An a16z partner's account: Boutique VCs are dead; scaling up is the ultimate goal for VCs.

Author: Erik Torenberg , Partner at a16z

Compiled by: Deep Tide TechFlow

Deep Dive: In the traditional narrative of venture capital (VC), the "boutique" model is often touted, with the belief that scaling leads to a loss of soul. However, Erik Torenberg, a partner at a16z, offers a counterargument in this article: with software becoming a pillar of the US economy and the advent of the AI ​​era, startups' needs for capital and services have undergone a qualitative change.

He believes the VC industry is in the process of shifting from a "judgment-driven" to a "deal-winning" paradigm. Only "mega-institutions" like a16z, with their scalable platforms and comprehensive support for founders, will be able to win in this trillion-dollar game.

This is not only 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 classical Greek literature, there exists a sub-narrative that transcends all else: respect for the gods versus disrespect for them. Icarus's scorching by the sun was not essentially due to his excessive ambition, but rather to his disrespect for the divine order. A more recent example is professional wrestling. You can simply ask, "Who respects wrestling, and who disrespects it?" to discern who the face and the heel are. All good stories take one form or another.

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

I understand why people hope this story will work. But the reality is, the world has changed, and venture capital has changed with it.

There's more software, leverage, and opportunity than ever before. There are also more founders building larger companies. Companies are staying private longer. And founders are demanding more from VCs than ever before. Today, founders building the best companies need partners who are truly committed to winning, not just those who write checks and wait for results.

Therefore, 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 a fund to raise, how to assist in closing deals, and how to allocate power to founders—derives from this.

Mike Maples famously said, "Your fund size is your strategy." Equally true is that your fund size is your belief in the future. It's your bet on the scale of output from startups. Raising massive funds over the past decade might have been seen as "arrogance," but this belief is fundamentally sound. Therefore, when top firms continue to raise huge sums to deploy over the next decade, they are betting on the future and delivering on their promises with real money. Scaled venture is not a corruption of the venture capital model: it's the venture capital model finally maturing and adopting the characteristics of the companies it supports.

Yes, venture capital firms are an asset class.

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

Roelof is one of the greatest investors of all time, and a really good guy. But I disagree with his views here. (Of course, it's worth noting that Sequoia Capital has also scaled up: it's one of the largest VC firms in the world.)

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

Software is no longer a fringe sector of the American economy comprised of oddballs and mavericks. Software is now the American 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. Software hasn't finished eating the world—in fact, accelerated by AI, it's only just begun—and it's more important than it was fifteen, ten, or five years ago. Therefore, a successful software company can reach a much larger scale than ever before.

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

This leads to why the second point—too much money chasing too few companies—is wrong. Output is far greater than before, the software world is far more competitive, and companies are going public much later than before. All of this means that great companies simply need to raise far more money than ever before. Venture capital exists to invest in new markets. What we've learned time and again is that, in the long run, new markets are always much larger than we expect. The private market is mature enough to support top companies at unprecedented scale—just look at the liquidity available to top private firms today—and investors in both private and public markets now believe that the scale of venture capital output will be staggering. We have been misjudging how large VC as an asset class can and should be, and venture capital is scaling up to catch up with this reality and the set of opportunities. The new world needs flying cars, a global satellite grid, abundant energy, and intelligence so cheap it's beyond measurement.

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

Modern tech companies typically require hundreds of millions of dollars because the infrastructure needed to build world-changing cutting-edge technologies is simply too expensive. In the dot-com bubble, a "startup" entered an empty field, anticipating the needs of consumers still waiting for dial-up connections. Today, startups enter an economy shaped by three decades of tech giants. Supporting "Little Tech" means you have to be prepared to arm David against a few Goliaths. Companies in 2021 certainly received excessive funding, with a large portion going into sales and marketing to sell products that weren't necessarily 10 times better. But today, money flows into research and development or capital expenditures.

Therefore, the winners are far larger than ever before, and require significantly more capital to be raised, often from the outset. Consequently, the venture capital industry must, naturally, grow much larger to meet this demand. This scaling is logical given the size of the opportunity set. If VC size were too large for the opportunities venture capitalists invest in, we should have seen the largest institutions underperform. But we haven't seen that at all. While expanding, top VC firms have repeatedly achieved extremely high multiples of returns—as 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's too big. Since then, some firms have exceeded 10x returns on a $1 billion fund. Some point to underperforming institutions to blame the 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 what allows institutions to maintain consistent returns. In other major asset classes, people sell products to or borrow from the highest bidder. However, VC is a typical asset class that competes in dimensions other than price. VC is the only asset class with significant persistence among the top 10% of institutions.

The final point—that the venture capital industry should shrink—is also wrong. Or at least, it's bad for the tech ecosystem, for the goal of creating more generations of tech companies, and ultimately for the world. Some complain about the second-order effects of increased venture capital funding (and there are some!), but it's also been accompanied by a dramatic increase in startup valuations. Advocating for a smaller venture capital ecosystem could very well mean advocating for smaller startup valuations, and the result could be slower economic growth. This perhaps explains why Garry Tan said in a recent podcast, "Venture capital can and should be 10 times bigger than it is now." Admittedly, if there were no competition and an individual LP or GP was the "only player," that might be good for them. But having more venture capital than we have today is clearly 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 far more founders in the world than there are today?

Second, if we suddenly have a much larger number of founders, what kind of organization can best serve them?

We're not going to spend too much time on the first question, because if you're reading this, you probably know we think the answer is obviously yes. We don't need to tell you too much about why founders are so good and so important. Great founders create great companies. Great companies create new products that improve the world, organize and direct our collective energy and risk appetite toward productive goals, and create disproportionate new corporate value and interesting jobs around the world. And we could never have reached an equilibrium where everyone capable of starting a great company has already started one. That's why more venture capital helps unlock more growth in the startup ecosystem.

But the second question is more interesting. If we wake up tomorrow to find that there are 10 or 100 times more entrepreneurs than there are today (spoiler alert, this is already happening), what should the world's startup scene look like? How should venture capital firms evolve in a more competitive world?

Come and win, instead of losing 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 come and go, and you meet them. Then occasionally you reach out, pick a startup off the conveyor belt, and invest in it."

The kind of VC Marc described—well, that's what almost every VC has been for most of the last few decades. Back in the 1990s or 2000s, winning deals was that easy. Because of that, the only truly important skill for a great VC is judgment: the ability to distinguish between good and bad companies.

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

Winning a deal used to be easy—as easy as picking up sushi on a conveyor belt. Now it's incredibly difficult. VCs are sometimes described as playing poker: knowing when to pick companies, knowing at what price to enter, and so on. But that may mask the all-out war you have to wage to get the right to invest in the best companies. Old-school VCs miss the days when they were the "only player" and could dictate to founders. But now there are thousands of VC firms, and founders have an easier time getting term sheets than ever before. Therefore, more and more of the best deals involve extremely fierce competition.

The paradigm shift is that the ability to win deals is becoming just as important—or even more important —as picking the right companies . What's the point of picking the right deal if you can't get in? Several things have contributed to this change. First, the proliferation of venture capital firms means they need to compete with each other to win deals. With more companies competing for talent, customers, and market share than ever before, 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.

Secondly, because companies remain private for longer periods, investors can invest later—when the company has been more validated and therefore more competitive in the market—and still receive venture-style returns.

The final, and least obvious, reason is that selection has become slightly easier. The VC market has become more efficient. On one hand, there are more serial entrepreneurs constantly creating iconic companies. If Musk, Sam Altman, Palmer Luckey, or a brilliant serial entrepreneur starts a company, VCs will quickly line up to try and invest. On the other hand, companies are reaching insane scale much faster (and have more room for growth due to staying private for longer), so the risk of product-to-market fit (PMF) has decreased compared to the past. Finally, with so many great institutions now available, it's much easier for founders to connect with investors, making it harder to find deals that other institutions aren't pursuing. Selection remains the core of the game—picking the right evergreen companies at the right price—but it's no longer the most crucial element by far.

Ben Horowitz hypothesizes that consistently winning automatically makes you a top firm: because if you win, the best deals will come your way. You only have the right to pick when you can win every deal. You might not pick the right one, but at least you have the opportunity. Of course, if your firm consistently wins the best deals, you'll attract the best pickers to work for you because they want to be at the best firms. (As Martin Casado said when recruiting Matt Bornstein to a16z: "Come here to win deals, not lose deals.") Therefore, the ability to win creates a virtuous cycle that enhances your pick-picking ability.

For these reasons, the rules of the game have changed. My partner, David Haber, described in his article the shift venture capital needs to make to cope with this change: "Firm > Fund".

In my definition, a fund has only one objective function: "How can I generate the most carry (performance fees) with the fewest people and in the shortest amount of time?" A firm, in my definition, has two objectives. One is to deliver superior returns, but the second is equally interesting: "How can I build a source of competitive advantage through compounding?"

The best institutions will be able to invest their management fees in strengthening their competitive advantage.

How can I help?

I entered the venture capital field ten years ago, and I quickly noticed that Y Combinator played a different game among all venture capital firms. YC was able to acquire great deals from excellent companies on a massive scale, and seemed to be able to serve them on a massive scale as well. Many other VCs, compared to YC, played a commoditized game. I would go to Demo Day and think: I'm at the table, and YC is the house. We were all happy there, but YC was the happiest one.

I quickly realized that YC possessed a moat. It had positive network effects. It had several structural advantages. People used to say that venture capital firms couldn't have moats or unfair advantages—after all, you're just providing capital. But YC clearly had one.

This is why Y Combinator remains so strong even after scaling up. Some critics dislike Y Combinator's scaling; they believe it will eventually fail because they feel it lacks soul. For the past 10 years, people have been predicting Y Combinator's demise. But it hasn't happened. During that time, they replaced their entire partner team, and the death still didn't occur. A moat is a moat. Like the companies they invest in, a scaled venture capital firm's moat is more than just a brand.

Then I realized I didn't want to play the same old venture capital game, so I co-founded my own firm, along with other strategic assets. These assets were incredibly valuable and generated a strong flow of deals, so I got a taste of the differentiated game. Around the same time, I started watching another firm build its own moat: a16z. So when the opportunity to join a16z a few years later a few years later arose, 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 the venture capital game is governed by power laws, then you should believe that venture capital itself will also follow power laws. The best founders will flock to the institutions that can most decisively help them win. The best returns will concentrate in these institutions. Capital will follow.

For founders looking to build their next iconic company, large-scale venture capital firms offer an incredibly attractive product. They provide expertise and a full range of services for everything a rapidly expanding company needs—recruiting, market entry strategy (GTM), legal, financial, PR, government relations. They provide enough funding to get you to your destination, rather than forcing you to be frugal and struggle against well-funded competitors. They offer tremendous reach—access to everyone you need in the business and government sectors, introducing you to every major Fortune 500 CEO and every important world leader. They offer access to 100 times more talent, with a global network of tens of thousands of top engineers, executives, and operators ready to join your company whenever needed. And they are everywhere—which, for the most ambitious founders, means anywhere.

At the same time, for LPs, large-scale venture capital firms are also a highly attractive product on the most important and simple question: Are the companies driving the highest returns choosing them? The answer is simple—yes. All the large companies are partnering with large-scale platforms, usually at the earliest stages. Large-scale venture capital firms have more opportunities to swivel to those important companies and more ammunition to persuade them to accept their investments. This is reflected in the returns.

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

Consider where we are right now. Eight of the world's ten largest companies are West Coast-based, venture-backed firms. These companies have accounted for the majority of new enterprise value growth globally over the past few years. Meanwhile, the world's fastest-growing private companies are also predominantly West Coast-based venture-backed firms: those founded just a few years ago are rapidly heading towards trillion-dollar valuations and the largest IPOs in history. The best companies are winning more than ever before, and they all have the backing of large institutions. Of course, not every large institution performs well—I can think of some epic collapses—but almost every great tech company has the backing of a large institution behind it.

Either go big or go refined.

I don't believe the future will simply be about large-scale venture capital firms. Like everything the internet has touched, venture capital will become a "barbell": at one end are a few super-large players, and at the other end are many small, specialized firms, each operating in a specific field and network, often in partnership with large-scale venture capital firms.

What's happening in venture capital is exactly what typically happens when software devours the services industry. At one end are four or five large, powerful players, often vertically integrated service providers; at the other end is a long tail of highly differentiated, small vendors, built on the back of industry disruption. Both ends of the dumbbell will thrive: their strategies are complementary and mutually empowering. We've also supported hundreds of boutique fund managers outside of institutional investors and will continue to support and work closely with them.

Both large-scale and boutique firms thrive; the ones in the middle are in trouble: these funds are too big to afford missing out on the big winners, but too small to compete with larger firms that can structurally offer better products for founders. a16z is unique in that it sits at both ends of the dumbbell—it's both a dedicated boutique firm and benefits from a large-scale platform team.

The institution best positioned to partner with the founder will win. This could mean massive reserve funds, unprecedented reach, or a huge, complementary service platform. Or it could mean unparalleled expertise, excellent consulting services, or simply an incredible risk tolerance.

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

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

To say that large-scale venture capital firms aren't "real venture capital" is like saying that NBA teams shooting more three-pointers isn't playing "real basketball." You might not agree, but the old rules of the game no longer hold sway. The world has changed, and a new model has emerged. Ironically, the way the rules of the game are changing here mirrors how VC-backed startups are changing the rules of their industries. When technology disrupts an industry and a new batch of large-scale players emerges, there's always something lost in the process. But there's also more gained. Venture capitalists understand this trade-off firsthand—they've always supported it. The disruptive process venture capitalists hope to see in startups applies equally to venture capital itself. Software has devoured the world, and it certainly won't stop with VCs.