Welcome to In the Trenches. It’s great to have thousands of you here. My goal with this newsletter is to be all signal and no noise. To that end, make sure you let me know each week how you liked the content:

• ​🔥🔥🔥This post was awesome​
• ​🔥🔥This post was good​
• ​🔥This post was subpar​

I’ll keep incorporating the feedback into future posts.

As we head into the Holiday weekend, I want to share a thought that I have been ruminating over and debating with friends recently - the value of a good services business. Many of you reading have started a services company or are running one today. Here's an approach to consider on why your company (with the right moves) could be worth more than you think.

To be a $1B company, the age old adage for software companies was you need to get to $100M in revenue. This idea was made popular / taken as conventional wisdom when Battery Ventures created the “T2D3” framework. The framework says you need to get to ~$1M ARR and then “Triple-Triple-Double-Double-Double”

Think of the revenue trajectory over 5 years like this: $1.5 → $4.5 → $13.5 → $27 → $54 → $108

At $100M in revenue with a 10x revenue multiple, voila you’re worth $1B. But why? What justifies the “10x multiple”? At a 10x multiple, there are 3 assumptions you are principally making about the business:

• Stable, Predictable Top Line Growth: The company will grow at 15% YoY for the next 10 years
• Healthy Contribution Margins: The company will produce ~30% contribution margin which generates enough risk-adjusted FCF
• Endurance: The company will be left standing a decade from now (and will have adjusted it’s business model enough where the quality of the business has at least stayed consistent vs. decayed)

SaaS businesses have two great characteristics which justifies belief in the above 3 assumptions: (1) revenue is recurring, (2) the gross margin profile of software is really attractive. At scale, recurring revenue gives points towards stability, predictability and endurance. While software gross margins give points towards healthy contribution margins.

Most great SaaS companies have always had services businesses attached to them; they’ve been necessary to provide customers with a “full solution”, not just technology - i.e. implementation, managed services and support. Despite services businesses having a lower margin profile and not being recurring, by occupying a relatively small portion of the overall revenue composition, they didn’t materially affect the overall gross margin profile. If anything, they added more support to the stickiness and defensibility of recurring revenue. Thus companies that had <25% services revenue, still got a full “software multiple.” as long as the blended gross margin of these businesses was still “software like” (e.g. 65%+).

It’s a common trope to separate businesses into “services” vs. “software” as a proxy for quality and valuation. Services businesses, by definition, are less valuable than software companies. Scaled services businesses are valued at 10x Earnings vs. 10x Revenue.

Why? It comes back to the same 3 variables above - margins are lower and because the business isn’t recurring, it’s more of a leap of faith whether there can be stable, predictable and enduring growth.

But what if you created a services business that had the exact same characteristics as a legacy software company? Would it get the same valuation? (think: Coke - Pepsi blind test). I think there are 2 variables that can drive this for any business: AI + Global Talent

AI and Global Talent are going to materially increase the gross margin profile of a lot of services businesses. I talked to a services company the other day that broke down their delivery into two modals and shared the following:

• Human [modal 1] + Human [modal 2]: 40% gross margin
• Human [modal 1] + AI [modal 2]: 55% gross margin
• AI [modal 1] + Human [modal 2]: 75% gross margin
• AI [modal 1] + AI [modal 2]: 90% gross margin

This was fascinating to me. If they could deliver one part of their solution solely via AI and the other via the right human team makeup (an appropriate blend of onshore/offshore talent), they could get the gross margin profile up to 75% (mirroring a high quality SaaS company). Tack that gross margin profile onto a services business that integrates implementation / managed services into its solution (most good ones do) and you solve the “recurring” part.

Side note - here’s a Narrative Violation for you: A lot of consulting contracts are >1 year (this is longer than many software contracts). And as we learned during the COVID trough, software company recurring revenue is actually a lot less “recurring” than we might think.

In the 2010 ZIRP era, we mistook every “startup” to be a “software” company. We valued Uber, Airbnb, Doordash, etc. as pure software businesses. Turns out they weren’t. We may be doing the inverse right now to services businesses. And if we are, there is a lot of alpha sitting underneath the surface.

The right agency / services / consulting business that looks like a “small cute cash flow company” on the surface, may actually turn out to be tomorrow’s unicorn.

Happy Labor Day Weekend,

Romeen

How did you feel about this week’s post?

• ​🔥🔥🔥This post was awesome​
• ​🔥🔥This post was good​
• ​🔥This post was subpar​