The Terawatt Power Law of Venture Capital
By: Alan Feld, Founder & Managing Partner at Vintage Investment Partners
Over the last number of weeks, there have been several blog posts about the “Power Law” of venture capital and the growing size of venture funds. Most of these blogs have presented a mathematical analysis showing that increasingly large fund sizes cannot generate expected returns with average “unicorn” exits. Some have concluded that all large venture funds must be avoided.
While the math is right, the conclusion is wrong. The reason is AI – not only because the way AI is changing traditional global businesses but also because AI is changing how one builds large, sustainable venture-backed companies.
For much of the last decade and a half, we have seen the rise of venture-backed companies providing best-of-breed software solutions. The classic SaaS mantra was selling the same narrow, limited feature products to the same persona in the same kind of organization and trying to scale the business with lots of marketing dollars and a strong inside sales team. In many cases, the business units of the customers drove the purchases from these startups, not their IT departments.
What happened as a result?
The average enterprise has found itself with hundreds, if not thousands, of applications that are not fully integrated, are almost impossible to manage, and are creating reams of inconsistently tagged data across these enterprises. All this has yielded a “cost blackhole” and an administrative nightmare with increasingly little marginal economic return.
Compounding this mess is the advent of AI-based applications. Every board of directors of every large enterprise is grilling its CEO about why the company is not moving quickly enough on AI; not surprisingly, every CEO is asking his or her CIO the same question. AI is moving most enterprises from a world of “economies of scale” to a world of “economies of scaled data.” However, the success of AI initiatives is dependent on data quality, accuracy and availability. As long as there is a “Tower of Babel” of applications, data will continue to be inconsistent and largely impossible to integrate in its current form, hindering scaled data initiatives. The challenge will grow even more with the proliferation of AI agents, moving from data support to execution of tasks, from supporting humans in their jobs to automated outcomes.
Offering outcomes means building very big companies with a combination of software and services, not just software. Not only will these large, integrated companies be the winners in the outcomes race, they will also be the ones that the public market investors will want to see IPO.
For some time, the bar has been rising for technology companies to go public with a tier-one investment bank. The investment management business is also consolidating and scaling. Investors are simply no longer excited about IPOs with market caps below $5 billion. Taking a big stake in smaller-cap companies means less liquidity and a lot of analysis and monitoring for something of marginal impact on a massive investment vehicle. Public investor dollars will increasingly be focused on the “winners” in a large space and not on the niche players.
How does this impact venture capital funding strategies?
First, the advent of AI technology will signal the death knell of the venture-backed best-of-breed product company. In other words, the companies that will be the big winners will no longer be the super high gross margin, non-customable, “off the shelf” providers, but the ones offering truly full stack, fully integrated solutions, together with (forgive me…) customization and services that allow them to be number one in a huge market. These companies will be built by both organic growth from internally built products and by a lot of well-integrated acquisitions of technologies and services businesses. They will target the most conservative industries and they will fundamentally change them. They will not offer 100% automation, but they will eventually offer 100% outsourcing – a combination of software and services where gross margins will be a function of how much will be automated over time. In the end, these full-stack companies will become the massive companies of the future, generating several tens of billions of revenue and hundreds of billions of investor value. Companies of this type will not be built in a day. They will take years – and lots and lots of money.
Second, with a higher bar for public investors, there will be fewer IPOs of sub-$5 billion market cap companies. The ones that do go public will offer sector-specific “nichier” solutions that will be interesting and profitable businesses, but will never grow to several tens or hundreds of billions of investor value. Some will be good enough to provide decent returns to selected funds, but will not generate enough value to support the needed returns of the venture industry as a whole. The days of expecting to IPO the number five player in an industry will be gone.
What does this mean for the size of venture capital funds?
There will be a bifurcation of the industry.
There will continue to be smaller, largely early-stage, venture funds generating the companies acquired by these platform companies. These funds will frequently be sector-focused or have multiple teams with sector expertise. Their exits will often be secondaries in some of their companies.
At the same time, we will see more and more full-stack technology investment platforms with the network and breadth of skills to build these behemoths and fund them all the way through. These funds will have several sector-focused teams that are best-of-breed investors in their sectors and will offer a broad and deep basket of services, ranging from talent recruiting to top-tier customer networks to brand building to corporate development support to strategic consulting, etc. These firms will likely be the ones to fund the truly great companies of the future and, despite their size, see outsized returns.
The venture funds facing the biggest challenge will be those in the middle – the venture funds that scaled their size “for scaling’s sake” but never changed their business models –investing the same way as they always have, just paying more for the same exit outcome. They will not have the expertise, the capital, or the services needed to “win” access to the massive winners. On the other hand, they will not be small enough that their mostly M&A exits will provide great returns. It will be these managers who will face the venture fund “math problem.”
In the end, we are moving to a “terawatt power law” of venture capital. Either you build the gigantic companies that everyone else integrates into, or you build the ones that are integrated into someone else’s gigantic company. To survive, every venture fund over the next decade will be forced to decide which kind of fund it wants to be.
Alan Feld is the Founder and soon Managing Partner Emeritus of Vintage Investment Partners
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