Do VCs Invest in Service Businesses? A Deep Dive into Funding Trends
Venture capital firms pour billions into high-growth startups every year. But when it comes to service businesses, VCs tend to be more cautious with their checkbooks.
In this post, we’ll analyze the VC landscape to understand investment trends for service startups. You’ll learn:
- The unique challenges faced by service businesses seeking funding
- What types of service startups do attract VC dollars – and why
- Tips for service founders to secure venture capital
So if you’re leading a service startup and wondering how to court VCs, read on.
The VC Bias Against Service Startups
First, let’s level-set: What exactly is a service business?
Service companies provide expertise, support, or access to a capability. Rather than selling a product, they sell their time, effort, and knowledge. Examples span professional services like consulting, creative agencies, healthcare providers, and more.
These human-centric firms pose a conundrum for VCs seeking exponential returns. Here’s why VCs hedge their bets:
Limited Scalability
Products can scale rapidly by replicating software or leveraging distribution partners. Services don’t have that luxury. Each new customer requires dedicated time and effort from the team.
So while a SaaS startup can acquire 1,000 customers with the same 10-person engineering team, a consultancy would need to hire another 50 experts to handle 50 new clients. That steep linear growth restricts how quickly service companies can scale.
Lower Margins
Services also suffer from compressed margins. Employees are the biggest expense for service firms, eating 60-70% of revenue.
Compare that to software companies, where gross margins can range from 75-90% thanks to minimal incremental delivery costs. This gives product startups more dry powder to reinvest in growth.
Limited Defensibility
Software-based companies also benefit from defensibility. Network effects, switching costs, and intangible assets like brands and data create competitive moats for product startups.
Meanwhile, service companies rely primarily on human talent. Since knowledge workers can change jobs fluidly, service firms struggle to establish meaningful defensibility beyond their brand reputation.
Unpredictable Outcomes
Finally, VCs love business models with predictable, recurring revenue. Enterprise SaaS companies excel here, with sticky subscriptions and negative net revenue churn.
But service projects carry riskier transactional revenue. Once an engagement wraps up, the client relationship might dissolve. And even long-term service contracts can fluctuate quarter-to-quarter based on project timelines.
These dynamics make service businesses less appealing for VC dollars focused on hypergrowth. But not all hope is lost…
When Do VCs Invest in Service Companies?
While VC firms approach service startups warily, they do make exceptions. Under the right conditions, both early-stage VCs and growth-stage investors will finance service businesses.
Here are a few scenarios that can persuade VCs to cut checks for service startups:
Clear Path to Scalability
As discussed above, most services don’t naturally ignite exponential growth. But some service models are primed for scalability, which piques investor interest.
Take Ro. This men’s health platform offers telehealth and prescription delivery. Ro can scale rapidly because the core service requires minimal labor per patient. Automation also streamlines onboarding and prescription fulfillment.
Other examples include credit underwriting, fraud detection, and cybersecurity services. These leverage data and technology to remove humans from the loop. Allowing a service to scale almost virally generates VC enthusiasm.
Defensible Assets
Some service businesses also develop proprietary assets that form a barrier to competition. Think of McKinsey’s industry knowledge base or IDEO’s design thinking expertise.
By codifying institutional knowledge into frameworks, training programs, and software tools, these firms have extracted defensible assets from their talent. This makes them more intriguing VC candidates.
Hybrid Business Models
Many startups blend service revenue with product income. A common example is SaaS companies that offer onboarding assistance and ongoing client success services.
This hybrid model provides recurring product revenue while allowing the startup to monetize its expertise. If the product portion can scale uncapped, the services element becomes almost a customer acquisition tool.
VCs will fund these hybrid companies even if services make up a large portion of current revenue. The model’s potential scalability and stickiness still shine through.
First Check Into an Industry
Finally, VCs often make an exception for startups bringing a novel service model into a traditional industry.
Being first-to-market provides a fleeting competitive advantage until incumbents catch up. But for 12-18 months, the startup enjoys a pole position to gain traction.
For example, real estate brokerage was a fragmented, offline industry before Compass. As the first well-funded digital brokerage, Compass could use venture dollars to quickly gain market share.
Similar first-check dynamics drove VC investment into new services like One Medical, Honor (home care), and Phil (prescription delivery).
Tips for Service Startups Seeking VC Funding
Based on the exceptions above, service founders can tailor their approach to improve the odds of raising venture capital:
Highlight scalability drivers – Emphasize factors like automation and technology that will enable uncapped growth. Downplay the reliance on human effort.
Develop proprietary IP – Build differentiating frameworks and playbooks that act as competitive moats. Codify institutional knowledge through software where possible.
Combine services with product revenue – Offer software tools or subscriptions to complement the core service. Hybrid models are more enticing than pure services.
Target archaic industries – Research markets dominated by offline incumbents. Being the first digital entrant can attract VC interest.
Start niche – Define a tight niche and vertical focus. Starting broad dilutes your positioning and advantages.
Optimize metrics beyond revenue – Highlight engagement, utilization, and client retention alongside financial metrics. This proves scalability and sustainability.
The Bottom Line
- VCs have an inherent bias against capital-intensive service startups with limited scalability and defensibility. But under the right conditions, they will invest in service models poised for technology-enabled growth.
- Service founders should amplify scalability drivers, develop proprietary IP, add product revenue, target legacy industries, get niche, and showcase granular operating metrics to court VCs.
- With adaptation and the right pitch strategy, service startups absolutely can attract venture capital – as long as the model demonstrates seeds of scale, sustainability, and defensibility.
In summary, VCs will fund service startups with strong fundamentals, even if the core revenue initially comes from services. By emphasizing scalability pathways and differentiating IP, service founders can overcome inherent VC biases around unit economics, margins, and niche expertise. Savvy positioning unlocks growth capital to compete and own categories long dominated by legacy players.
