Dear all,
I recently attended the Milken Conference in early May, where amongst many fascinating panels and discussions, I had the opportunity to listen to a conversation between Elon Musk and Michael Milken on perspectives for the future, just a few days before xAI announced that it had raised $6 billion, positioning it to compete with the likes of OpenAI and Anthropic in the foundational model race.
At the heart of the Milken Conference discussions was the potential revival of deals later this year or in 2025. However, the spotlight was also on genAI and its far-reaching implications for private markets. The debate was intense, with investors questioning the existence of a bubble at the Venture Capital level, the possibility of a 2021 hype resurgence, and the transformative power of the technology beyond the genAI tech stack, extending to 'material world' companies. The consensus was clear: genAI heralds a significant technology shift, akin to the commercialization of the internet with the browser, and far surpassing the move to the cloud. As with any technology shift, there are both disruptors and disruptees.
The race for innovation is on across the entire genAI tech stack, from foundation models to the application stack. The key question is the value creation potential of genAI for Venture Capital through investments in startups capable of building robust economic models with true moats, be they technological or commercial as ARR starts to build up. While many of these startups may face hurdles or even fail, a small fraction is expected to yield significant returns. This is the time for strategic cherry-picking, guided by a comprehensive understanding of the economics of these companies.
At the disruptee level, all businesses, particularly technology businesses, are expected to be disrupted. According to Ravi Mhatre in conversation with Open AI COO Brad Lightcap, "Any business that has a technology element is going to be disrupted, and quickly." Within Technology, SaaS businesses are particularly vulnerable to disruption, while they were until recently considered a haven of stability with predictable recurring revenue streams. It is now unclear whether the value will shift from SaaS incumbents to native genAI companies or if the opposite will occur. To recall, when the SaaS wave emerged in the 2010’s, native SaaS companies took the lion's share. It is not certain that genAI native companies (putting aside foundation models) will win. Indeed, SaaS incumbents have the data and the workflows, as Marc Benioff recently recalled in a recent Salesforce earnings call. But though many incumbents could become AI winners, patience is vital, and AI-led revenue increases through new features or products should still take a couple of months to unfold while costs are already here.
Beyond the disruption of how SaaS companies operate and the winners/losers, genAI is bringing another form of disruption: that of valuations. For years, SaaS companies have been valued per the Rule of 40, which marks a valuation frontier between those companies that surpass the Rule of 40 when adding up LTM revenue growth and operating cash-flow margin, and does that not. We unveil an article in which we envision a move from a Rule of 40 to a Rule of 55. While genAI should allow for growth acceleration, most of the 15pp leap will result from productivity gains at the S&M, R&D, and G&A levels, while the impact on gross margin should remain minimal. Hence, genAI comes with new standards, and the bar has risen for SaaS companies. CEOs need to prepare for this upcoming shift and ensure that their businesses can capture the technology's transformative potential and deliver higher operating leverage through it.
Operating leverage. That is the key word behind a new form of buyouts that we are poised to see more importantly: venture buyouts, i.e., buyouts by large Private Equity players of companies previously sitting in the Venture World and who now with a decelerated growth (but still growing double-digit levels) are choosing the Private Equity route. These deals – for which the recent Lumapps buyout provides a perfect example - do not resemble the traditional buyout due to i) higher levels of growth implying higher risk and specific to those businesses and ii) margins that are close to zero or still in negative territory. We propose a framework of analysis for successful operations of this sort, resting on a double conviction of durable growth and operating leverage to reach Private equity Tech Buyouts standards.
Thank you for reading!