Dear Investor,

As venture investors, there is nothing more exciting than getting to work at the dawn of a new era of technological innovation. With the extraordinary rate of progress in AI over the last year, it is apparent that we are in the early stages of a new era in technology.

To provide some context of the seminal impact we’re currently witnessing with AI, we need only to reflect on the history of invention - and most notably the introduction of the transistor in December 1947 by pioneers William Shockley, John Bardeen and Walter Brattain from Bell Labs. There are two important observations about this milestone that are worth reflecting on. Firstly, the invention of the transistor was a truly profound historical event and most subsequent modern technologies have been built on its foundations. Yet despite the seismic shift we now know the introduction of the transistor represented, it wasn’t immediately apparent to most people at the time that the world had been forever changed by this invention.

In fact, when Bell Labs announced the first demonstration of the transistor in July 1948, the first media mention of the “transistor” appeared buried on page 46 of The New York Times, as the last item in a radio news roundup column. The Bell Labs trio were ultimately recognised for their historic invention almost a decade later when they were awarded the Nobel Prize in Physics in 1956.

The second observation is the invention of the transistor did not occur in a vacuum (pun intended!). It was built on the shoulders of the giants who came before the Bell Labs trio and the invention was only possible as a result of the work that had been done over preceding decades. 

Nearly 75 years later, we saw another seminal event for the technology industry; the launch of ChatGPT by OpenAI on November 30 2022. Like the invention of the transistor, the launch of ChatGPT was built on decades of research and product development that commenced with a workshop convened at Dartmouth in mid-1956. The ensuing decades have seen much progress and also much disappointment, as the progress of AI has ebbed and flowed, at times advancing more slowly than anticipated and at other times much faster.

Dawn of a new tech era: the power of artificial intelligence

We are convinced that we are at the early stages of what may prove to be the most important innovation in human history, and we have unambiguously entered the AI era. It is only natural for us all to be both incredibly excited about the enormous potential at our fingertips, and also somewhat nervous about what lies ahead. 

It is of course highly arbitrary to declare the launch of ChatGPT as heralding the start of the AI era, in much the same way as it is somewhat arbitrary to credit the launch of the Mosaic browser in 1993 as marking the start of the Internet era, or the launch of the iPhone in 2007 as signalling the start of the mobile Internet era. However, in each case, these products were both incredibly profound in their own right but also emblematic of the extraordinary potential of these new technologies.

Unlike the transistor, people understood the implications of ChatGPT and other groundbreaking AI products almost immediately. ChatGPT attracted 1 million users within 5 days and 100 million users within 2 months. Alphabet CEO Sundar Pichai recently appeared on 60 Minutes and said the impact of AI could be more profound than the impact of fire or electricity. After much hype, and decades of unfulfilled promise, the AI era is here.

As technology investors, the AI revolution taking place represents an inflection point. In the late 1990s, a number of Square Peg team members made a deliberate decision to arc their careers towards the rise of the Internet, and in the 2020s we are seeing a similar shift as many of our team adapt their mindset and double-down their focus on AI and AI-first technology companies.

As we assess AI-first businesses, these are some of the fundamental technology and business model questions we are asking ourselves:

• Is this a great business in its own right, regardless of its use of AI?
• Will AI unlock a new way to solve a problem that is 10x better than before?
• How does the business build a sustainable competitive advantage, particularly where there is heavy reliance on third-party foundational models?
• Can the business find a distribution angle over incumbents that can add AI to their existing products?
• How important are technological advantage and R&D to this business (relative to factors like product and go-to-market strategy), and how does that impact our perspective of the team and the space they compete in? 
• Is this team the best positioned to build a generational business and navigate the quickly-shifting sands of the AI space? 

Although these are the questions we’re asking of AI businesses, they are often equally applicable to general software businesses. Whilst the skills we have developed collectively over the past 11 years, and individually over our entire careers, are highly relevant, the questions are much more complex in the context of an emerging technology.  The answers to these questions will be obvious in hindsight but they are anything but obvious today. This excites us enormously and we are hard at work to best position ourselves for the years ahead. 

We are deeply engaged with AI and bring an open and curious mindset to exploring the problems founders can solve with AI, and the opportunities and business models that will evolve. We’re continually deepening our knowledge base and networks. In this context, there are a couple of important points that we want to make:

• Our involvement in AI is not new, and in fact, Square Peg has made investments in AI-first business models from as early as 2016, with almost a quarter of our current portfolio companies using AI in a fundamental way. These include; Deci.ai, Aidoc, Tomorrow.io and Partly.  
• While the acceleration of AI has received much hype and attention, we are equally focused on our other core investment themes of fintech and SaaS and those tackling the existential climate challenge of our generation through technology. 

Market headwinds and a return to normal

We thought we might be able to complete a half-year letter without mentioning market conditions but we didn’t quite succeed! We wrote the following to you a year ago in our June 2022 letter:

“We are currently in a period of high uncertainty and there is a wide gap between the bull case and the bear case outcome over the next couple of years. Like every other business, we need to have a plan. However, we need to hold our views lightly and be flexible and agile as the facts become clearer.”

A year later, there continues to be a gap between the bull case and bear case, but that gap has somewhat narrowed. The likely outcome is something that is pretty close to being down the middle of the bull and bear case.  Markets continue to function but it is more challenging for companies to raise rounds of capital as the pace of investing in startups has slowed. Top quartile and second quartile companies are still able to raise money, albeit at muted valuations, and it is much harder for third and fourth quartile companies to raise. To some extent, this is the way things should be. 

Valuations have trended lower and there is a reasonable prospect of them falling further. This of course has the potential to (negatively) impact our existing portfolio and (positively) impact new investments we make. When we talk about valuations we are talking about averages and not specific companies and the valuation of individual companies will vary enormously based on their individual performance and other factors such as the market segment they are operating in. Importantly, the companies that are the key contributors across each of our funds are well capitalised and performing well. We are comfortable with the holding value of our portfolio including the general and specific provisions that we have made.

A few weeks ago there was a breathless headline in the Israeli media talking about the dramatic fall in funding for Israeli startups in the first half of 2023 (the year-on-year decline was 68%) and noting that funding levels had not been seen at this level since 2018! This encapsulates the core point. If you are assessing the current level of startup funding and valuations, your view of the market depends on your point of comparison. If you are comparing the data to the period of late 2020 and 2021, it looks pretty bleak. If you are comparing the data to the 2016-2019 period, both funding levels and valuations look very normal.

We have talked previously about the good decisions and poor decisions we made during the 2020-2021 period and the decision that looks best in hindsight was the proactive steps we took to return nearly $600 million to you during that peak valuation period. To be clear, we do not look to “time” markets but we consistently look to return capital to our investors at the right time. The period 2020-2021 was the right time both from the perspective of the maturity of our early portfolio and a market perspective.

We do not expect to return much capital over the next 12 months. The measure that we are most focused on, as always, is whether the key contributors in our various funds are continuing to create long-term value. We will return capital to you when the relevant portfolio companies reach the appropriate level of maturity and market conditions allow. We never forget this is your capital. 

Growing the Square Peg team to expand our portfolio support

In the last half, we welcomed two new members to the Square Peg investment team. Phil Ngo joined the team as a Portfolio Analyst, following senior strategy and operations roles at Safety Culture and Deloitte. Darren Shein also recently joined Square Peg as a Senior Associate in the Israel investment team. Darren was most recently the VP of Operations at Compete and previously held a range of investment roles at ION Crossover Partners, Record Point, and Charter Hall. We’re excited to have Phil and Darren on the team as we continue to support and expand our growing portfolio. 

Thank you for your support

We are grateful to our investors for all of your support, and are cognisant of the need to be responsible stewards of your capital. 

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