By Justin Stevens

Pure software has grown to be the majority of the venture financing ecosystem over the past decade. I’m not surprised — it’s a very efficient market in two critical ways.

First, it’s easy to scale — you write the code once, sell it a million times.

Second, it’s easy to diligence — take the growth rate, the profit margin and the customer acquisition cost, slap a multiple on it, and move on to the next one.

For these reasons, software is often a preferred investment for venture capitalists over hardware and frontier tech, as those other sectors come with inherent capital intensity: Founders have to create real physical products, which is tricky business and expensive to scale.

However, I come with serious foreboding to those who dare enter the world of software investing in today’s market. The golden age of SaaS is behind us — there are risks lurking behind every corner, looking to snatch away precious investment dollars.

Danger in numbers

Supply and demand are unavoidable facts of life when it comes to investing. The more people chasing a deal, the more expensive it will be — and the more you need to sell the software for in order to make a profit.

Unfortunately, given the strong performance of the software investing market over the past 10 to 15 years, more and more investors have piled in. There’s now an overabundance of VCs focused on software; according to an analysis by my firm, Overlap Holdings, the ratio of pure software VCs to pure software deals is a staggering 4:1, which makes hunting for value quite difficult.

Nowhere to hide

Most successful businesses rely on barriers to entry for their target markets, whether they be technical patents, expensive machinery or established complex supply chains.

Pure software startups offer none of these protections. There’s nothing stopping two college kids from building a better app than you. In fact, it’s never been easier for them to do so. With artificial intelligence apps and no-code tools at their fingertips, even the inexperienced can create professional-looking software for cheap. Danger literally lurks behind every dorm room door.

Dark rooms make for irrational thoughts

Speaking of AI: Chances are good that if you’re investing in a software startup today, it’s using ChatGPT or another large language model as the lynchpin of its operations. Unfortunately, these models are black boxes which are anything but foolproof.

Given they’re using statistics to generate answers based on the words they see on the internet, the potential for these models to spit out nonsensical answers is ever-present, and even has a name: hallucinations.

If you had a human employee in a critical operational role that was prone to daily hallucinations, wouldn’t you be worried?

The walking dead

All the big green pastures for pure software startups are already taken. Amazon Web Services was launched 19 years ago. Since then, every low-hanging fruit idea has been farmed, fought over and consolidated into a rigged duopoly. Got a “great idea” for an app that you think customers would love? Do a Google search and you’ll find five companies already doing it.

As a result, startups find themselves trying to control a smaller and smaller niche of the market — whether it’s a dating app for people who like beards or the ultimate guide for airport lounges. These are nice for consumers, but do you really think they’ll make their investors a venture-scale return?

The chilling finale

Investing is all about balancing risk and reward. While software investments have made people a lot of money, it’s worth understanding the ways the risk profile has changed in recent years. For all the reasons mentioned above, when it comes to software, I believe there’s a clear rationale for being afraid. Very afraid.

Justin Stevens is the founder and CEO of Overlap Holdings, a frontier-tech focused venture capital firm investing in and advising capital-intensive startups in sectors such as energy, life science, materials science, space, robotics and semiconductors. Previously, he was a senior partner at Apollo, one of the world’s largest alternative asset managers, where he worked for over 18 years.

Illustration: Li-Anne Dias