant to ignore. VCs are seizing the opportunity to shape the future, embracing the uncertainty and the possibility of great rewards. “The world is in dark times right now, and people are looking for something to latch on to that is hope, and generative AI appears to be that,” added Huang. 

This might be a hint towards the failure of cryptocurrency and blockchain ventures. Colin Treseler, co-founder of Supernormal, a platform that leverages generative AI to summarise online meetings, expressed similar views, “The Web3 hype ended, and these people needed a place to go,” he said. 

According to a report by Mckinsey, VC investments in AI have grown 13X over the last ten years. And according to PitchBook, VC investment in generative AI has increased by 425 percent since 2020, even when the broader technology market is declining.

Gartner predicts that more than 30% of the drug discovery by 2025 will be done by generative AI solutions, which is a rise from almost zero today. And this is just one of the hundreds of use cases. Sure, the immediate ROI might be elusive because generative AI is still in its infancy. Many startups explore the uncharted territories of creativity and problem-solving, and VCs are tapping into that potential for solving specific use cases. 

Spend, Spend, AI Will Send

“Generative AI is well on the way to becoming not just faster and cheaper, but better in some cases than what humans create by hand,” concluded Sequoia Capital’s investment thesis using GPT-3 in September last year. 

It is clear that these early investments are not just about instant gratification; they are about building a foundation for a future where generative AI becomes indispensable. VCs believe that instead of investing in “boring sectors” that involve a lot of technicalities, now that the generative AI startups are expanding into different verticals like enterprise and several other applications, it is becoming an increasingly attractive stage for them.

Most investors that AIM spoke with have said that they seek guidance from several technological experts to evaluate the tech behind the products. As Brett Calhoun puts it, “We are betting on the jockeys, not the horse.” The startups have to build a clear roadmap for generating ROI before asking for large capital from investors. 

Think about it this way: the technological world is evolving at an unprecedented pace, with digital transformation penetrating every aspect of our lives. Companies across sectors will soon find themselves relying on generative AI products to innovate, automate, and outperform competitors. Those who were visionary enough to back generative AI early on will reap the rewards of their foresight, and that is what the investors are striving to be.

So yes, investors are well aware that they are not investing for today but for tomorrow. After all, sometimes the best investments are the ones made in the future, even if they come with a sprinkle of hype.