The sweet spot in the missing middle.
(or: The virtues of the small-TAM technology company.)
Hello friends,
tl;dr: Small-TAM tech companies get no love. But small-TAM tech companies that build software for mid-size clients in traditional industries fill a big and underserved niche, have a counterintuitive competitive moat, and have a more sustainable mechanism for growing big if they want to. First, a note about consumption: It’s that time of year when gifting becomes ubiquitous. Have you considered giving yourself or someone else idk, the tool I made for learning how to be more productively uncomfortable and better at dealing with uncertainty? Ships worldwide from the US and Germany.
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The sweet spot in the missing middle
In September, I wrote about why we need industry-specific AI tool incubators for medium-sized firms.
Artificial intelligence (AI) has exploded in the public consciousness. It now attracts huge amounts of investment and attention. The focus has mostly been on building and improving underlying technologies and building out infrastructure. However, as we marvel at all these new AI-enabled capabilities, there remains a huge but often overlooked gap: Applications of AI to solving existing real-world business problems — especially in traditional industries like manufacturing, logistics, and construction.
While venture capital-backed startups chase massive but still not-yet-existent markets, there’s a missed opportunity for small, cashflow-focused tech companies to provide industry-specific AI solutions for medium-sized traditional businesses.
Since September, I’ve been nosing around this opportunity by talking to people in the AI industry, private equity investors, and operators in traditional industries. This issue unpacks some counterintuitive answers to their questions around the desirability and feasibility of a “technology Mittelstand” — a robust ecosystem of tech companies that build software for mid-size clients in traditional industries and which thus have small total addressable markets (TAMs).
Why focus on the medium-sized firm in a traditional industry?
Because the medium-sized traditional firm is the excluded middle.
Large firms often have both the resources and the business-case for a fully customized AI solution. A bank like JPMorgan Chase or a construction giant like Bechtel can afford to develop in-house customized AI tools (or engage a top-tier consulting firm to build these custom applications).
Small firms usually lack the resources to adopt sophisticated AI applications. They might benefit from off-the-shelf tools that improve operational efficiency, such as payroll automation or CRM systems. However, for these businesses, the investment required for retrofitting a customized AI application into their existing workflows is too high compared to the potential benefits.
In my conversations with both PE funds and mid-sized companies, the consensus appears to be that the perfect target profile for lightly customized AI tools is a traditional company that is big enough to have a Chief Procurement Officer (CPO) or Chief Operations Officer (COO) but without a dedicated technology executive (like a CIO or CTO) or an in-house technology practice beyond basic IT support. Businesses of this size operate at enough scale to benefit from tooling up but are simultaneously too small for a full custom solution to be economic, underserved by standard off-the-shelf solutions, and don’t have the capacity to build the tools internally.
Medium-sized firms are both the excluded middle and the sweet spot.
Why do these tools for mid-sized businesses need to be industry-specific?
Solutions best suited for these medium-sized clients are highly specialized, industry-specific applications. General AI tools with large, cross-industry total addressable markets (TAMs) might sound appealing, but to get to enormous TAMs you often need to build a product that spans multiple industries and so by definition must omit the understanding of existing industry-specific business process context that medium-sized firms always need.
For instance, a voice-to-text-to-prompt application that could serve many sectors would attract both VC funding and tremendous competition due to its potentially broad applicability and enormous TAM — but mid-size firms would have to adjust their business processes to make it work for them, and such firms just won’t have the internal capacity to do that kind of reorganisation just to use a new tool.
A tool designed specifically for one industry — such as an AI tool for construction companies to automate their safety compliance checks based on the regulations in one specific country — has an inherently smaller TAM and also requires more specialized, industry-specific knowledge to build. But once built, its utility to firms inside the industry becomes rapidly apparent.
Beams is an example of a small-TAM tech company. It provides the airline industry with AI tools for analyzing safety risk and now works with over 20 airlines including the Delta Airlines Group, Lufthansa Group, and Icelandair.
Valuable tools in traditional industries must be tailored to already-existing workflows, business processes, and regulations. All these are likely to be industry-specific rather than industry-spanning.
Aren’t small TAMs strategically bad?
Products with small TAMs are overlooked by VCs (and by product people looking for VC funding) because they aren’t scalable products that can achieve unicorn status. However, the overlooked advantage of the small TAM is that it discourages large tech companies from entering these niches. Small TAMs become a barrier to entry, defending tech SMEs from competition from companies seeking big TAMs.
Each of these industry-specific small-TAM tech companies would end up occupying a distinct tech ecological niche, much as a tropical rainforest has a huge number of species coexisting, each in its own niche that other species have no particular interest in trying to invade. (The need for industry-specific knowledge is another barrier to entry.)
And small TAMs aren’t even that small. SMEs in traditional industries such as construction, logistics, retail, manufacturing, finance, and real estate always make up a huge portion (usually well over 80%) of most countries’ GDPs.
Small TAMs act as an effective moat for attractive markets that aren’t as small as they superficially appear.
Will small-TAM tech companies never get big?
Designing products with (relatively) small TAMs doesn’t preclude a small-TAM tech company from becoming big — but if they get big, they do so starting from a different position.
VC-funded tech startups begin from envisioning a product for an enormous market. Neither the product nor the market exist yet, and often the product relies on technology that also doesn’t exist yet. (Some of these products also rely on the enormous market to exist before the products “work.” All the multisided platforms fall into this category.) So VC-funded startups have to build the technology, the product, and the market, then successfully sell the product into the market. All this is very hard, which is why most VC-funded tech startups fail along the way. (We aggressively celebrate and envy the ones which made it all the way to an IPO and forget that they are the exception, not the rule.)
The small-TAM tech company starts from a different place: a real need faced by actual companies working in an existing industry. The market already exists and the value of the product can be established. The need is frequently addressable without developing fundamentally new technology. The small-TAM tech company’s challenge faces is not like what VC-funded startups face in terms of developing new underlying technology or building not-yet-existent markets. Instead, the challenge is to understand what real clients actually need and are willing to buy. This takes yet more industry-specific knowledge about how real clients’ existing legacy business processes work and how to build a product that can integrate non-disruptively with those legacy processes with only light customization.
Acquiring deep industry-specific knowledge leads to identifying other needs in the same industry. For small-TAM tech companies that want to pursue it, this ends up being the path to bigness.
ServiceTitan shows how a small-TAM tech company can get big. It was founded in 2007 to build software for independent contractors to manage paperwork. Over time, it grew by adding more industry-specific tools, becoming the back-office software solution for small and mid-sized contracting businesses. Last year, ServiceTitan’s 8000+ contractor clients ran $6.2 billion in revenues through the company’s suite of services. The company has raised over $1.5 billion in funding so far, and filed for an IPO a few weeks ago.
By initially focusing on a clearly defined product that fills a need for an existing market in a specific industry, small-TAM tech companies create a strong foundation for sustainable growth if they want it. And they don’t need to pursue the high-failure-rate business models of VC-funded startups to do it.
Expanding how we think about tech entrepreneurship.
The intersection of technology deployment and traditional industries is an area overdue for innovation — especially in expanding what we valorise and support in technology entrepreneurship.
VC funding is crucial for driving highly uncertain new technology development. But we already valorise unicorns and have extensive infrastructures for funding and supporting VC-type tech entrepreneurship.
What’s underserved is the traditional industries that are the backbone of every economy, and especially the SMEs in those industries. Supporting these traditional businesses strengthens the whole economy. Apart from encouraging VC funding models and business models, we also need to fund and focus on the sweet spot in the missing middle: Developing a dense layer of small-TAM technology companies to service these traditional mid-size firms.
There’s literally no other way to equip these traditional industries to create jobs and foster long-term economic growth.
Next time here, I’ll probably write about the fundamentally different approach to product management needed to build a small-TAM tech company.
See you soon,
VT
> Small-TAM tech companies that build software for mid-size clients in traditional industries fill a big and underserved niche, have a counterintuitive competitive moat, and have a more sustainable mechanism for growing big if they want to.
Most clients in the small-tam situation tend to be non tech and expect a turnkey (or near turnkey) solution.
This means the industry-specific solution very quickly becomes a company-specific implementation.
I suspect the counterintuitive thing is to lean into the beast of acting like a services vendor and implement these turn key solutions for the first 3-5 clients of the same industry even if these turnkey solutions are not scalable.
Then after those 3-5 successful implementations, figure out if there are any common abstractions and then pull them out.
If it's possible these common abstractions can be client facing, then great, you can slowly transition to be a product company with some self-serve features.
If these common abstractions are only useful for developers, then sadly you will still be like a services company except that now you are far more efficient than the first 3-5 times you did this.
By the way, if you have a tip jar, I will gladly pay something to incentivise you to write the follow up on this.