Software Is AI, If You Do It Right: Spaht

Key Concepts

• Quality of Revenue: High renewal rates and a large customer base indicating strong product-market fit and customer retention.
• Domain Knowledge: Deep understanding of specific business processes and industries, crucial for successful AI integration.
• AI Opportunity Framework: An internal assessment tool used to evaluate companies based on their potential to leverage AI, considering factors like data depth, integration complexity, and criticality of calculations.
• Deterministic Calculations: Calculations requiring precise and error-free results, common in industries like payroll and aviation.
• Genetic Office of the CFO/Procurement: A vision for the future of finance and procurement, integrating human expertise with AI-powered tools.
• TAM Expansion: Total Addressable Market expansion, indicating potential for growth and increased market share.

Software in the Age of AI: A Toma Brothers Perspective

This discussion centers on the current market sentiment surrounding software companies, particularly in light of recent market downturns and the rise of Artificial Intelligence (AI). The speaker, representing Toma Brothers, argues that the market is undervaluing software companies with specific attributes, presenting a significant buying opportunity. They differentiate between generalized fears and the realities of AI’s impact on specific software niches.

Market Sentiment and Opportunity

The speaker acknowledges the “carnage” in public markets but attributes much of it to sentiment and narrative rather than fundamental issues with software itself. They believe the market is failing to discern between different types of software, overlooking companies poised to benefit from AI. They see current valuations as attractive, especially within their investment space, and view this as an “exceptional buying opportunity.” The speaker notes that while public markets react quickly, private valuations adjust more slowly, creating opportunities in both spheres. They also observe some funds attempting to reduce their software exposure, further contributing to potential acquisition targets.

The Toma Brothers Investment Thesis & AI Framework

A core tenet of Toma Brothers’ investment strategy is “quality of revenue,” defined by high renewal rates and a large, diverse customer base. This focus aligns with their internal “AI opportunity framework,” which prioritizes companies possessing:

• Depth of Domain Knowledge: A thorough understanding of the specific industry and business processes the software serves.
• Complexity of Integrations: The ability to seamlessly integrate with other software systems.
• Complexity of Calculations: The need for intricate and accurate calculations, particularly in high-stakes environments.
• Criticality of Application: Whether the software is a “system of record” used for real-time decision-making with low tolerance for error.

Real-World Examples & Case Studies

Several examples illustrate the types of companies that fit this profile:

• DeForce (Payroll): Payroll processing is cited as a prime example due to its complexity, strict regulations, and the severe consequences of errors.
• A-Plan (Supply Chain Management - LVMH): Managing inventory for a luxury brand like LVMH requires rapid response to manufacturing issues, highlighting the need for reliable and accurate systems.
• Jeppesen (Aviation Software): Flight planning software demands high accuracy and adherence to regulations, making it a critical application where errors are unacceptable. The example of United Airlines and pilot scheduling underscores this point.

These companies are not only surviving but thriving in the age of AI, accelerating their development and expanding their offerings. The speaker emphasizes that most software companies are private, and the narrative of widespread disruption is “overwrought.” The recent take-private deal of Day Four is highlighted as an example of finding value in the current market.

AI Disruption: Where the Real Threat Lies

The speaker argues that the primary disruption from AI will not come from startups attempting to replicate existing software. Instead, the threat lies with large foundational model companies like OpenAI and Anthropic. However, even this disruption is limited. These companies excel at data science but lack the deep understanding of specific business processes necessary to replace specialized software.

Potential areas of disruption are identified as:

• Lead Sorting: Tools for qualifying sales leads.
• Marketing Automation (Front-End): Basic marketing tasks.
• Document Management (Simple Tasks): Extracting keywords from documents.

Conversely, companies with strong domain knowledge and critical applications are more resilient. The speaker dismisses the notion of “vibe coding” – quickly creating code to replicate complex systems – as unrealistic, particularly for mission-critical applications like payroll.

Addressing Common Narratives & Future Outlook

The discussion addresses several prevalent narratives:

• AI Replacing Enterprise Software: The speaker refutes this, stating AI is software and that successful companies are integrating AI to enhance their existing offerings. Recent results show median bookings growth of 22% year-over-year, with AI contributing to a significant portion of new sales (10-15% of SKUs in Q4).
• Decreasing Enterprise Software Spending: The speaker believes this is also inaccurate, pointing to a shift towards value-based pricing and consumption-based AI offerings. They acknowledge the evolution of pricing models but downplay the idea of seats becoming obsolete.
• AI Product Proliferation: While acknowledging the rapid release of AI products, the speaker emphasizes the importance of domain knowledge and the difficulty of automating complex enterprise processes without a deep understanding of data ontology.

The speaker highlights the importance of continuous innovation, exemplified by A-Plan’s expansion from five to twenty-six applications in a year. They envision a future “genetic office of the CFO” and “office of procurement” powered by a combination of human expertise and AI agents.

CEO Confidence & Strategic Response

The speaker reports strong confidence among portfolio company CEOs, stemming from robust performance and a focus on innovation. They advocate for a proactive approach, leveraging the current market conditions to make strategic acquisitions and capitalize on the opportunities presented by AI. They emphasize the importance of not being complacent and actively developing new AI-powered SKUs. The sentiment from the recent CEO summit was overwhelmingly positive, with a focus on capitalizing on the current moment.

The overall takeaway is that while the market is experiencing uncertainty, software companies with strong fundamentals, deep domain knowledge, and a proactive approach to AI integration are well-positioned to thrive. The current market downturn presents a compelling buying opportunity for investors who can discern between hype and genuine value.