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+Cal Paterson | [1]Home [2]Services [3]About
+
+Building LLMs is probably not going be a brilliant business
+
+November 2024
+
+The Netscapes of AI
+
+image of early 20th century train advert for Watford Railways improved the
+lives of millions - but investors were rewarded with a [4]dramatic bust
+
+Large language models (LLMs) like Chat-GPT and Claude.ai are whizzy and cool. A
+lot of people think that they are going to be The Future. Maybe they are — but
+that doesn't mean that building them is going to be a profitable business.
+
+In the 1960s, airlines were The Future. That is why old films have so many
+swish shots of airports in them. Airlines though, turned out to be an
+unavoidably rubbish business. I've flown on loads of airlines that have gone
+bust: Monarch, WOW Air, Thomas Cook, Flybmi, Zoom. And those are all busts from
+before coronavirus - times change but being an airline is always a bad idea.
+
+That's odd, because other businesses, even ones which seem really stupid, are
+much more profitable. Selling fizzy drinks is, surprisingly, an amazing
+business. Perhaps the best. Coca-Cola's return on equity has rarely fallen
+below 30% in any given year. That seems very unfair because being an airline is
+hard work but making coke is pretty easy. It's even more galling because
+Coca-Cola don't actually make the coke themselves - that is outsourced to
+"bottling companies". They literally just sell it.
+
+Industry structure - what makes a business good
+
+If you were to believe LinkedIn you would think a great business is made with
+efficiency, hard work, innovation or some other intrinsic reason to do with how
+hardworking, or clever, the people in the business are. That simply is not the
+case.
+
+What makes a good business is industry structure.
+
+Airlines - unfavourable industry structure
+
+To be an airline is to be in an almost uniquely terrible market position. For
+starters, there are only two makers of aeroplanes (Airbus and Boeing). For
+reasons of training and staff efficiency, you have to commit to one or the
+other, which gives the aeroplane makers very strong pricing power.
+
+And buyers of airline tickets are incredibly fickle and have no loyalty. They
+will switch from one "carrier" to another over even small differences in price.
+Annoyingly, there are loads of other airlines and they're all running the same
+routes as you!
+
+Worse yet, starting a new airline is surprisingly easy. Aircraft hold their
+value so banks will happily lend against them. There are loads of staff
+available that new entrants can hire. So randos will continually enter your
+market, often selling tickets below cost for quite a while before they go bust.
+And to top it off, there are plenty of substitutes for air travel - from
+government-subsidised high speed trains to Zoom calls.
+
+Airlines that get more efficient, work harder or come up with innovations
+aren't going to be able to "capture" the value of what they've done. If you
+make more than the bare minimum to survive Airbus will notice that you're being
+undercharged and you'll find that the next renewal on your service contract
+eats up the difference.
+
+Fizzy-drinks - very favourable industry structure
+
+Being the Coca-Cola company is pretty great though.
+
+Coke is just water, colourant, flavouring, caffeine and sweetener. Those are
+all widely available and really cheap. And as I said, you don't even have to
+combine them yourselves - bottling companies will do that for you for almost
+nothing.
+
+Handily, consumers are really picky about what goes in their mouth. The
+unofficial motto of your main competitor is "Is Pepsi ok?". This is despite the
+fact that they are identical in both taste and colour. And a significant
+minority of people actually say no!
+
+And it isn't easy for new competitors to enter the market. They can't call
+their new drink "coke" due to trademarks. They have to call it something else.
+And consumers will generally refuse it because drinking an alternative is
+considered some kind of weird statement.
+
+What is industry structure?
+
+Classically, there are five basic parts ("forces") to a company's position:
+
+ 1. The power of their suppliers to increase their prices
+ 2. The power of their buyers to reduce your prices
+ 3. The strength of direct competitors
+ 4. The threat of any new entrants
+ 5. The threat of substitutes
+
+It's industry structure that makes a business profitable or not. Not
+efficiency, not hard work and not innovation.
+
+If none of the forces are very much against you, your business will do ok. If
+they are all against you, you'll be in the position of the airlines. And if
+they're all in your favour: brill, you're Coca-Cola.
+
+The industry structure of LLM makers: OpenAI/Anthropic/Gemini/etc
+
+So is the position of LLM makers any good? I'm afraid it's not good news.
+
+LLM makers sometimes imply that their suppliers are cloud companies like Amazon
+Web Services, Google Cloud, etc. That wouldn't be so bad because you could shop
+around and make them compete to cut the huge cost of model training.
+
+Really though, LLM makers have only one true supplier: NVIDIA. NVIDIA make the 
+[5]chips that all models are trained on - regardless of cloud vendor. And that
+gives NVIDIA colossal, near total pricing power. NVIDIA are more powerful
+relative to Anthropic or OpenAI than Airbus or Boeing could ever dream of
+being.
+
+How much power do buyers have over LLM token prices? So far, it seems fairly
+high. Most LLM users seem willing to change from Chat-GPT to Claude, for
+example. It doesn't seem like brand loyalty is being built up. And companies
+that build AI into their businesses are starting to do so via abstraction
+layers that allow them to switch model easily. That makes LLMs interchangeable
+- which is bad for those who sell them.
+
+What's the strength of direct competitors? Again, it is considerable. There are
+loads of LLM vendors and pricing [6]appears competitive. Worst of all, Facebook
+basically dump their model on the market for no cost. It's [7]reminiscent of
+Internet Explorer - not exactly a great portent.
+
+And it seems fairly easy for new entrants to build brand new models. That is
+why there are so many LLM makers. Most of the techniques for making LLMs are
+openly published in papers. Even bad models can gain customers if they are
+cheap, which allows new entrants to gain a foothold.
+
+The situation on substitutes is mixed. Instead of having Chat-GPT write some
+text you could pay a person to do it instead. That is likely to be much more
+expensive but also less likely to hallucinate, which might be important for
+some use-cases (law is the field least likely to use LLMs). And then there is
+the trend that [8]metadata tends to displace artificial intelligence once
+particular application has been proved out - so as soon as you find a solid
+use-case you stand to be replaced.
+
+A single mildly positive point does not make a profitable business. LLM makers
+look a lot more like Netscape - who invented graphical web browsers, then went
+bust - than Google, who made something good that ran on top of the web
+browsers.
+
+How are they raising so much money?
+
+If LLM makers seem cursed to an airline-style business destiny, how come they
+are able to raise so much money? OpenAI [9]raised $6.6 billion at a valuation
+of $157 billion less than two months ago. That might be the biggest VC round of
+all time.
+
+What do they know that I don't? It is a mystery - but let's consider the
+options.
+
+Perhaps they are hoping to develop their own chips to reduce their dependence
+on NVIDIA. $6.6 billion is not enough to build a new fab but it might be enough
+to get a new chip designed which allows them to migrate off NVIDIA. That would
+save them paying so much money for GPU time. But, NVIDIA are actually one of
+the investors in the round (although only a fairly small amount) - so it's
+unlikely "develop an NVIDIA competitor" was on any of the pitch deck slides.
+
+Perhaps OpenAI are hoping to build a strong brand so that customers won't
+switch to competitors so easily. It's not impossible, there is proof the [10]
+branding and lock-in can work in technology - but it seems difficult to manage
+given that LLMs themselves generically have a textual interface - meaning that
+there is no real API as such - you just send text, and it sends text back.
+
+Can they do anything about new entrants? Possibly. If investing $6.6bn allows
+them to develop a major improvement in their model then that would raise
+everyone else's costs considerably and probably force some of their smaller
+competitors out of the market. The trouble is that money is the most fungible
+of all goods (that is the point, after all) and that $6.6bn is not all that
+much of it. So this round wouldn't, by itself, be enough to dissuade others. I
+used to work at a bank and I can tell you that individual bond raises can be a
+lot more than $6.6bn.
+
+It's worth saying that even companies that raise huge sums of money sometimes
+turn out to have no viable business. WeWork ultimately raised over $10bn at a
+valuation of $47bn before it was realised that their business simply did not
+make sense. WeWork were valued at just $0.56bn in their most recent financial
+restructuring - having lost well over 95% of what was invested.
+
+Not all AI companies are doomed
+
+If LLM makers aren't going to be good businesses, does that bode ill for The
+Future?
+
+Firstly, it does not mean the technology will be bad. Whether the technology
+ends up being good or not is mostly unrelated to whether Open AI/Anthropic/
+Mistral/whoever makes any money off it. Container virtualisation technology is
+pretty well developed even though Docker made almost nothing on it. Web
+browsers are extremely advanced pieces of software even though making a browser
+is such a bad business that most don't usually count it as a business at all.
+And CRMs are terrible despite the fact that Salesforce is tremendously
+successful. Technology success and business success are mostly unrelated.
+
+And then: not all AI businesses are building models. Ideally, if I were running
+an AI business I would avoid building a model at all costs. Building your own
+models looks like an undifferentiated schlep. Using a tiny bit of some
+expensively trained model that Anthropic has produced could be very cost
+effective and might make some business idea work that wouldn't have 5 years
+ago.
+
+Beware software companies that aren't software companies
+
+Software companies are really good businesses. You have no real suppliers, your
+software is often unique (so no competitors) and the substitute is just users
+doing the job themselves. For this reason, software companies tend have really
+great margins.
+
+The problem is that not all technology companies are software companies. If you
+have a hugely powerful single supplier like NVIDIA then the economics of your
+company are going to look less like Microsoft Office and more like [11]Pan-Am.
+
+━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━
+
+Contact/etc
+
+Write to me at [12]cal@calpaterson.com about this article, especially if you
+disagreed with it.
+
+See [13]other things I've written or learn more about me on [14]my about page.
+
+Get an alert when I write something new, by [15]email or [16]RSS[17] rss-logo.
+
+I am on:
+
+  • [18]Bluesky
+  • [19]Mastodon
+  • [20]Twitter
+  • [21]Github
+  • and [22]Linkedin.
+
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+
+Other notes
+
+The AI safety movement is a fantastic hypeman for LLMs as a technology.
+Implying (pretty dubiously) that we are [23]10 minutes from midnight in some
+kind of Ghost-in-The-Shell style AI crisis is in fact an extremely effective
+form of product marketing. Perhaps that is why OpenAI and others employ so many
+AI safety specialists.
+
+The Coca-Cola company mainly sit back and rake in the megabucks - but they do
+spend a little bit of their earnings on research. And a little bit of a lot is
+still significant. It's interesting that coke's market research has discovered
+that coke works better as a gender segregated product: Coke Zero is Diet Coke,
+but for men.
+
+If you want to read more about industry structure and market strategy, the
+place to start is with Michael Porter. He reworked his famous essay [24]The
+Five Forces that Shape Corporate Strategy in 2008. It's not the last word, but
+it probably should be the first word you read if you want to learn more. And if
+you like it, he has a lot more.
+
+
+References:
+
+[1] https://calpaterson.com/
+[2] https://calpaterson.com/services.html
+[3] https://calpaterson.com/about.html
+[4] https://en.wikipedia.org/wiki/Railway_Mania
+[5] https://en.wikipedia.org/wiki/Hopper_(microarchitecture)
+[6] https://a16z.com/llmflation-llm-inference-cost/
+[7] https://en.wikipedia.org/wiki/Browser_wars#First_browser_war_(1995%E2%80%932001)
+[8] https://calpaterson.com/metadata.html
+[9] https://www.reuters.com/technology/artificial-intelligence/openai-closes-66-billion-funding-haul-valuation-157-billion-with-investment-2024-10-02/
+[10] https://calpaterson.com/amazon-premium.html
+[11] https://en.wikipedia.org/wiki/Pan_Am
+[12] mailto:cal@calpaterson.com
+[13] https://calpaterson.com/
+[14] https://calpaterson.com/about.html
+[15] https://calpatersonltd.eo.page/calpaterson
+[16] https://calpaterson.com/calpaterson.rss
+[17] https://calpaterson.com/calpaterson.rss
+[18] https://bsky.app/profile/calpaterson.bsky.social
+[19] https://fosstodon.org/@calpaterson
+[20] https://twitter.com/cal_paterson
+[21] https://github.com/calpaterson/
+[22] https://www.linkedin.com/in/calpaterson
+[23] https://en.wikipedia.org/wiki/Doomsday_Clock
+[24] https://hbr.org/2008/01/the-five-competitive-forces-that-shape-strategy