E305: Why 95% of AI Startups Will Never Build a Moat

16:47Nick Beim:And I think however the Ukraine war ends is likely it will end with the Ukrainian army still probably the most significant land army in Europe, the most experienced in how war is changing. So what's changing is a couple of things. One is hardware is becoming commoditized and attributable for the most part. There will remain some exquisite, very powerful hardware systems, weapon systems, aircraft, and so on. But there's going to be a huge amount of mass production of land, sea, and air drones that are able to do a lot of the work that humans used to do so you can deploy them without the human risk.

17:24Nick Beim:And there are going to be specific defenses that are arrayed against them. And when you think about where the intelligence for those is, it's really in software and AI. So that's one change, sort of autonomous systems, attributable systems at the edge. Another change is the ability of AI to ingest all of the sensor data from the battlefield, from potential battlefields, and understand what the most intelligent operational decisions are. So it's been very difficult to get all that information historically in the first place. To get it all together into AI and be able to sort of query it and have it be a sort of partner in decision-making for operational decisions is incredibly powerful.

18:07Nick Beim:In the Cold War, when the Cold War started to get, it started to really heat up. So with the Korean War in particular, and with Sputnik, we put a huge national effort into innovations. We We created DARPA. We created STEM education in the United States. We made all sorts of changes to try to avoid that sort of technological surprise in the future. But as the Cold War wore on and when the Cold War ended, we sort of sat on our haunches a little bit and we weren't as aggressive in adopting new technologies as we should have. And the result is now China is trying to develop a more capable military primarily by trying to leapfrog us in the area of applying advanced technologies to their military and to their intelligence.

18:50Nick Beim:And I think we now have a lot of urgency in this area, but we've got a lot of work to do.

18:56David Weisburd:Ukraine is really the testbed for this asymmetric warfare, which means you have these$500 drones that are destroying five$10 million tanks. So you have almost this last generation of technology battling out the next generation of technology. What is the United States doing in order to evolve their defense tech for next generation warfare?

19:21Nick Beim:It's interesting. So on counter drones specifically, there are a lot of approaches that are being experimented with, both sort of in the lab, so to speak, and on the ground in Ukraine, like working with Ukraine. But I think generally, there is a part of the military revolution that we are not currently well-suited to execute on, and that's low-cost hardware. If you look at the margin structure in the business model of traditional defense primes, it's cost plus. They charge a very large amount for their hardware systems, and they bundle services with these systems, whether it's an aircraft, a radar system, whatever it is, a ship.

20:00Nick Beim:But the action going forward is going to be in a lot of these low-cost systems, and they don't see enough margin for that to fit their current business models. One might say their business models have to change. I think more likely you're going to get new players like Andrel and there are going to be others that are able to make great businesses around doing that really, really well. And it's interesting if you look at how much we spend on defense, I think we could spend, you know, half of that and have it be more effective because so much of the money is wasted in these huge, exquisite contracts that have lots and lots of maintenance costs.

20:30Nick Beim:And, you know, it's interesting if you look as a subset of that and how software is developed in the Department of Defense and intelligence agencies, it's often by companies that aren't really software companies. And they throw lots of bodies at the problem. And you get this custom code by people who aren't, you know, the kind of software talent that Silicon Valley runs on. And I don't think our country is best served by that.

20:51David Weisburd:You mentioned cost plus. Not only is there no incentive to lower the cost, there's a disincentive because oftentimes this cost is a percentage, not a dollar sum. So it's not like if they lowered the cost by 10 times, they would make the same amount of money, which doesn't really matter. They actually make less money.

21:05Nick Beim:Absolutely. And if you look at the major systems that have been driven by cost plus, their cost keeps going up and up and up and up. You know, there's a joke in the military that eventually all military spending will go into one airplane. I don't know if it's the F-94, but, you know, just the cost of aircraft, the F-35 was so incredibly over budget. And we can't afford to have that type of development drive our spending going forward. We need to be smarter about where we spend money and make sure it has the biggest impact.

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22:10David Weisburd:And the best part, you keep 100 % of your savings. Get started with Experian app today. Results will vary. Not all bills or subscriptions are eligible. savings not guaranteed. Paid memberships with a connected payment account required. See Experian.com for details. How are the new defense tech companies like Andurl able to compete with these entrenched defense companies?

22:38Nick Beim:They've done something very intelligent, which is not try to compete with existing primes on their core territory, but carve out some new territory, in particular autonomous systems, and get really, really good at that. And autonomous systems are such an important area for all parts of the military, is really one big dimension of where warfare is going, that they've been able to grow rapidly. And I don't think the traditional primes are going to be very effective in competing with them because it's a low cost game and that's not what they do. And I think that's not what they can really afford.

23:09Nick Beim:And I think the technology, you know, AI development is not currently really what they're good at. Whereas Andruil, I think, has a lot of highly trained AI engineers that really are good at it.

23:21David Weisburd:Stepping back, AI is changing on just such a fast pace. We normalized last week's changes as if it was 10 years ago, but it's just changing almost on a weekly and monthly basis. Given all this change, how do you come up with principles and methodologies to diligence invest in companies, either both in AI, within the AI space, but also those heavily reliant on AI?

23:50Nick Beim:It's something I think about a lot. And for the kind of investing that I do, early stage venture capital investing, it's very intuitive. It's very people-driven. And the most valuable tools that I have found are really two. One is finding the smartest people in the world in certain problem areas, technology areas, the application of certain technologies to different business sectors. They're out there. I spend a lot of my time just trying to find who the brightest people are to help figure out what are the big new opportunities in the space. Often they're entrepreneurs who are active in that space and who have a lot of calibrated imagination about what's possible in it.

24:33Nick Beim:The other thing that's very valuable in venture capital, you don't always have the chance to experience this, but if you invest in a company that's a real pioneer in an area, it's doing something very disruptive. Usually they're the kind of companies, DataMiner was an example of this, Altruist was an example of this, where people sort of scratch their heads and say, really? You think you can do that? That seems impossible. Like, you know, talk to me in two years and let's see where you are. And if those companies succeed, which both have, both are, you know, multi-billion dollar companies now, they often bring a huge wake of innovation behind them.

25:10Nick Beim:And they often have, if you are an investor in those companies and working with those management teams, you have really interesting insights into what else is possible in innovation in related areas. And so I think in part because of my investment in Altruist seven years ago, I had a chance to work with Jason Wank, the founder, and he created such a terrific company that opened up so many other opportunities that it led to a much deeper focus on my part in wealth management because I suddenly saw all these big opportunities. And Jason and myself, Bill McNabb, the former CEO of Vanguard and others collaborated on finding and making the best investments also in creating some brand new companies.

25:53Nick Beim:So all of which to say, if you are fortunate enough to be in one of those pioneering companies, that gives you disproportionately valuable and often proprietary insight into where other opportunities lie.

26:05David Weisburd:Has that been one of your keys to success is essentially to focus on a niche, kind of like a business? It might not be the biggest, well, tech, let's be honest, it's not as big as AI LLMs, but it is a niche. It has specific players, it has specific ways of winning. Was that a purposeful strategy or is it just something that you'd made a couple investments and you're like, okay, I now have two more investments than 99 % of the world?

26:29Nick Beim:I'd like to say it was all prescience that I had this all figured out 15 years ago. But no, it was very opportunistic based initially on the success of Altruist and then the success of other companies like Vanilla and Moment that I've invested in and wealth management. And I found that in virtue of those investments, I just, not only could I see where the opportunities were and did I have a group of people that were so well attuned to where innovation was possible in the industry, but I also knew all the major customers. I got to know, you know, so many of the, you know, leaders of large RIAs, of the wire houses and custodians that it became very straightforward to help create new companies to go after new opportunities.

27:11David Weisburd:Do you have to avoid the temptation to enter these new hot sectors when you have a niche that's a great opportunity, but sometimes you have these temptations that come about that seem very interesting?

27:26Nick Beim:I find it's often very helpful to yield to that sort of temptation because the world is changing so fast. I think if you've really built a franchise, an investment franchise in an area, it will always yield fruit, but maybe you've gotten the most attractive fruit early on. And AI has increased the pace of change so much that vast new things may be possible in areas that you previously had written off as not being sufficiently exciting to invest in, or maybe you missed some of the early investments, but you'll see very big new ideas. It's in venture capital. The moment you stop exploring fascinating new ideas that could be highly disruptive and are content with what you're doing, you're done.

28:07Nick Beim:The world just moves too fast.

28:08David Weisburd:You've had a storied career, McKinsey, Goldman Sachs, Matrix Partners. You've been a VC for almost 26 years coming up. I don't want to age you. But what is one piece of advice you would have given a younger Nick when you just started at McKinsey that would have either helped accelerate the rest of your career or helped you avoid costly mistakes? The biggest piece of advice would be to be more cautious about pattern recognition.

28:37Nick Beim:Pattern recognition is incredibly valuable to venture investors in sort of sorting all the opportunities that you see and to very quickly make a judgment on whether something might be a good investment. But it fails in one critical case, the most important case of all, which is very big new disruptive investments. They don't fit a pattern. And when you see them, they look different. They sparkle with greatness, but they look kind of weird. and there are 50 reasons to turn them down according to traditional pattern matching. And this is true for, if you think back at Apple, if you look at open AI, if you look, you know, it was a nonprofit, you know, how would you invest in that?

29:14Nick Beim:A lot of the most disruptive companies, you have to throw out pattern recognition, shift from fast thinking to slow thinking and go to ground fundamentals and really use your imagination based on those fundamentals to think what's possible. And right now I spend all of my time looking for really big opportunities. I'm not satisfied with things that could be a double or a triple. I'm satisfied to take my time, take really a significant risk, but really calibrated, thoughtful risk in areas where I think I have an advantage to go after something huge. Because in our business, all that matters is the big wins.

29:54Nick Beim:Everything else is really a rounding error to those.

29:57David Weisburd:Do you feel that more 25 and a half years into your venture career? Do you feel that more like you've internalized this power law?

30:09Nick Beim:I think I have. And I think one of the reasons is that I got lucky, particularly for all of us in the last five, six years, we lived in the age of this AI explosion. So there are more of these huge companies that are being built and they're home run, so to speak.

30:23David Weisburd:Power law is one of those things that it's this unlearnable lesson that until you experience it yourself, it's like, yeah, yeah, power law. Great, great. I'm going to focus on two, three acts and yeah, I'm going to get my power law. But it's so powerful that it's hard to actually internalize until you've experienced it.

30:40Nick Beim:And here's the challenge in venture. When you see something like that, something that sparkles with promise has all sorts of challenges with it, lots of reasons to turn it down, but there's been nothing like it before. And you introduce it to your partners. Some of them are going to say, wow, this looks interesting. But often for the most disruptive ones, the bulk of the partners might say, hey, it looks cool. I don't see this though. Or, you know, gosh, we think you're probably too excited about this one. And in those moments, and Venrock is terrific because we have a decision-making structure that allows partners to go forward with those investments, even if all the other partners disagree with them.

31:16Nick Beim:For us, it's not about banging the table. It's about being incredibly thoughtful about what, you know, you have to have a really thoughtful reason, set of reasons for wanting to make an investment. But the biggest wins of all tend to have the signature of zero or one other, you know, one other person in the partnership thinks this could change the world. And everybody else thinks, yeah, this is kind of nuts to us.

31:39David Weisburd:But, you know, how would you explain that?

31:43Nick Beim:Because they're so different. They don't fit traditional pattern recognition. And to appreciate them, you have to really spend a lot of time understanding how they grow, where their competitive advantage is, what's distinctive about them, where their defensibility is.

31:57David Weisburd:It's idiosyncratic. You don't actually know until you're deep in them. And it's so driven by the people, like the person typically, or the people that are founders

32:06Nick Beim:have to understand what they're doing in such depth, understand the problem better than anybody else has thought about it. And if you see all that, those are often the best kind of investments to make. But when you make them, it takes a lot of courage of your convictions to say, I very much appreciate that people disagree with me. I think this could be huge. I'm obviously going to be judged on my performance. I love venture firms that allow people to do that. Venrock has that kind of structure. And those have been some of our biggest wins.

32:33David Weisburd:To play devil's advocate, obviously these startups, Facebook, Google, SpaceX, these are just completely idiosyncratic, completely nonlinear companies, but there must be pattern matching when it comes to the founders. Is that also completely different for each generation or is the founder archetype and something in the founders subject to pattern matching over your career?

33:02Nick Beim:It's very much subject to pattern matching. And on top of the founder archetypes, there are deep relationship networks that we find lots of insight in that might tell us this founder is extraordinary. I love calls where someone says, Nick, this is one of the most extraordinary people I've ever met. You're going to think he's kind of weird. You're going to think he might not understand all these things. Hear him out. I will invest in whatever he does and he's going to change the world. I don't quite know how and he's going to make a bunch of mistakes along the way, but he needs a great partner.

33:35Nick Beim:And please take the time to talk. I will drop everything I have going on if a really calibrated person introduces me in that way. And yeah, founders come in a lot of shapes and sizes, but the good ones tend to cluster around five or six different artists.

33:49David Weisburd:A lot of the top investors I know have told me, both private and publicly, that they will invest in a top founder with what they consider to be the wrong business and the wrong business model. Do you subscribe to that? I completely agree with that. Why does that work? Play that out.

34:05Nick Beim:Well, the best founders change their business model, change their business focus, but companies that are committed to a specific business model or business focus don't suddenly increase the caliber of the people at the team. For us, we do a lot of what are called incubations, where we really help start a company in our offices. And it's interesting, a lot of those exercises begin with, this is an incredible person that we would love to build a company with. let's go find, you know, there are three or four areas that we've talked to this person about and they'd like to work in. We'd like to really go deep with them and come up with a really great idea.

34:40Nick Beim:Some of our biggest wins, in fact, many of our biggest wins have that structure and it all starts with a person. There's a wealth tech company, two wealth tech companies that I have that'll be coming out of stealth mode in the next several months that both have that background where we started with the person and then it was a great idea, but the idea changed a lot. but the person is what makes it magic.

35:03David Weisburd:Distill what makes somebody so special that Venrock wants to put resources behind him or her, maybe not even with an idea.

35:12Nick Beim:Several things. One is just incredible intellectual horsepower and incredible drive. And the drive is interesting because you and I know a lot of incredibly driven people who have always stayed on the straight and narrow and don't take a lot of risks. The drive that we're looking for has a huge quotient of raw willpower to it. Someone who can create something out of nothing and just make it happen. A lot of grit and a lot of just sort of -

35:36David Weisburd:You see a lot of trauma there. I know you're not a therapist or psychologist, but is trauma either a necessary component or an amplifier of founder success?

35:46Nick Beim:That's a really interesting question. I can imagine in some cases it is. And in some cases, there are psychological attributes that aren't trauma per se. they may be related to trauma, but like having a big chip on one shoulder, that can be a huge motivator. So, you know, we tend to love that. That's not a necessary condition. Some people are just incredibly driven. It's who they are. It's maybe how they were raised. So I think very high intellectual horsepower, very high commercial instinct. What's going to work? You know, what's going to make money? Not just in the abstract, what's an interesting business model or technology area.

36:21Nick Beim:I think having leadership capabilities, they don't have to be great managers per se, you can pair them up with all sorts of people. But people who are going to have an industry follow them, the customers in that industry follow them, the best talent who wants to, you know, be a part of something big in the industry, follow them and join their company. Investors follow them. So there's almost a Pied Piper element of someone who, and it's not based on anything false. It's based on charisma and a very compelling vision. The last thing is someone who really, really understands the nature of the problem they're trying to solve.

36:56Nick Beim:A lot of companies get started kind of on the fly. We're going to do something in this area. We'll figure it out. But we love people who are scientific about the problem they're trying to solve and have incredibly thoughtful approaches to solving it. And they know the customer. They know the pain. Often they were the customer or they've previously felt the pain. And so those, I'd say those are four critical elements and there are others as well, but I'd say those are the core ones.

37:22David Weisburd:You mentioned this magnetism. I love the Ashton Kutcher role. Ashton Kutcher, a lot of people don't know, is a great early stage investor, Airbnb and a lot of other great seed investments. And he has this role that in order for him to invest into a founder, he needs to, for even one split second, think about quitting whatever he's working on and co-work for that person. Not think about them as somebody that could hire great people, but literally he himself has to be like, well, maybe this investing thing isn't for me. I'm going to be his CMO or his co-founder because he's that compelling.

37:52Nick Beim:I agree with that. And there's one interesting criterion that goes along with that. That's really important to us, kind of a potential corrective to it or corrective to areas where that could go wrong, which is that we really seek to work with people who are truth seekers, who don't drink their own Kool-Aid, who don't get caught up in their own charisma, but who always are interested in discovering the truth and are the first ones to bring up, hey, actually, I was wrong about this. And it looks like things are going to be different. And here's how I'm approaching it now. That commitment to truth and transparency is critical to success because the rate of learning at a startup is one of the big drivers of success.

38:27Nick Beim:And you don't learn quickly if you don't admit your mistakes and stop drinking the Kool-Aid.

38:31David Weisburd:I think there's a tacit thing there. I like to say the best sales, like the best plastic surgery is unseen. So if somebody, if you look at someone, you're like, whoa, you know, that a lot of plastic surgery, that's obviously really bad. Or if you say that good plastic surgery, that's also bad. The best one is when you can't tell that that plastic surgery. Same with sales, the people that people think are the best salespeople are maybe A minus B plus salespeople. The best salespeople aren't seen as salespeople. I think charisma is the same thing. It's not this, these people that go into a conference and give the speech that they think everybody else is going to be hyped by.

39:04David Weisburd:It's the people that drive other people to go and follow them. And to your point, they might be completely weird. They might be even antisocial, but they believe so much in their vision that again, you want to follow them. It's almost an involuntary thing that you want to follow them. You're not even making a decision. It's almost an unconscious decision. Absolutely. Well, Nick, this has been an absolute masterclass. Thanks very much for jumping on.

39:28Nick Beim:Terrific to be with you.

39:29David Weisburd:That's it for today's episode of How to Invest. If this conversation gave you new insights or ideas, do me a quick favor. Share with one person in your network who'd find it valuable or leave a short review wherever you listen. This helps more investors discover the show and keeps us bringing you these conversations week after week. Thank you for your continued support.