Why venture capital must evolve to keep pace with AI innovation

Our job as investors, especially in the venture capital (VC) industry, is to try and foresee the future to the best of our ability. We invest in startups, knowing that some will fail completely, some will barely return the invested capital, and some, hopefully, will become huge successes.

The founders we meet sell us their dreams for the future. We analyze their ideas and pick the most convincing ones - those that have the highest potential for success based on the team, the market, and the technology. In early-stage investments, the defining factor is often a personal and subjective belief in the team and the market potential.

I always try to envision the future when assessing a team's ability to deliver on the promises they've presented to me. Every investor today should ask themselves: How will AI impact the future?

AI as an Enabler for Disruption

Since the introduction of large language models (LLMs) and specifically ChatGPT by OpenAI in November 2022, it feels like we're in a never-ending storm of transformative innovation. Our lives have already been significantly impacted and improved by AI-related innovation—with so many people using ChatGPT, Claude, Perplexity daily, and that's just one example. The hype around the potential of AI technology to transform our lives, disrupt industries, and reshape business models is unlike anything we've witnessed before.

How Investing in the AI Era Is Different

High Pace of Innovation

One of the key differences I see now compared to other technological shifts in recent years is the rapid pace of innovation. Every few months, a new LLM model is introduced that significantly outperforms the previous one. Dozens of new startups and products leveraging AI capabilities are emerging on a weekly basis. This understanding impacts our analysis of new investment opportunities. We ask ourselves: Is it likely that this startup's technology or value proposition will still be relevant a year from now?

AI Doesn't Equal "Magic"

Some of the teams we meet use the word AI as a synonym for "magic”, implying their solution will just seamlessly work. Many assume AI will be able to do anything and solve problems, even before it has been proven. This optimism can be a double-edged sword, as it may lead to overvaluations or investments in unproven concepts. We therefore try to understand the assumptions of the founding team, for why AI will be able to solve the problem they’re tackling.

Moreover, when we invest in a startup, we look for a barrier to entry—something that will make it difficult for competitors to copy or implement quickly. In a world where AI and LLM technology are becoming a commodity, I often ask myself: Why does this startup stand out? Will competitors be able to easily replicate the same value proposition? The secret sauce, therefore, is often not the AI itself but rather a new business model, an exceptional user experience, or the team's ability to execute effectively.

The Role of Capital

In the AI era, teams can build quickly and at relatively low costs. Automation is accelerating dramatically with tools like co-pilots and AI agents. Investors must ask themselves about the role of capital in ventures: Does the team really need funding? How much do they need to start with? AI innovation pushes both extremes—teams can either operate very leanly, thanks to AI capabilities, or require substantial capital to train AI models and utilize expensive computing resources.

What's the Startup Advantage?

Incumbents are innovating very fast, and unlike previous technological shifts, they are investing heavily and are highly aware of the changes occurring in this landscape. So, what's the startup advantage in this scenario?

Startups possess agility and the ability to pivot quickly. They can focus intensely on niche problems and innovate without the constraints that larger organizations face. While incumbents have resources, they also have legacy systems and bureaucratic processes that can slow them down. Startups can experiment with new ideas, iterate rapidly based on feedback, and bring products to market faster.

Another key differentiator is the ability of new startups to develop disruptive business models. A prime example is startups that utilize AI agents to replace work previously done manually. This approach allows them to create new pricing models, offer scalable "human-like" services, and tap into previously untapped industries such as the services sector.

The Impact on Investors

• Assessing Team Adaptability: Given the rapid pace of technological changes, a team's ability to adapt is just as important as their initial idea.
• Due Diligence Is More Critical Than Ever: We need to dive deeper into the technology to understand whether it's truly innovative or just leveraging out-of-the-box AI capabilities.
• Long-Term Viability Over Short-Term Hype: We must look beyond the hype and evaluate whether a startup has a sustainable business model that can withstand the evolving landscape.
• Risk Management: The high expectations and fast pace mean that risks are amplified. We need to balance optimism with caution.

Outlook

Investing in the AI era is both exciting and challenging. The unprecedented pace of innovation means that opportunities are vast, but so are the risks. As investors, we must adapt our strategies, focus on the fundamentals, and support teams that not only have brilliant ideas but also the resilience and flexibility to navigate the turbulent waters of rapid technological advancement.

The future is being written faster than ever before, and while we cannot predict it with certainty, we can position ourselves to be part of shaping it. By investing wisely and thoughtfully in the AI space, we have the chance to contribute to innovations that could redefine industries and improve lives on a global scale.

Avi Shulman is a Principal at StageOne Ventures.