What are AI-enabled services?
For the longest time, VCs have been backing software-first companies. Today, some of the biggest companies in the world are software-based, VC-funded companies. This includes the likes of Google, Meta or Salesforce.
Software businesses have high margins, high fixed cost structures, and few infrastructure challenges as they scale (mainly due to cloud providers improving their systems). It is the perfect blend for a VC. It can easily grow to a massive scale, create great defensibility around it, and create a monopoly, providing outlier returns for investors.
The goal of enterprise software building was always to enable FTEs to do more. Not replace incremental need for hiring. AI has changed this. Now, applications are built to augment an FTE by a factor of 2 or more, which reduces the need to hire new ones. A recent case of this was Klarna’s AI tool for customer support, which reduced the need for 700 additional workers.
This created an interesting new opportunity in the market. Startups can now improve the cost structures and margins of FTE-intensive companies. These are usually service providers whose core business relies on the talent that they have. Here, pricing, and thus margin, is calculated on a per-worker basis. Therefore, being able to reduce incremental hire needs as they scale can generate a lot of value.
These types of businesses are what we call AI-enabled services. They will be one of the most defining category in VC in the next years.
Why is the AI-Enabled Services Market So Interesting?
When we look at the recent numbers for SaaS spend worldwide, Gartner predicted overall SaaS spend in 2024 would hit ~232.3B. In contrast, Gartner also forecasted IT services spend worldwide, would hit ~1.6T in 2024.
If we convert just 10% of IT service headcount into SaaS spend, we would increase the market size by 65%. And this does not consider other outsourcing services like legal or management consulting. If we added everything we could probably roll over the entire SaaS spend market at the same conversion.
The market has clear potential to be venture scalable. But investors have long avoided investing in services and actively criticize them. An early example of this was Palantir. The company suffered many criticisms, having been told that it was no different from other enterprise traditional consulting firms. By using, what they called “deployment strategists” they were able to build a personalized product and integration journey for their clients. This was a critical factor to their success that led them to become a $57 billion company. Remarkably, they continue to expand, reportedly growing over 20% year-over-year.
Enterprises increasingly want to have personalized solutions. Therefore, having a service/product mix will be key to winning this market. Also, by reducing costs, services will become cheaper and more democratized. This means startups have the potential to capture a completely untapped growing market.
How AI-Enabled Services Will Disrupt Industries
Services companies were never a VC’s target market. But PE funds love them for buy-and-build strategies. A business that consolidates a fragmented market is very attractive. It increases its pricing power and net cash flow margins become much higher, as a result.
The problem with PE portfolio companies is that they often lack in customer experience. Due to the nature of the PE business, cost cutting is a major priority, as means to achieve better returns. Meaning that most of these markets will be of extremely low NPS.
This is where we see disruption happening: markets with extremely dissatisfied customers that are forced to deal with stagnant incumbent solutions because there is no better alternative. Here, startups can shine by offering better customer experience, attractive pricing models while moving at a faster pace.
Breaking down a consolidated player is tough. However, a major increase in NPS can be enough to cause disruption. This is because the incumbents in the market have been dominating for a while and have increasingly generated lower NPS as the years go by. Poor innovation and reduced attention to clients needs created a clear wedge. A major increase in NPS will be enough to cause some disruption. Coupling this with faster scaling abilities, and exceptional product execution could allow for a next-gen of service companies with better economics and NPS than consolidated giants.
Additionally, it seems that previous founders or long-time operators in startups are the best suited to build these companies. First-time founders haven’t had to deal with service providers, so they aren’t as deeply connected with the pain points. Moreover, having operational scaling experience at a company before is useful. It is tough to scale a service company. But here it is even tougher since an AI-enabled service also requires product scalability skills, and more often than not, M&A knowledge.
Examples of Disruption by AI-Enabled Services
Many industries are already being disrupted. Below are three noteworthy examples that we have seen.
ClaimSorted
ClaimSorted is a tech-enabled TPA for the insurance industry. Having recently been backed by Y Combinator, the company is aiming to disrupt how traditional claims processing is done. It is a prime example of an industry in which top players are PE-backed and have extremely low NPS.
In this industry, tech adoption is very slow. Selling the solution to incumbents would be a lot harder than competing against them. By selling the actual work, ClaimSorted gives a 10x+ better experience to the end-user.
Pilot
Pilot is a tech-enabled accounting firm, tailored for startups. This is an interesting market, because while accounting firms have existed for a long time, they haven’t quite changed much or adopted a lot of new technology in the last 20 years.
The market is becoming digital-first and old accounting firms have a lot of friction when they work with innovative companies like startups. Pilot had a clear vision on how the future would look like in accounting. Hence, they decided to target a growing and valuable crop of the market that had very low NPS with the current model. This is because technology-driven companies will always prefer to work with partners alike.
Today they work with some of the biggest private companies in the world: OpenAI, Lattice, and Scale.
Condoroo
Condoroo is a tech-enabled condominium management startup. This is a market that follows the similar framework of the two above. Dominated by PE-backed companies, which have extremely low NPS, and no real tech innovation in the last decades
Condoroo brings a fresh perspective to the market. They augment the service and can serve multiple condominiums with fewer operational hires. This does not only include reducing admin workload for them, but also automating a lot of bureaucracy for end-users. By boosting their own operational productivity and being nimbler, they are also able to focus a lot more on clients needs.
There are many other examples of AI-enabled businesses that are popping up in different verticals. Some of them have been fortunate enough to raise great investment rounds. For example, Harvey (backed by Kleiner Perkins), Anterior (backed by Sequoia), or EvenUp (backed by Bessemer and Bain Ventures).
What risks do we see when venture backing service companies?
While we are bullish in this new category of companies, it is still very much early days. We are still very unsure on how many of these risks will play out.
Below, are some that still are major concern to us.
VC or PE play?
The standard rule for a VC-backed company is that it must be able to become a category-defining company. In other words, it must be able to become a market leader. A PE-backed company, on the other hand, focuses on stability and cash flow optimization.
The main difference here will be competition. A PE firm can just roll up many undifferentiated companies and create a giant company. But VC firms have to bet on the company that can do this alone. Going at it alone means consistently out-executing the competition while also not losing pricing power. This is a tough job to do, especially in services.
There is another reason that may shy away VCs from these investments. At some point, PEs will approach many of these companies to acquire them as these are the perfect type of companies to roll up and optimize for cash generation. Preferably, they will buy them at the cheapest price possible. This won’t be the best outcome for VCs aiming for +€10B companies.
It is likely that many of these investment opportunities may only be interesting to smaller funds
How to disrupt credibility?
Many of the first markets that we think of when talking about services like management consulting , auditing or legal services are extremely tough to rebuild as tech-first businesses. This is because these are credibility-based industries. Clients approach and return to them to get a stamp of approval from their brand, which has been built over many decades.
Founders that want to go after these markets can either sell into them, try to disrupt the status-quo, or expand the market. A combination of the first and last will always be the best for VC. It avoids competition and still improves the existing industry as a whole.
The more interesting service play here is to expand the market. By taking advantage of superior margins, they can reduce pricing and address clients others can’t. Harvey, for example, sells to elite law firms. But it has the potential to offer services to a large group of enterprises and individuals that cannot afford elite-level rates.
Scaling a service or a product?
Scaling services is a hard job. The operational headaches will never stop, as these businesses strongly rely on FTEs for scalability. There is a fine balance between growth and efficiency, much more than in a product company.
If you add to this the need of consistently build out new products and sell them, you create a two-headed scaling problem. Founders will have to balance scaling to new clients, and building out new products to improve their processes.
This creates an even finer line between efficiency and growth, because now you add additional engineers to the mix. And the reality is that you will always be somewhat dependent on FTEs to scale as automation will never be 100%.
Where is the defensibility?
VCs always prefer businesses that have clear defensibility rooted in their business models. It usually looks like some type of network effects or lock-in. With service companies, there is no real sustainable advantage, which makes it even tougher for a VC investment case.
In a sense, it gives even more emphasis to the founding team. The pressure will be on continuously being able to serve the end-user needs while scaling without ever compromising on customer experience. This will be the single most important thing for these companies to keep or increase pricing power.
Conclusion
At Start Ventures, we want to see this next generation evolve and definitely want to invest in them. So if you are a founder building in this space or a VC wanting to exchange some thoughts please do reach out to us!
By: Rafik Shamsudin, Associate
