A New Kind of Dealmaking for AI Startups Is Shaking Up Silicon Valley

“This is not normal,” added Kyle Sanford, venture analyst at PitchBook.

Just last year, Character.AI raised $150 million in venture capital, valuing the company at $850 million. The app has been a success, with 3 million downloads last month, ranking 15th in the entertainment category on Apple’s app store, according to SensorTower.

But the reality is that the startup’s growth has been a mixed bag, with minimal revenue. Its appeal as a chatbot that uses artificial intelligence to create virtual characters that interact with users seems decidedly niche. The company hasn’t had enough momentum to raise another big round in today’s ultra-competitive funding environment, according to Iris Sun, an investor at 500 Global.

“They seem to be doing quite well at first glance, but they are not,” Sun said. “They only made about $200,000 from the mobile app in July, and their estimated revenue this year is only about $17 million, so they cannot support themselves.”

Most of the founders and investors Business Insider spoke with for this article say Google has no interest in an actual Character.AI product. The real goal is to bring back the company’s star co-founders, CEO Noam Shazeer and President Daniel De Freitas, so they can compete with Microsoft, Amazon, and other big tech companies that are seen as more advanced in the AI ​​talent wars.

“The dirty little secret of the AI ​​craze is that there’s a huge bottleneck in terms of the number of world-class computer scientists and engineers who can push real boundaries and innovate,” said Jack Selby, head of Peter Thiel’s family office and managing partner at AZ-VC. “They number in the thousands. Given that scarcity, they’re very expensive.”

Another motive is to circumvent antitrust scrutiny that has made it much harder to greenlight traditional mergers and acquisitions under the Biden administration. This week, a federal judge ruled that Google violated U.S. antitrust law in its search business. Last month, cybersecurity startup Wiz rejected a $23 billion takeover bid from Google’s parent company, in part out of fear the deal wouldn’t be approved.

“This solution could avoid some scrutiny and would be faster because it would not require approval from the Federal Trade Commission or the Department of Justice,” said Steve Brotman, founder and managing partner of Alpha Partners.

“To challenge a deal, the FTC and DOJ are forced to consider antitrust actions, which can take years to resolve. By the time the dispute is resolved, there’s nothing left to resolve. That’s why many acquirers go down that route, whereas traditional M&As can take years.”

Venture capitalists are changing their relationships with founders

Traditionally, startups have raised capital until they’re acquired or go public, rewarding investors, employees, and founders with huge payouts. This win-win model is how Silicon Valley typically works.

In recent deals like Character.AI, only the founders are really celebrating, with Shazeer, who owns up to 40 percent of the company, on track to earn up to $1 billion, according to the New York Times. He and De Freitas are being forced to return to their Google desks, which they left in 2022, complaining they were frustrated by the company’s growing bureaucracy. Meanwhile, 80% of the startup’s employees who aren’t joining Google are in limbo.

“If the founders are gone, they are gone, and someone else has the keys to the car,” said S. Somasegar, managing partner at Madrona Venture Group.

Most importantly, investors only receive a return of around 2.5x.

“It’s not an ideal situation for anyone in it,” said PitchBook’s Sanford. “When investors invest in these companies, they’re looking for a 50x return. If they end up with 1.5 times what they invested in a few years down the road, they’re not going to be sad about that. But they’re probably not going to be thrilled.”

VCs own a piece of the startup, not the founder. So the string of founders, lured by huge paydays, who are walking away from their startup is causing VCs to rethink their dynamics with founders, according to investor Roy Bahat, head of VC firm Bloomberg Beta.

“This puts a new priority on the level of trust in the relationship between the VC and the founder, because the VC has to trust that the founder will look out for their interests,” Bahat said. “It can also change the way some people think about their deals. If founders ultimately have the freedom to work wherever they want, then you have to find a different way to structure the deal so that you can share in the value that you helped create.”

Some founders say they wouldn’t consider abandoning their startup too soon, even if the returns were big.

“I personally wouldn’t be interested in something like that because we feel like we’re here to have an impact,” said Arvind Jain, CEO of Glean, an AI assistant platform that’s reportedly raising $250 million at a $4.5 billion valuation. “As long as we feel like the way to maximize our impact is to remain independent, that’s what we want to do.”

But even if deals like the one struck between Google and Character.AI are met with widespread hostility, Cameron Lester, global co-head of technology, media and telecommunications investment banking at Jefferies, believes they will be durable.

“I think you’ll see a lot of that over the next few years,” Lester said. “We’re talking to a lot of strategies, both public and venture-backed, that are looking at these assets right now and see this as a good way to hire AI talent in an environment where AI talent is hard to come by.”