From Riskgaming to Moravec’s Paradox: Unpacking Lux Capital’s Q1 2024 Insights

Framing The Q1 2024 Lux Capital Letter:

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Why do I analyze the Lux Capital letters like it’s some kind of Kabbalah? Well, like Josh Wolfe, I’m another NY hardcore punk kid who ended up in finance. I love Agnostic Front, Gorilla Biscuits, and Anthrax. The NYC HC punk band Madball slept on my floor for a week. My house didn’t smell the same for a month.

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Also, another reason that I feel aligned with the firm is because they’re leaders in speaking out against anti-Semitism. Few firms in finance take a stand as strongly as Josh and the team at Lux Capital. I lost members of my extended family in the Holocaust and the person that I’m dating is the child of a Holocaust survivor. I’ve ended numerous business relationships in the last 8 months due to anti-Semitism. I respect a firm that is unafraid to stand up for their values, every day.

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It’s not so much that I think the Lux Capital’s ideas are the gospel truth about how anyone should invest, but I think they at least post very cogent ideas about their investment thesis which is more than I can say for most of the PE/VC firms out there. Their letters demonstrate not just knowledge and understanding of high-level themes in the marketplace but also a keen understanding of marketing, brand building, and stakeholder engagement. More importantly, they exhibit a profound grasp of investment analysis, which is crucial for informed decision-making and sets them apart from their peers.

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Past As Prologue: What Lux Has Written In The Last Year

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Before we go through the new Lux Letter, a little bit to bring you up to speed on what they’ve written in the last year or so. Sometimes reading a new Lux Capital letter is a little dense, so I’ve sorted through the last 3 or 4 to pull out the best bits.

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1. Q4 2023 Report: In Q4 of last year, Lux Capital closed their largest fund to date, Lux 8 ($1.15B), at a time when fundraising was super-challenging. The letter discussed the firm's conditional optimism about the future despite a broader contraction in VC. Lux Capital highlighted the importance of maintaining/recruiting top talent, especially from tech giants like Apple and Google. Key investment areas included AI, defense, and biotech, with a big emphasis on open-source software platforms and AI. Natch, investments included Hugging Face and Sakana AI.

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2. Lux Capital's Last Fundraise (2021): Lux Capital raised $1.5 billion in new funding in early 2021. This new capital is designated to invest in and create new startups, with a specific focus on early-stage investments. The fundraise reflects Lux Capital's ongoing commitment to backing visionary founders and groundbreaking technologies. The letter emphasizes significant opportunities in artificial intelligence (AI) and robotics, aligning with Lux Capital's strategic focus on sectors poised to redefine industries through technological advancements. This fundraise is part of Lux Capital's broader strategy to stay at the forefront of technological innovation and support companies that can drive significant change in their respective fields.

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3. Recent Developments in AI and Robotics (Feb 2024 letter): Lux Capital has been particularly active in the AI and robotics sectors. They’ve invested in companies that leverage AI to create new business paradigms and solve big/complex problems. The letter notes the significant demand for AI talent and technology in New York City and the transformative potential of AI-driven robotics. Lux's investments aim to capitalize on these trends, supporting companies that integrate AI into practical applications, enhancing efficiency and innovation.

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Key Themes From The May 2024 Letter:

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1. The Dry Powder’s Really Wet
2. Riskgaming
3. Possible adjacencies + the ADJACENT POSSIBLE
4. Build your cash position for tuck-in M&A 
5. Prepare for rising cost of capital (and a lot less of it)…
6. Moravec Paradox’s ––what’s easy is hard and what’s hard is easy

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The Dry Powder’s Really Wet

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This part was sort of buried on page 3, but if you’re a founder it’s super important. Lux did a detailed and insightful analysis of the current investment landscape, highlighting several key trends and strategic decisions. One critical piece of information was the allocation of their $300 million in "dry powder." Contrary to the typical perception of dry powder as funds reserved for new investments, Lux Capital clarified that this capital is pre-allocated to existing portfolio companies. This pre-allocation effectively makes the funds "wet," meaning they are actively being used to support and stabilize companies within their current portfolio. This approach underscores Lux Capital's commitment to nurturing and growing their existing investments, ensuring these companies have the necessary resources to navigate the challenging market conditions.

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This presents a really big problem for founders who need capital right now that don’t either (1) have it locked down or (2) have $420-840k coming in every month.

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The letter also highlighted the prevalence of down rounds in the current financing environment. Specifically, down rounds accounted for 25% of all financings, indicating a big portion of companies are raising capital at valuations lower than their previous rounds. This trend reflects the broader market pressures and the cautious sentiment among investors, leading to more conservative valuations. Lux Capital's acknowledgment of this trend demonstrates their awareness of the market realities and their strategic flexibility in adapting to these conditions.

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Another noteworthy point from the letter was the emphasis on bridge rounds, which constituted 40% of all Series A and B rounds. Bridge rounds, often seen as interim financing to extend the runway for companies until they can raise a more substantial round, were described metaphorically by Lux Capital as "piers to nowhere." This vivid imagery highlights the potential risks associated with relying heavily on bridge financing. While bridge rounds can provide temporary relief, they may not always lead to sustainable long-term solutions if not followed by successful subsequent funding rounds or strategic pivots.

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The Riskgaming Initiative

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What’s the Deal? Why Is It Important?

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Lux Capital's Riskgaming Initiative is designed to immerse participants in strategic scenarios that simulate real-world challenges and complex decision-making. This initiative engages startup founders, political and military leaders, scientists, and other key stakeholders to explore the implications of future innovations before they become reality. By participating in these high-stakes scenarios, players develop their expertise in risk-taking and decision-making, gaining a deeper appreciation for the trade-offs and constraints they might face in real-world situations. Lux Capital sees this initiative as crucial for preparing leaders to navigate the increasingly complex and competitive global landscape.

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Who Else Has A Program Like This?

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Other VC capital and PE firms have undertaken similar initiatives, though often with different focuses. For example:

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- Andreessen Horowitz (a16z): This firm often hosts invite-only events and simulations to foster connections and provide strategic insights to their portfolio companies, though not as explicitly focused on gaming scenarios as Lux's initiative.

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- Sequoia Capital: They’ve been known to run "black swan" events and scenarios to prepare their portfolio companies for unexpected challenges and crises, aligning somewhat with the Riskgaming concept.

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- Palantir: While not a VC firm, Palantir's work in modeling and simulation for complex data-driven decision-making aligns with the principles behind Riskgaming.

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Critics and Skeptics:

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There are critics who view initiatives like Riskgaming as overly theoretical or even gimmicky. Some argue that the simulated environments can’t fully capture the unpredictability and nuances of real-world events, leading to a fake/false sense of preparedness. Critics also suggest that the resources dedicated to such initiatives might be better spent on direct investments and tangible support for startups. However, the supporters believe that these exercises provide invaluable insights and foster a culture of proactive rather than reactive problem-solving..

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Overall, Lux Capital's Riskgaming Initiative represents a novel approach to preparing leaders for future challenges by simulating complex scenarios. While it has its skeptics, many in the venture capital and private equity space recognize the value of such strategic foresight activities.

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Possible Adjacencies & The Adjacent Possible:

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Lux’s concept of "Possible adjacencies + the ADJACENT POSSIBLE" refers to the exploration and investment in technologies and ideas that are not just immediately adjacent to current capabilities but also represent the next steps in the evolution of what is possible. This concept is deeply rooted in the idea of expanding the boundaries of innovation by considering what could be achieved next, given the current technological landscape and scientific understanding.

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The term "adjacent possible" is borrowed from theoretical biologist Stuart Kauffman, and it represents the idea that at any given moment, certain innovations are only a step away from our current reality. For Lux Capital, this means investing in technologies that might seem speculative or futuristic but are feasible with the current advancements in science and technology. By doing so, they aim to foster breakthroughs that could significantly impact various fields such as AI, biotechnology, and aerospace.

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Wolfe and Lux Capital apply this principle by supporting companies that operate at the cutting edge of science and technology, pushing the envelope of what is possible. This approach allows them to identify and nurture groundbreaking innovations that can redefine industries and create new markets.

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In the VC landscape, this approach is somewhat unique, but other firms like a16Z and Sequoia also engage in similar forward-thinking investment strategies. These firms look to support disruptive technologies and visionary founders who can leverage the adjacent possible to create transformative products and services.

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Critics might view this approach as risky or overly speculative, saying that it can lead to investments in tech that may not have immediate practical applications or market readiness. But, proponents believe that by focusing on the adjacent possible, firms like Lux can stay ahead of the curve and support the development of technologies that will shape the future.

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Cash For Tuck-In M&A

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One of the key recommendations was to build a cash position to be prepared for tuck-in mergers and acquisitions (M&A). This advice reflects a proactive approach to leverage market conditions where valuations are more favorable, allowing companies to strategically acquire complementary businesses or technologies that can enhance their competitive edge.

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Tuck-in acquisitions, which involve integrating smaller companies into a larger entity, can be an effective strategy for growth, especially in a market where organic growth may be challenging. By maintaining a strong cash position, companies can act swiftly and decisively when attractive opportunities arise. Lux Capital's emphasis on this strategy underscores the importance of financial flexibility and readiness to seize such opportunities. This approach not only helps in expanding the company's capabilities and market presence but also in achieving synergies that can lead to increased efficiency and innovation.

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Further, Lux’s recommendation to build a cash position aligns with their broader investment philosophy of strategic adaptability and risk management. In a volatile market, having liquid assets provides a cushion against uncertainties and allows companies to navigate through downturns more effectively. It also positions them to take advantage of distressed assets or companies that may be undervalued due to market conditions. This foresight in maintaining liquidity demonstrates a balanced approach to growth and risk, making sure that portcos are not only surviving but also strategically positioning themselves for future success.

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By sharing these strategic insights, Lux reinforces its role as a thought leader in the VC space. Their advice to prepare for tuck-in M&A reflects a solid understanding of market dynamics and the importance of strategic financial management. It also highlights their commitment to guiding their portcos companies through complex market landscapes, making sure that they have the tools and strategies needed to thrive in both stable and challenging times.

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Overall, the rec to build a cash position for tuck-in M&A is proof of  Lux’s strategic acumen. It shows their proactive approach to investment management, focusing on long-term growth and resilience. This guidance is not just about immediate financial maneuvers but about positioning companies for sustainable success through strategic acquisitions and effective resource management.

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Prepare for Rising Cost of Capital (and a Lot Less of It)

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In this recent quarterly letter, Lux highlighted the critical need for companies to prepare for a rising cost of capital and a general reduction in available funding. As interest rates increase and market conditions tighten, the cost of raising capital becomes more expensive. This environment demands that companies be more strategic and judicious in their capital allocation and financing decisions. Lux Capital advises portcos to prioritize efficiency and operational excellence to minimize reliance on external funding.

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This guidance reflects a broader trend in the VC landscape where investors are becoming more selective, and funding rounds are harder to come by. Companies are encouraged to optimize their existing resources, streamline operations, and focus on achieving profitability. By preparing for a higher cost of capital, businesses can mitigate risks associated with financing constraints and ensure they remain resilient in a more challenging economic climate. This approach not only helps in sustaining growth but also in maintaining financial health and stability.

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Moreover, the emphasis on preparing for less available capital underscores the importance of strategic financial planning. Companies should explore alternative financing options, such as strategic partnerships, revenue-based financing, and internal cash flow management, to reduce dependency on external equity or debt. This proactive stance positions companies to better navigate financial uncertainties and capitalize on opportunities even when traditional capital sources are limited.

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I know, this is hard advice to read. But it’s important to get used to reading it.

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Moravec's Paradox – What’s Easy is Hard and What’s Hard is Easy

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Another intriguing insight from Lux Capital’s letter revolves around Moravec's Paradox, – what is easy for humans is often hard for machines and vice versa. 

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This paradox has profound implications for the development and deployment of AI and robotics. Lux Capital explains that while AI systems excel at complex computations and pattern recognition tasks, they struggle with simple, intuitive tasks that humans perform effortlessly, such as perception and physical manipulation.

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Understanding Moravec's Paradox is crucial for companies working in AI and robotics because it highlights the limitations and strengths of current technologies. Lux Capital advises businesses to focus on integrating AI in areas where it naturally excels, such as data analysis, predictive modeling, and automation of repetitive tasks. At the same time, they should recognize and address the challenges AI faces in areas requiring human-like perception and dexterity.

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This insight encourages a balanced approach to AI implementation, leveraging the technology's strengths while acknowledging its limitations. It also underscores the importance of ongoing research and development to overcome the challenges posed by Moravec's Paradox. By strategically focusing on areas where AI can deliver the most value and continuing to innovate in areas where it struggles, companies can maximize the benefits of AI and robotics technologies.

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Lux Capital’s exploration of Moravec's Paradox also suggests a forward-thinking approach to AI and robotics investment. By identifying and addressing the inherent challenges in these fields, companies can better navigate the complexities of AI development and deployment. This understanding is essential for creating robust, versatile AI systems that can effectively complement human capabilities and drive significant advancements across various industries.

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Outro

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What sets Lux Capital apart is not just their investment acumen but their holistic understanding of market dynamics, strategic foresight, and a commitment to their values. Their letters are more than just updates—they are rich with insights on market trends, investment strategies, and the challenges and opportunities within the tech landscape. By sharing their knowledge and strategies so openly, Lux Capital provides a valuable blueprint for navigating the complexities of venture capital, and that’s something worth paying attention to.