Navigating the AI Boom | Startup Finance Basics w/ Kruze's Scott Orn

0:03All right, everybody. Welcome back to the program. You know, we like to do these startup basic segments. Why do we like to do them? Well, we get asked a lot of questions over and over and over again. We have 20 ,000 startups apply for funding from our firm every year. It's called Launch. You can go to launch.co slash apply to apply for funding from our little seed fund. And then we'll meet with probably 5 ,000 of those founders just in a brief Zoom call. And we wind up investing in 100 of them a year. What that means is we get the same questions about cap tables, about accounting, about human resources all the time.

0:42So if you go to thisweekandstartups.com slash basics, you'll see all the basic videos we have. This is the blocking and tackling. And the partner I use for our finances is Cruise, K-R-U-Z-E. And Scott from Cruise comes on the program. And he's a CFA. He's a COO over at Cruise. And we talk about the basics. and things have been booming in silicon valley in the tech industry recently because of ai huh absolutely i actually saw some of the stats today and it's just it's mind-blowing what's happening i i thought venture capital investing would be down but it's actually up for the year can you believe that well you know we we we do have to parse out some of the mega rounds right because ai and we're going to get into it today we're going to talk about you know sort of financing saying revenue accounting everything for ai specifically it's really a lot of work um to put up you know uh clusters of hardware takes a lot of highly paid sought after developers to build anything good which means a lot of capital is being spent and invested so i bet you there's a a fat part of that long tail there where you know elon orders a hundred thousand h1s and him and i heard the story of him and larry or larry ellison's story of him with jensen begging for h100 begging to throw piles of caches into cash over the moat into the nvidia um castle as it were but uh let's get into it you know you you've got 175 of your clients uh that you do uh the books for are ai so it's like one in four basically for you what's unique about this boom in your mind yeah well the boom is very real we have a really great great stat where our clients raised two and a half billion dollars this year and one and a half billion of that is the ai companies so even though they account for what, 20, 25 % of the clientele, they're raising more than half the money, which is pretty mind blowing.

2:52But I think to validate your point, they just have a lot of infrastructure costs. It's kind of like the rest of the business model is kind of like SaaS. Like, you know, you spend money on marketing, you spend money on headcount, things like that. But what we found is their infrastructure costs are about two X higher than a typical SaaS company. And that really adds up across all these companies. That's a really interesting point. And it's because this new hardware layer is very expensive in order to do this. And we've been living in a compute light ecosystem for a long time. Compute got way ahead of what was necessary.

3:31Storage, bandwidth. I mean, it's not like a SaaS application. If you're using Slack or Zoom requires some ton of CPU. It doesn't require a ton of storage and doesn't require a ton of bandwidth, you know, the bandwidth of a cable modem at home, more than enough to do a nice crystal clear zoom call, your laptop or your G drive, your Dropbox, plenty of room box to store your files. So we've been kind of through almost two decades of not worrying about hardware. And here we are again, racking and stacking and trying to make this data move quickly. But let's talk about the revenue side, because there is this term air gap, basically all that spend.

4:19And then where's the revenue coming from? Turns out people will pay for AI, but it has a big cost. and so people are seeing value here it's kind of the antithesis of what you and i saw scott with crypto we were talking about crypto and startup basics and how lucky that was because you had all this vision gonna change the world but not a lot of application right like and then we start talking about ai i know you've got tax uh ai companies coming at you who want to do co-pilots we have one tax vpt i know for production we have a company podcast ai that's doing the transcripts of this very podcast and hosting our website and helping us make clips.

4:59I think they're a cruise client. I think podcast AI is a cruise client, actually. I hope so, because that revenue is going up and to the right. I think they're part of your group. So, you know, people are willing to pay for this stuff and they're getting value from it. But tell me what you're seeing, because you actually can take the data across these 800 companies of which, you know, one in four or so are AI based, and you can give us an approximation of what's going on. Yeah, exactly. So we're this really great index for Silicon Valley. And what we're seeing is AI companies are growing 60 % faster than a traditional SaaS company.

5:34And we could talk about the expense side of the equation in a little bit, but that's pretty impressive. I think you talked about why all the capital costs going into AI companies, and that's very real. But I think the reason why investors are happy to write those checks is they're actually seeing growth. This is really happening. And those are on companies that are over a million dollars in ARR. So this isn't like the little dinkers who are growing 60 % a year because they had a really good three months. These are companies that are substantial. And so that's a real stat. And so to me, I still think we're really early in this whole trend.

6:10And I mean, you have all these companies that you've invested in, you're probably seeing the same thing. But the winners are starting to kind of emerge. And in the venture capital ecosystem, the winners are usually the ones that are growing the fastest those are the ones people get so excited about so we're seeing it there's that stat is pretty mind-blowing to me yeah it we're seeing it in our portfolio as well i mentioned podcast ai and you know when they pitch a podcaster on hey we'll make your website for you for 500 bucks a month transcribe every episode help you make clips you start putting that against producer time and then if a producer in uh a podcast you know let's see 2 000 hours i always do the back of the envelope math it's when you and i you do your math perfectly i do back of the envelope as an early stage investor 2 000 hours uh times 30 40 bucks an hour 60 to 80 thousand dollars a year is what you know editors if you want to do offshore editors would be a fraction of that half of that maybe but you know us-based editors producers maybe 60 70 80k so that's 30 bucks an hour if you can save you know i don't know 10 20 hours a month of time which is what podcast ai saves us per week you know then the arbitrage is between those two numbers isn't it you know they're they're providing us with 100 hours saved 80 hours saved a month and they're charging us for 10 hours that's a really good deal that's called efficiency and that is what drives the US economy.

7:42Totally. And I remember actually when Sean and Ed were, I think someone on your team sent them over and they gave me the similar pitch. It's not just about the time save, but it's about kind of that cognitive relief. I mean, like for example, you, you're a super busy guy, knowing that that's just kind of taken care of has this other benefit that's even beyond dollars and cents, which I really like. And we're kind of seeing that, we're lucky that we have a bunch of these AI clients. And so a lot of times we'll like dog food their stuff, you know, and it's really fun. It's also just like, I think what it's also doing, I still think we're very early, like first or second inning of this stuff.

8:19It's just kind of sparking new ideas or sparking new applications that we'll continue to see this over the next two or three years. I remember when SaaS first came, I'm old enough to remember like in 1999 and 2000, when the baby SaaS companies were coming. And it was like, you can put the stuff in the cloud. That's amazing. You don't have to rack and stack servers in your office. I mean, people don't remember this. But you know, if you had a company of over 100 or 200 people, you were on a couple of floors of a building. This is when people went to things called offices. And they work together on projects called companies.

8:53But at that time, you'd have a closet and it would be your server closet. So you found a closet or an old conference room, you converted it, you would have air conditioning brought into that floor for a hundred thousand dollars you'd spend a half million dollars on servers then it moved to the cloud similar thing happening here i like your analogy though of we're not analogy i i like your insight it's the first time i've heard it actually that lowering stress by just having something automated is virtuous and that is exactly it i would have to be on top of a producer to be on top of updating the website i got to check it you know humans make mistakes and now hey the website's done humans don't make mistakes so i feel like a third of the grunt work that we face this year you know or of the last two years is being automated i think it's like somewhere in that number um and proofreading is another example of it you know we use grammarly which is ai based chat gpt claude also do a great job of this you dump any text in there and say check this or superhuman one of our customers and i think you you did their accounting for a bit uh maybe still do um you know they have ai built into it so composing an email and not having somebody have to check oh before i send this to a client can you proofread it you know or you know a deal memo having to be proofread it's just kind of already proofread so i used to spend so much time two years but two years ago reading deal memos and making sure commas were in the right place because i'm the best writer on the team we're top two out of 20 you know we have two good writers, three really good writers.

10:30We had three great writers in the company now, and we had 17 who were okay or bad or good. Now everybody's good. And the three people are awesome because you don't have to worry about where the comment goes. Yeah. There's also a nice time savings thing that's happening. I mean, for us, our VP of marketing, Healy Jones hooked up ChatGBT through our Slack channel to index all of the content that Vanessa and I have written or all my videos, which is really kind of like the intellectual property of Cruz, right? Like all, just like all this knowledge we have in our brains. And so now our accountants can actually go to the questions channel, type in a question and they get the answer as of Vanessa or I would be answering it.

11:09And it's really, really powerful. Now we always proofread it. We're always really careful because we're regulated. We don't want to send out bad information, but just if you're an accountant and you're trying to get back to your client as fast as possible, getting that really, that answer instantly and sanity checking it, of course, It just relieves the stress and improves our ability to get back to them. And then you multiply that by 800 clients and all the questions we're getting every single day. It's really powerful. That's not even something we charge for. That's not even something that's revenue generating.

11:37It just made us a better accounting firm. I feel like the entire labor force in the United States or the ones globally that are embracing these tools are leveling up. and the distance between people using these tools and not using them the gap is really wide i insisted everybody in our company when you open a new tab in your browser have it and you can get these browser extensions um you know in the chrome store or brave store or firefox add-ons whatever it is when you open a new window i open by default chat gpt4o and then sometimes i'll switch it to claw why because i want it to be what i open up to and i start conversing i'll give you another podcasting experience um or an experience i had today on a call with a serial entrepreneur who's coming back to us uh with a second company and we're investing and having them you know do the 125k standard accelerator note and we were talking about this field and i wanted to know what the terms of service of a company said about this idea boom i type it in then i wanted to know what other companies had tried this and i said was there an uber for blank i'm going to put in what blank is and i said boom i said okay put it in a table tell me how much money was raised give me citations and this new reasoning engine that 4o has really started to give me results that would have been the same as an associate a venture associate would be on that call and after the call they might spend the afternoon doing that work now i'm getting it in real time on the call for the first time scott i took my q a from the zoom call and i gave it to the founder and shared it with them and i said here's the research i just did now normally an associate would give me that they'd share it with me i would share it back with the founder it would take four or five hours now if You start talking about associate time.

13:37Now you're looking at 40, 50 bucks an hour. All of this is abstracted away. And so if you're not using these tools, you're falling behind. Yep. And you talked about something that was really interesting where it's now your default opener on your web browser, which is, that's kind of the next stage. I think, I mean, we're, we're very fortunate. We work with a company called perplexity and I know a bunch of people. I mean, it's a classic cruise. It's like when superhuman, you know, when rule came over Vivek, they come up the two people and an idea, you know, two or three, it's probably been two or three years now.

14:05And all of a sudden now they're exploding. And I know in our company, a lot of people just use perplexity instead of Google now, you know, and that would have been mind blowing to think about two years ago or three years ago, but these defaults are starting to change and it just makes so much more. There's so much more potential. It's really exciting. So yeah, these companies, it's, it's for real. And I know. Tell me about the accounting. I mean, that's what, let's get down to brass tacks here. they're going to be charging consumers and enterprises for this product and there's a lot of expense so how do you how does anything change or is it just standard sass accounting and then how do people charge for this because i think sometimes people don't take into account what these uh you know chat gpt uh bills could be you know using some of these models and so So, man, you could get a bill as a CEO and all of a sudden see$7 ,000,$8 ,000 from Claude or ChatGPT or whoever and be like, whoa, that's a little expensive.

15:05I mean, try million dollar invoices from the cloud. I mean, we have a lot of companies, I'd say probably 5 to 10 that are spending something like$500K to a million dollars a month just on their cloud infrastructure. Yeah. And so there's kind of the revenue accounting, which we'll talk about in a second, but the expense accounting is really, really important, especially because, I mean, a lot of these, you know, this is Amazon, Microsoft, Google Cloud, they're fantastic companies, but these groups are growing so fast. their invoicing is not really how you want it to be, to put it nicely. And so we see companies getting double invoiced on accident, or they forget to bill the company for June.

15:49And all of a sudden, the next month, they get a$2 million bill instead of a$1 million bill. So this materially affects your burn. So we're actually doing a ton of work right now just doing these spend analysis for AI companies because you miss a million dollars here, million dollar there, that could actually dramatically impact your cash runway. The companies are spending a ton of money with this. And what's also interesting, Jason, which is, it shows you how nascent thing is. This is a lot of our big AI companies are spending a lot of money with like Anthropic or OpenAI. They actually have like executive to executive.

16:23It's not like the sales guys talking to this, the CTO talking. It's like the CEO to CEO kind of conversations because these are really big contracts. They're spending a lot of money with each other. because sometimes they're aggregating each other so it's this is like real real dollars and look at this i mean the gap here is unbelievable ai uh we're looking at spending on hosting compute and software as a percentage of revenue these ai startups are spending over 50 percent and it's been growing since 2023 and then you look at standard sass it's fixed 19 18 15%, not even above 20. So this proves what we've been talking about.

17:03It's supposed to be getting cheaper. They're supposed to be lowering the cost by 90 % a year. But I think people are finding new things to do. Every time you solve something, we just talked about the podcasting applications, you then find another reason to use AI. And that's why this is such a profound shift in technology. once you start using it you cannot stop it becomes the paradigm shift for you as a as a executive as a founder you're just going to look at every problem and say how does ai solve this and then that comes with an expense totally and i mean core weave was one of our clients for two or three years and that's one of the major kind of compute power companies out there and like they all these companies are just constrained by their capacity they can't add enough capacity so they have pricing power.

17:51You told that story about Elon asking NVIDIA for the processors, right? If that's the case, everyone's got pricing power. So what's kind of interesting to put this in a venture landscape is we're seeing, I think we're seeing a deeper J curve, meaning these companies have to invest a lot more just to get going. We know they're growing revenue faster at 60 % faster, but is that going to be enough? Do they need to be growing 200 % faster than a normal SaaS company? That's what's going to play out here. But yeah, they have dis-economies of scale, which is a little scary as an investor or even someone working in the industry.

18:29But I think I'm kind of like, I think this is what you were saying. I think entrepreneurialism, capitalism is going to come by and start working those costs down. Moore's Law, all these things that we've seen historically in technology, starts driving economy to scale. It's just going to take a little bit longer. It's one of these things where you're now using in so many different places, you're going to want to do line items if you're doing some like in my example in our firm and we're just using off the shelf stuff but if we were going deeper you might be using some part for your podcasting media business you might be using some for your legal accounting you might be using some where your developers are using a co-pilot those are different uh cost items uh and cost centers and so getting one giant bill from your web provider your your web services provider you You need to break those up.

19:21I don't suppose they do that very elegantly in the bill. No. A lot of times we're going... But you're making an excellent point, especially research and development and cost of goods sold. So cost of goods sold is the cost that deliver the service just kind of in a normal way to your customers. Research and development is what your advanced team is working on building new capabilities. And what's really important for startups to break that out is, first of all, venture capitalists really care about your margin. And what we've been kind of talking around is things like gross margin, right? If you have a really terrible gross margin, no matter how exciting the business is, VCs are going to be hesitant to invest.

19:57And then the second part of that is for your R &D tax credits, money you actually get back from the government as a tech startup, you only are able to claim your research and development costs. And so breaking that out allows you to claim the R &D compute expense on that credit. And so these companies are getting$250 ,000 to$500 ,000 back as a payroll tax offset, meaning they don't have to pay payroll taxes. So just that simple act of breaking that out, the accounting pays for itself by 10x, right? You're just getting a huge benefit there. You want to do that. And here, as we're talking, for those of you who don't know the J-curve, I just said, explain and show the J-curve to chat GPT-4.

20:37Oh, I'm not even using the new preview of 01. But, you know, I didn't realize there was a political J curve. I didn't either. Yeah. So in political systems, reforms or shift might initially lead to instability or dissatisfaction. However, once the changes are institutionalized, the benefits are realized, stability and satisfaction prove, again, showing a J curve. So it might be like, oh, my God, we give women the right to vote and everybody gets upset, but then it comes back and everybody's happy, whatever it is. I mean, I'm picking a very dramatic example there. But here's, you know, more representations.

21:10And I said, hey, just explain the J curve, which basically means you'll lose money, you go into a deficit, and then you recover. And here's Tesla's and here's Uber's. Those are two famous businesses. And it says here Tesla faced significant financial losses early years as an invested in R &D production facilities and building a brand. the cost of electric vehicles and same thing for the J-curve for Uber subsidizing rides expanding globally and legal and regulatory challenges cost a lot of money so you're going to go into a deficit and then hopefully it returns if you're going to do this you need to have a partner Cruise is a great partner they really really help a lot of our startups because one of the things that drives me personally crazy and my partner Mike Savino in the business who's a bit of a bean counter himself.

21:59I mean, that in the most positive way possible because we don't want to waste beans. He asks a lot of tough questions. Mike sends us emails asking tough questions about accounting and finance. Well, because you know what? He's so good at accounting and finance that we'll have these discussions and you only see the ones he can't answer. So if it gets to your desk, it's because he understands most of this stuff, but something new comes up. You need to have a great partner. Scott's that partner at Cruz. I just love having him here to help us with this. AI is going to be changing everything. And really, you know, what I'll tell you is I've seen as many startups fail because of legal accounting and HR issues, which I'll put into operations as fail because of not getting to product market fit.

22:49It's an equal amount. So, you know, eight out of 10 startups fail hard, return nothing to investors, you know, and it's just an experiment that fails. That means four of the 10, in my estimation, fail because of operational issues, which in a way are self-inflicted and you can remove them by having a great partner. cruises our partner for accounting uh and all this finance stuff and then um you know becky degraw over at wilson cincini helps us with the legal stuff here's your call to action go to cruiseconsulting.com twist talk to scott he's my guy and if you want to learn a ton this week in startups.com basics and he's scott at cruiseconsulting.com k-r-u-z-e thank you scott

23:39Thank you.