'These are not normal;' A new type of dealmaking for AI startups is rattling Silicon Valley

• Traditionally, startups aim to be acquired or go public –which rewards investors, employees, and founders.
• In the case of recent deals like Character.AI, only the founders are truly celebrating.
• Even if deals such as Character.AI's are widely disliked, they are very much here to stay.

Google unnerved Silicon Valley last week when it agreed to pay $2.5 billion to license Character.AI's technology, hire its two superstar cofounders and 20 percent of employees. The deal came after AI developers Adept and Inflection both effectively sold themselves to Amazon and Microsoft, respectively, in recent months.

"Seeing these acqui hires for companies that have raised so much money so quickly is kind of a shock," said Brent Queener, managing partner at Bonfire Ventures.

"These are not normal," added Kyle Sanford, a venture analyst at PitchBook.

It was only last year Character.AI raised $150 million in venture funding, which valued the company at $850 million. The app has been a hit, with 3 million downloads last month, ranking it #15 in the Apple app store entertainment category, according to data from SensorTower.

But the reality is that the startup's growth has not been blockbuster and revenue is minimal. Its appeal as a chatbot that uses AI to make virtual characters that interact with users seems decidedly niche. The company did not have enough momentum to raise another big round in today's ultracompetive funding environment, according to Iris Sun, an investor at 500 Global.

"They seem to be doing pretty well on the surface, but they are not," said Sun. "They only made about $200,000 from the mobile app in July, and the estimated revenue for this year is only around $17 million, so they cannot self-sustain."

Most of the founders and investors Business Insider spoke to for this story say Google has little interest in Character.AI's actual product. The real aim is to bring back the company's star cofounders, CEO Noam Shazeer and President Daniel De Freitas, to compete against Microsoft, Amazon, and other Big Tech companies that are seen are further ahead in the AI talent wars.

"The dirty little secret with the AI craze is that there is a massive bottleneck in regard to the number of world-class computer scientists and engineers who are positioned to push real boundaries and innovate," said Jack Selby, the head of Peter Thiel's family office and managing partner at AZ-VC. "These people number in the low thousands. Given this scarcity, they are very expensive."

Another motivation is circumventing the anti-trust scrutiny that has made it much more difficult for traditional mergers and acquisitions to be greenlighted under the Biden Administration. This week, a federal judge ruled Google violated US antitrust law with its search business. Last month, cybersecurity startup Wiz turned down a $23 billion takeover bid from Google's parent, partly out of concern the deal would not be approved.

"This might evade some scrutiny and is faster because there is no acquisition for the Federal Trade Commission or Department of Justice to approve," said Steve Brotman, founder and managing partners of Alpha Partners.

"To challenge a contract, the FTC and DOJ are forced to consider an antitrust action that might take years to unwind. By the time the litigation is over, there is nothing to unwind. Hence, this path is the way a lot of acquirers are going, whereas traditional M&A might take years to complete."

VCs rethinking their relationships with founders

Traditionally, startups have raised capital until they are acquired or go public, rewarding investors, employees, and founders with huge paydays. That everybody-wins model is how Silicon Valley usually works.

In the case of recent deals like Character.AI, only the founders are truly celebrating, with Shazeer, who owns up to 40 percent of the company, standing to net up to a billion dollars, according to the New York Times. And he and De Freitas are forced to return to their desks at Google, which they left in 2022, complaining they were frustrated with the company's sprawling bureaucracy. Meanwhile, 80% of the startup's employees who are not joining Google are in limbo.

"If the founders are not there, then they are gone, and somebody else has the keys to the car," said S. Somasegar, managing partner at Madrona Venture Group.

Most significantly, investors are getting a return of just about 2.5x.

"This isn't something that is the ideal situation for anyone in it," said PitchBook's Sanford. "When these investors invest in these companies, they hope for that 50x return. If they're getting one and a half times their money after a couple of years, they won't be sad about that. But they're probably not going to be ecstatic."

VCs own part of the startup, not the founder. So a string of founders enticed by huge paydays walking away from their startup has VCs rethinking their dynamic with founders, according to investor Roy Bahat, head of VC firm Bloomberg Beta.

"It puts a new premium on the level of trust in the relationship between the VC and the founder because the VC has to trust that the founder's going to look out for their interests," said Bahat. "It also might end up changing how some folks think about their contracts. If founders are free to work where they want ultimately, then you have to figure out a different way of structuring the deal so you can participate in the value you helped create."

Walking away from your startup early is something some founders say they would not consider, even with a huge payday.

"For me personally, I wouldn't be interested in something like this because we feel like we are here to make an impact," said Arvind Jain, CEO of Glean, an AI assistant platform that is reportedly raising $250 million at a $4.5 billion valuation. "As long as we feel like the way for us to maximize our impact is through staying independent, that's what we want to do."

But even if such deals as Google's arrangement with Character.AI are widely disliked, they are very much here to stay, according to Cameron Lester, global co-head of technology, media and telecom investment banking at Jefferies.

"I think you're going to see a lot of them over the next several years," said Lester. "We're talking to a number of strategies, both public as well as sponsor and venture-backed, that are looking at these assets right now and viewing this as a good way to hire AI talent in an environment where that talent is difficult to find."