Original Title: The Case for Scaling Venture

Original Author: Erik Torenberg, a16z

Original Compilation: Deep Tide TechFlow

Deep Tide Introduction:

In the traditional narrative of venture capital (VC), the "boutique" model is often revered, with the belief that scaling leads to a loss of soul. However, a16z partner Erik Torenberg presents a counterargument in this article: as software becomes the backbone of the U.S. economy and the era of AI arrives, the demand for capital and services from startups has undergone a qualitative change.

He believes that the VC industry is shifting from a "judgment-driven" paradigm to one driven by the ability to win deals. Only "large institutions" like a16z, which have scalable platforms and can provide comprehensive support to founders, can succeed in the trillion-dollar game.

This is not just an evolution of the model but also a self-evolution of the VC industry in the wave of "software eating the world."

The full text is as follows:

In ancient Greek literature, there is a meta-narrative that transcends all: respect for the divine and disrespect for the divine. Icarus was scorched by the sun not because of his ambition but because he disrespected the sacred order. A closer example is professional wrestling. You can distinguish who is a face and who is a heel by simply asking, "Who respects wrestling, and who disrespects it?" All good stories take this form in one way or another.

Venture capital (VC) has its own version of this story. It goes like this: "VC has been, and always will be, a boutique business. Those large institutions have become too big and too ambitious. Their downfall is inevitable because their approach is a disrespect to the game."

I understand why people want this story to hold. But the reality is that the world has changed, and so has venture capital.

Today, there is more software, leverage, and opportunity than ever before. There are more founders building larger-scale companies than ever. Companies are staying private longer than before. And founders have higher expectations of VCs than ever. Today, the founders of the best companies need partners who can truly roll up their sleeves and help them win, rather than just write checks and wait for results.

Thus, the primary goal of venture capital firms now is to create the best interface to help founders succeed. Everything else—how to staff, how to deploy capital, how large to raise funds, how to assist in closing deals, and how to allocate power for founders—derives from this.

Mike Maples has a saying: "Your fund size is your strategy." Equally true is that your fund size is your belief in the future. This is your bet on the scale of startup outputs. Raising large funds over the past decade may have been seen as "hubris," but this belief is fundamentally correct. Therefore, when top firms continue to raise large amounts of capital to deploy over the next decade, they are betting on the future and putting their money where their mouth is. Scaled Venture is not an erosion of the VC model: it is the maturation of the VC model, adopting the characteristics of the companies they support.

Indeed, venture capital is an asset class

In a recent podcast, legendary Sequoia investor Roelof Botha made three points. First, while the scale of venture capital is expanding, the number of "winners" each year is fixed. Second, the scaling of the VC industry means too much capital is chasing too few great companies—therefore, VC cannot scale; it is not an asset class. Third, the VC industry should shrink to correspond to the actual number of winning companies.

Roelof is one of the greatest investors of all time, and he is a great person. But I disagree with his points here. (It is worth noting that Sequoia has also scaled: it is one of the largest VC firms in the world.)

His first point—that the number of winners is fixed—is easily falsifiable. In the past, about 15 companies achieved $100 million in revenue each year; now there are about 150. Not only are there more winners than before, but the scale of the winners is also larger. While entry prices are higher, the output is much greater. The ceiling for startup growth has risen from $1 billion to $10 billion, and now to $1 trillion or even higher. In the early 2000s and early 2010s, YouTube and Instagram were considered massive acquisitions worth $1 billion: at that time, such valuations were so rare that we referred to companies valued at $1 billion or more as "Unicorns." Now, we assume that OpenAI and SpaceX will become trillion-dollar companies, with several others following suit.

Software is no longer a marginal sector of the U.S. economy made up of quirky, misfit individuals. Software is now the U.S. economy. Our largest companies, our national champions, are no longer General Electric and ExxonMobil; they are Google, Amazon, and Nvidia. Private tech companies account for 22% of the S&P 500 index. Software has not finished eating the world—in fact, due to the acceleration brought by AI, it has only just begun—it is more important now than it was fifteen, ten, or even five years ago. Therefore, a successful software company can achieve a larger scale than ever before.

The definition of "software companies" has also changed. Capital expenditures have increased significantly—large AI labs are becoming infrastructure companies with their own data centers, power generation facilities, and chip supply chains. Just as every company has become a software company, now every company is becoming an AI company, and perhaps also an infrastructure company. More and more companies are entering the atomic world. Boundaries are becoming blurred. Companies are aggressively verticalizing, and the market potential of these vertically integrated tech giants is much larger than anyone imagines for pure software companies.

This leads to why the second point—that too much capital is chasing too few companies—is incorrect. The output is much greater than before, the competition in the software world is much fiercer, and companies are going public later than before. All of this means that great companies need to raise much more capital than before. The existence of venture capital is to invest in new markets. What we learn time and again is that, in the long run, the scale of new markets is always much larger than we expect. The private market has matured enough to support top companies reaching unprecedented scales—just look at the liquidity available to today's top private companies—and both private and public market investors now believe that the output scale of venture capital will be astonishing. We have consistently misjudged how large VC as an asset class can and should scale, and venture capital is scaling to catch up with this reality and opportunity set. The new world needs flying cars, global satellite grids, abundant energy, and intelligence that is so cheap it doesn't need to be measured.

The reality is that many of today's best companies are capital-intensive. OpenAI needs to spend billions on GPUs—more than anyone imagines can be obtained in computing infrastructure. Periodic Labs needs to build automated labs at an unprecedented scale for scientific innovation. Anduril needs to build the future of defense. All of these companies need to recruit and retain the best talent in the most competitive talent market in history. The new generation of large winners—OpenAI, Anthropic, xAI, Anduril, Waymo, etc.—are all capital-intensive and have completed massive initial funding at high valuations.

Modern tech companies typically require hundreds of millions in funding because the infrastructure needed to build world-changing cutting-edge technology is incredibly expensive. In the internet bubble era, a "startup" entered a blank slate, envisioning the needs of consumers still waiting for dial-up connections. Today, startups enter an economy shaped by thirty years of tech giants. Supporting "Little Tech" means you must be ready to arm David to fight against a few Goliaths. Companies in 2021 did indeed receive excessive funding, with a large portion going to sales and marketing to sell products that did not improve tenfold. But today, funding is directed toward R&D or capital expenditures.

Therefore, the scale of winners is much larger than before, and they need to raise much more capital than before, often from the very beginning. Thus, the VC industry must necessarily become much larger to meet this demand. Given the scale of the opportunity set, this scaling is reasonable. If the scale of VC were too large for the opportunities that venture capitalists invest in, we would expect to see the largest institutions underperform. But we do not see this happening at all. While expanding, top VC firms have repeatedly achieved extremely high multiple returns—so have the LPs (limited partners) who can access these firms. A famous venture capitalist once said that a $1 billion fund can never achieve a 3x return: because it is too large. Since then, certain companies have exceeded 10x returns on a $1 billion fund. Some point to those underperforming institutions to condemn this asset class, but any industry that follows a power-law distribution will have huge winners and a long tail of losers. The ability to win deals without relying on price is why institutions can maintain sustained returns. In other major asset classes, people sell products or lend to the highest bidder. But VC is a typical asset class that competes on dimensions other than price. VC is the only asset class with significant continuity among the top 10% of institutions.

The last point—that the VC industry should shrink—is also incorrect. Or at least, it would be bad for the tech ecosystem, for the goal of creating more generational tech companies, and ultimately for the world. Some complain about the second-order effects of increased venture capital (and there are indeed some!), but it also comes with a significant increase in the market value of startups. Advocating for a smaller VC ecosystem likely also advocates for smaller startup valuations, and the result could be slower economic development. This may explain why Garry Tan said in a recent podcast, "Venture capital can and should be ten times larger than it is now." Certainly, if there were no competition, and a particular LP or GP were "the only player," that might benefit them. But if there were more venture capital than today, it would clearly be better for founders and for the world.

To further illustrate this point, let’s consider a thought experiment. First, do you think there should be many more founders in the world than there are today?

Second, if we suddenly had many more founders, what kind of institutions could best serve them?

We won’t spend too much time on the first question, because if you are reading this article, you probably know that we believe the answer is obviously yes. We don’t need to tell you too much about why founders are so great and so important. Great founders create great companies. Great companies create new products that improve the world, organizing and directing our collective energy and risk appetite toward productive goals, and creating disproportionately new enterprise value and interesting job opportunities in the world. And we can never have reached a state of equilibrium where every capable person has already founded a great company. That’s why more venture capital helps unlock more growth in the startup ecosystem.

But the second question is more interesting. If we woke up tomorrow and the number of entrepreneurs was ten or a hundred times what it is today (spoiler alert: this is happening), what should the entrepreneurial institutions in the world look like? How should venture capital firms evolve in a more competitive world?

To win a deal, not lose it all

Marc Andreessen likes to tell a story about a famous venture capitalist who said that the VC game is like a conveyor belt sushi restaurant: "A thousand startups go by, and you meet with them. Then occasionally you reach out and pick one off the conveyor belt and invest in it."

The kind of VC Marc describes—well, for most of the past few decades, almost every VC has been like that. Back in the 1990s or 2000s, winning deals was that easy. Because of this, the only truly important skill for a great VC was judgment: the ability to distinguish good companies from bad ones.

Many VCs still operate this way—essentially the same way VCs did in 1995. But beneath their feet, the world has changed dramatically.

Winning deals used to be easy—like picking sushi off a conveyor belt. But now it is extremely difficult. People sometimes describe VC as poker: knowing when to pick companies, knowing at what price to enter, and so on. But this perhaps obscures the all-out war you must wage to win the right to invest in the best companies. Old-school VCs reminisce about the days when they were "the only player" and could dictate terms to founders. But now there are thousands of VC firms, and founders have more access to term sheets than ever before. Thus, more and more of the best deals involve extremely fierce competition.

The paradigm shift is that the ability to win deals is becoming as important as picking the right companies—even more important. If you can’t get in, what does it matter if you pick the right deal?
Several factors have contributed to this change. First, the surge in venture capital firms means that VC firms need to compete with one another to win deals. With more companies than ever competing for talent, customers, and market share, the best founders need strong institutional partners to help them win. They need institutions with resources, networks, and infrastructure to give their portfolio companies an edge.

Second, as companies stay private longer, investors can invest later—when companies have received more validation, making deal competition fiercer—and still achieve venture-like output returns.

The last reason, and the least obvious one, is that picking has become slightly easier. The VC market has become more efficient. On one hand, there are more serial entrepreneurs continuously creating iconic companies. If Musk, Sam Altman, Palmer Luckey, or a genius serial entrepreneur starts a company, VCs quickly line up to try to invest. On the other hand, companies are reaching crazy scales faster (due to staying private longer, the upside is also greater), thus the risk of product-market fit (PMF) has decreased compared to the past. Finally, with so many great institutions now, it is much easier for founders to reach out to investors, making it hard to find deals that other institutions are not pursuing. Picking is still at the core of the game—selecting the right evergreen company at the right price—but it is no longer the most important aspect.

Ben Horowitz hypothesizes that the ability to win repeatedly automatically makes you a top institution: because if you can win, the best deals will come to you. Only when you can win any deal do you have the right to pick. You may not have picked the right one, but at least you have that opportunity. Of course, if your institution can repeatedly win the best deals, you will attract the best pickers to work for you because they want to get into the best companies. (As Martin Casado said when recruiting Matt Bornstein to join a16z: "Come here to win deals, not to lose them.") Thus, the ability to win creates a virtuous cycle that enhances your picking ability.

For these reasons, the rules of the game have changed. My partner David Haber described in his article the transformation that venture capital needs to undergo to respond to this change: "Firm > Fund."

In my definition, a fund has only one objective function: "How do I generate the most carry with the least personnel in the shortest time?" Whereas a firm, in my definition, has two objectives. One is to deliver excellent returns, but the second is equally interesting: "How do I build a source of compounding competitive advantage?"

The best firms will be able to invest their management fees into strengthening their moats.

How can we help?

When I entered the venture capital field ten years ago, I quickly noticed that Y Combinator was playing a different game than all other VC firms. YC was able to secure favorable terms for great companies at scale while seemingly also being able to serve them at scale. Compared to YC, many other VCs were playing a commoditized game. I would go to Demo Day and think: I’m at the poker table, and YC is the casino dealer. We were all happy to be there, but YC was the happiest one.

I soon realized that YC had a moat. It had positive network effects. It had several structural advantages. People used to say that venture capital firms could not have moats or unfair advantages—after all, you were just providing capital. But YC clearly has one.

That’s why YC remains so strong even as it scales. Some critics don’t like YC scaling; they believe YC will eventually fail because they feel it lacks soul. For the past ten years, there have been predictions of YC's demise. But that hasn’t happened. During that time, they replaced their entire partner team, and death still did not occur. A moat is a moat. Just like the companies they invest in, scaled venture capital firms have moats that are not just about brand.

Then I realized I didn’t want to play the commoditized VC game, so I co-founded my own firm and other strategic assets. These assets were highly valuable and generated strong deal flow, so I tasted the sweetness of a differentiated game. Around the same time, I began observing another firm building its own moat: a16z. Therefore, when the opportunity to join a16z arose a few years later, I knew I had to seize it.

If you believe in venture capital as an industry, you—almost by definition—believe in power-law distributions. But if you truly believe that the venture capital game is governed by power laws, then you should also believe that venture capital itself will follow a power law. The best founders will cluster around those institutions that can most decisively help them win. The best returns will concentrate in those institutions. Capital will follow.

For founders trying to build the next iconic company, scaled venture firms offer an extremely attractive product. They provide expertise and comprehensive services for everything a rapidly expanding company needs—recruiting, go-to-market strategies, legal, financial, public relations, government relations. They provide enough capital to truly get you to your destination, rather than forcing you to penny-pinch and struggle against well-funded competitors. They offer tremendous reach—connecting you with everyone you need to know in business and government, introducing you to every important Fortune 500 CEO and every significant world leader. They provide access to a hundred times the talent, with a network of tens of thousands of top engineers, executives, and operators around the globe ready to join when your company needs them. And they are everywhere—this means anywhere for the most ambitious founders.

At the same time, for LPs, scaled venture firms are also an extremely attractive product on the most important simple question: Are the companies driving the most returns choosing them? The answer is simple—yes. All the large companies are working with scaled platforms, often at the earliest stages. Scaled venture firms have more swings at bat to capture those important companies and more ammunition to persuade them to accept their investments. This is reflected in the returns.

Excerpt from Packy's work: https://www.a16z.news/p/the-power-brokers

Think about where we are at this moment. Eight of the ten largest companies in the world are West Coast-based, venture-backed companies. Over the past few years, these companies have provided most of the global new enterprise value growth. At the same time, the fastest-growing private companies globally are also primarily venture-backed companies based on the West Coast: those companies that were born just a few years ago are rapidly approaching trillion-dollar valuations and the largest IPOs in history. The best companies are winning more than ever, and they all have the support of scaled institutions. Of course, not every scaled institution performs well—I can think of some epic failures—but almost every great tech company has the backing of a scaled institution.

Either go big or go boutique

I don’t think the future is solely about scaled venture firms. Just like in every field touched by the internet, venture capital will become a "barbell": one end will have a few super-large players, and the other end will have many small, specialized firms, each operating in specific niches and networks, often collaborating with scaled venture firms.

What is happening in venture capital is what typically happens when software eats the services industry. One end has four or five large, powerful players, usually vertically integrated service firms; the other end has an extremely differentiated long tail of small providers, whose establishment benefits from the industry being "disrupted." Both ends of the barbell will thrive: their strategies are complementary and empower each other. We also support hundreds of boutique fund managers outside of institutions and will continue to support and work closely with them.

Both scaled and boutique firms will do well; it is the institutions in the middle that will have trouble: these funds are too large to bear the cost of missing out on giant winners, yet too small to compete with larger institutions that can structurally offer better products to founders. What makes a16z unique is that it sits at both ends of the barbell—it is both a set of specialized boutique firms and benefits from a scaled platform team.

The institutions that can best collaborate with founders will win. This may mean super-large backup capital, unprecedented reach, or a massive complementary service platform. Or it may mean irreplaceable expertise, excellent consulting services, or simply incredible risk tolerance.

There is an old joke in the venture capital world: VCs believe every product can be improved, every great technology can be scaled, and every industry can be disrupted—except their own.

In fact, many VCs do not like the existence of scaled venture firms at all. They believe scaling sacrifices some soul. Some say Silicon Valley is now too commercialized and is no longer a haven for misfits. (Anyone claiming that there aren’t enough misfits in tech clearly hasn’t attended a tech party in San Francisco or listened to the MOTS podcast.) Others resort to a self-serving narrative—that change is "disrespect to the game"—while ignoring that the game has always served the founders, and has always been so. Of course, they would never express the same concerns about the companies they support, whose very existence is predicated on achieving massive scale and changing the rules of their respective industries.

To say that scaled venture firms are not "real venture capital" is like saying that NBA teams shooting more three-pointers are not playing "real basketball." You may not believe so, but the old rules no longer dominate. The world has changed, and a new model has emerged. Ironically, the way the rules of the game change here is similar to how the startups supported by VCs change the rules of their industries. When technology disrupts an industry and a new set of scaled players emerges, something is always lost in the process. But much more is gained. Venture capitalists understand this trade-off firsthand—they have always supported this trade-off. The disruption that venture capitalists want to see in startups should equally apply to venture capital itself. Software has eaten the world, and it certainly will not stop at VC.