Generative AI is taking the venture capital world by storm. Despite the slump in overall VC funding, investor interest in AI is intensifying.

PitchBook notes that "in the world of startup valuations, there's generative AI—and everything else." The Wall Street Journal describes the current environment as "ChatGPT fever . . . Amid broader venture-capital doldrums, it is boom times for startups touting generative artificial intelligence tech."

As VC investors look to the generative AI market and companies seek funding, there are several things to consider including valuations, the ever evolving regulatory landscape and a heightened need for robust diligence and corporate governance processes.

Increase in Valuations and Funding

According to PitchBook data as of May 18, 2023, median pre-money valuations for early-stage rounds of generative AI companies jumped by 16 percent this year compared to 2022. All other startups saw a 24 percent drop. Investments in generative AI are expected to hit $42.6 billion by the end of 2023.

Generative AI companies are causing a lot of excitement and while we continue to hear reports that there is a FOMO mentality among many investors, there have also been rumblings that these increases in excitement and valuation bear similarities to other market bubbles. Accordingly, investors need to weigh these signals against the general consensus that generative AI has a staggering potential as a disruptive technology, leading to big winners and above average multiples.

U.S. chip maker Nvidia and other large technology companies have also been making numerous investments in AI startups, including through their corporate venture capital funds. Salesforce Ventures announced that it is expanding its Generative AI Fund to $500 million, up from $250 million in March 2023. The Fund was one of the investors in Toronto-based Cohere, a language AI startup that raised $270 million from a mix of VC and strategic investors.

AI's Undeveloped Regulatory Landscape

The AI regulatory landscape is still in its infancy and will continue to change as the technology and public perception develops. Investing in a rapidly-developing industry brings risks as well as opportunities. Having a robust diligence process, go-forward management plans, governance policies and special shareholder rights may become even more critical for investors.

On June 14, 2023, the European Union's parliament approved the text of draft legislation for one of the world's first laws governing AI. The comprehensive Artificial Intelligence (AI) Act includes a ban on police use of live facial recognition in public places as well as transparency requirements for AI-generated content. The following week, U.S. President Joe Biden spoke in San Francisco about the risks and opportunities of AI—saying that his administration is "committed to safeguarding America’s rights and safety, from protecting privacy, to addressing bias and disinformation, to making sure AI systems are safe before they are released."

In Canada, a picture of AI regulation is beginning to emerge. New AI legislation—the Artificial Intelligence and Data Act (AIDA)—was introduced as part of Bill C-27 which is now undergoing its second reading in the House of Commons. A new companion document for the AIDA outlines a proposed roadmap for any future AI regulation.

Bennett Jones has previously written in Artificial Intelligence—A Companion Document Offers a New Roadmap for Future AI Regulation in Canada, on how the Canadian government intends to take an agile approach to AI regulation by developing and evaluating regulations and guidelines in close collaboration with stakeholders on a regular cycle, and adapting enforcement to the needs of the changing environment.

AIDA will apply to "high-impact AI systems", which has yet to be clearly defined and is expected to come into force no sooner than 2025.

As an illustration of the close collaboration that will be required for AI regulation and enforcement, in May 2023 the Office of the Privacy Commissioner of Canada announced that it is joining with the privacy authorities in Alberta, British Columbia and Québec to expand its investigation into OpenAI, the creator of ChatGPT. The four privacy offices will investigate a complaint alleging the collection, use and disclosure of personal information without consent by OpenAI.

ESG Investment Considerations

VC investors will need to consider how investing in generative AI companies fits within their broader ESG initiatives and investment thesis, particularly given the rapid rise in development and implementation of AI that is creating new ESG risks and opportunities. From an environmental perspective, the AI industry uses a lot of electricity to power its programs, similar to crypto mining. Investors and companies should consider how much power is being used in their AI operations and how it is being generated.

Energy use in AI is also creating opportunities. Boston-based startup Lightmatter, which uses light to drive energy efficiencies in computing, raised USD$154 million and tripled its valuation in late May 2023, as customers in need of faster, more energy efficient computing for AI work are buying its systems.

Investors will also need to be aware of the potential for bias in generative AI. Bloomberg analyzed more than 5,000 images created with the AI tool Stable Diffusion and found that racial and gender disparities were amplified in 14 different job areas and categories related to crime. We have already seen the introduction of legislation aimed at addressing bias in AI (including AIDA) and we expect this trend to continue.

VC investors will need to consider how investing in generative AI companies fits within their broader ESG initiatives and investment thesis.