Services Have A Larger Market
Service businesses are better businesses than Tech Enabled Service (TES) businesses. Service businesses can charge higher prices points for a similar service as a Tech Enabled Service businesses, and serve a wider set of customers. Effectively creating a larger market.
Services Have Higher Operating Margin
Service businesses can have higher gross margins. Service businesses can drive down operating costs through better processes, efficient use of labor, and decreasing software costs. Software costs decrease over time through the commoditization of SaaS products.
At the same time, Tech Enabled Services are saddled with the high salary cost of R&D without the corresponding benefits. The software platform developed for a TES does not achieve the same leverage as a normal software company – because there is one target customer of the platform. Gross margins are low. And, a TES doesn’t benefit from the commoditization of SaaS that drives down software costs over time. Instead, R&D costs are more like operating expenses.
Ultimately, this reduces the profitability of the TES and limits the available moats for the company to defend itself against competitors. A TES can be picked off by well run service companies or a pure software company.
Services Can Charge More
Service businesses can charge higher prices than Tech Enabled Services for a variety of reasons.
- Services anchor their price point at hiring a full time employee – leading to a higher price.
- Services can handle a wider array of situations – if something doesn’t fit inside the box, the company can just chart more for it.
- Services can used the past resume/eduction of the team to price the service – think McKinsey
High Operating Costs
Service businesses are labor costs plus pricing. SaaS companies are server costs plus customer success. Technology Enabled Service companies are labor, server, customer success, AND the costs of developers to build the technology.
Neither Services Nor TES Have Moats
A number of traditional moats are unavailable to TES.
- Low cost producer – the higher operating margin of R&D means the company cannot be a low cost producer. At the same time, because a TES can only scale as well as the services component, the TES cannot achieve a massive scale.
- Network effects – The service is provided by the TES. This reduces the network effects that might come with multiple parties using the same software, i.e., Google Docs
- Data – This seems like one of the most likely moats, after all, the TES is providing the service, capturing all of the information, and can harness that data. A16Z addresses the Empty Promises of Data Moats in this great blog post.
- Brand – Brand is expensive to build without a great product experience. And, with a service, the user experience is going to be highly variable and dependent upon the service provider.
Build Software or Build Services
It’s tempting to think that a service business can be improved and scaled like a software company through the use of software. This is an illusion. Software can improve the productivity of the services provider, but it’s better to use off the shelf software. This will keep operating costs lower over time. Or, just build software for the service providers in the industry.
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