This post is by Tomasz Tunguz from Tomasz Tunguz
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In 2015, I wrote about the trade-off facing vertical SaaS companies. Vertical SaaS companies focus their efforts on a particular group of customers. Procore targets construction with their software and Veeva targets pharmaceuticals with their CRM. This concentration limits the market size, but improves product market fit. Both of those businesses are now worth more than $3B. There is a new twist in SaaS with a parallel dynamic.
I’ve started to call them AI Agencies. AI Agencies use machine learning to disrupt a market dominated by agencies. Often, these startups begin as software companies selling machine learning software into agencies.
Finding scant market demand from the incumbents whose owners prefer status quo, these startups start their own agency. If you can’t sell to ‘em, beat ‘em. But they are not the typical agency. The startup leverages machine learning under the hood. AI agencies exist in recruiting, translation and online advertising. expect this trend to continue across all major agency segments.
Agencies scale revenue linearly with people. To grow revenue, an agency must hire more people. Most technology companies scale revenue independently of people. Consequently, agencies generate lower gross margins than software companies. The costs of goods sold – the salaries of employees – is higher than a server’s electricity bill.
The AI Agency aims to leverage technology to break free from the linear relationship between revenue and people. Starting an AI Agency has two important benefits for machine learning companies.
First, they create a data advantage. As they operate, AI agencies create high quality data for training machine learning models. In its early days, an AI agency operates identically to its less sophisticated cousin. But as it scales and as it grows, the AI agency replaces human hands with software. They accelerate workflows, and eventually automates some fraction of them.
Second, they grow their market size. A software vendor in many of these categories might be able to address 5-10% of the total spend. Agencies address 95-100%. By repositioning as an agency, the start up increases market size by 10x-20x.
The AI agency strives to have the best of both worlds. Larger market size and competitive gross margins through the use of technology. They will be an important movement in software over the next decade.