AI Coding Startups Face Cost & Margin Challenges

The Uncertain Economics of AI Coding Startups

In February, Windsurf, an AI coding startup, was reportedly in discussions to secure a substantial new funding round, potentially valuing the company at $2.85 billion. This valuation represented a doubling of its worth in just six months, according to sources who spoke with TechCrunch. However, this deal ultimately did not materialize.

Subsequently, reports surfaced in April indicating Windsurf was considering a sale to OpenAI for approximately $3 billion. Despite initial promise, this acquisition attempt also failed to come to fruition.

Why Sell When Growth is Strong?

A key question arose from these events: if Windsurf was experiencing rapid growth and attracting venture capital, why would the company explore a sale at all?

Sources within the industry suggest that, despite the widespread popularity and hype surrounding AI coding assistants, these businesses can be significantly unprofitable. Specifically, companies like Windsurf often face expensive operational structures leading to “very negative” gross margins, meaning operational costs exceed revenue.

The High Cost of Large Language Models

This financial strain is largely attributed to the substantial costs associated with utilizing large language models (LLMs). AI coding assistants are under constant pressure to integrate the newest, most advanced, and consequently, most expensive LLMs.

Model developers are continually refining their latest models, particularly for improvements in coding and related tasks such as debugging.

Intense Market Competition

The competitive landscape within the AI-assisted coding market further exacerbates these challenges. Companies like Anysphere’s Cursor and GitHub Copilot, which boast established customer bases, present significant competition.

A viable path to improved margins involves startups developing their own proprietary models, thereby reducing reliance on external suppliers like Anthropic and OpenAI.

The Risks of Model Development

However, this approach is not without its own risks. Varun Mohan, Windsurf’s co-founder and CEO, ultimately decided against pursuing in-house model development, recognizing the substantial investment required.

Furthermore, major model providers are now directly competing in the AI coding space, with Anthropic offering Claude Code and OpenAI providing Codex, for example.

A Strategic Exit

Selling the business was viewed as a strategic maneuver to secure a favorable return before potential disruption from the very companies supplying its AI technology – OpenAI and Anthropic.

Wider Industry Implications

Several industry observers believe that similar margin pressures faced by Windsurf could be impacting other companies, including Anysphere (Cursor), Lovable, Replit, and others.

Nicholas Charriere, founder of Mocha, a vibe-coding startup, stated that margins on “code gen” products are generally neutral or negative, describing them as “absolutely abysmal.” He estimates that variable costs across the sector are remarkably similar, varying by only 10% to 15%.

Anysphere's Path

Unlike Windsurf, Anysphere has experienced rapid growth and intends to remain independent, having reportedly declined acquisition offers, including one from OpenAI.

The company announced in January its intention to build its own model, aiming for greater control over expenses. However, two key hires from Anthropic’s Claude Code team subsequently returned to their previous employer.

Hope for Decreasing Costs

In addition to model development, Anysphere anticipates that the cost of LLMs will decrease over time.

Erik Nordlander, a general partner at Google Ventures, believes that current inference costs represent the highest they will ever be.

Rising Model Costs

However, this expectation is not universally shared. The cost of some of the latest AI models has actually increased, due to the greater time and computational resources required for complex tasks.

OpenAI's New Model

Recently, OpenAI introduced GPT-5, its new flagship model, with fees significantly lower than Anthropic’s Claude Opus 4.1. Anysphere promptly made this model available to Cursor users.

Pricing Adjustments and Customer Reactions

Anysphere has also adjusted its pricing structure to reflect the increased costs of running Anthropic’s latest Claude model, particularly for its most active users. This change surprised some Cursor customers, who were not anticipating additional charges beyond the $20-per-month Pro plan. Anysphere CEO Michael Truell later apologized for the lack of clarity surrounding the pricing change.

A Delicate Balance

This situation presents a difficult trade-off. While Cursor is a popular AI application, achieving $500 million in ARR in June, its user base may not remain loyal if a superior alternative emerges.

Windsurf's Resolution

Given the competitive pressures and associated costs, Windsurf’s decision to seek an exit appears increasingly understandable. Following the failed OpenAI deal, the founders and key employees joined Google in a transaction that resulted in a $2.4 billion payout to shareholders. The remaining business was then sold to Cognition.

Although criticized by some for leaving approximately 200 employees without roles at Google, a source familiar with the deal maintains that the acquisition maximized outcomes for all employees.

Broader Implications for the AI Industry

Other rapidly growing AI coding tools, such as Replit, Lovable, and Bolt, also rely on external model providers. The challenges faced by these companies raise questions about the sustainability of building businesses on top of model makers, particularly for emerging industries.