When buyers are performing due diligence, adding an algorithm to a service business does not change the business's cost of goods sold.
The difference between building and operating a technology business is how the market will value the company based on its valuation multiples, its engineering talent density, and its access to capital.
This post creates a calculation of the specific financial requirements, R&D intensity metrics, and revenue structures that will differentiate true technology companies from tech-enabled companies.
Capital Market Mechanics of Technology Revenue
When determining what is a tech company, it is an entity that generates revenues primarily from the creation and sale of technology products. The output of a tech company is the technology itself, whether it be software, hardware, a cloud platform, an AI model, semiconductors, or telecom networks. Tech companies all have the same financial footprint that is built by high R&D intensity, proprietary IP, and extreme scalability afforded by digital delivery.
The capital markets do not take into consideration whether or not your internal teams can work faster using more advanced tools and are thus able to offer a better user experience.
If your business primarily relies on a service business model that does not rely on technology (for example, retail, financial services, hospitality, or logistics), then your company is tech-enabled. A tech-enabled company is one that utilizes technology to improve its ability to provide more efficient services and/or to create a better user experience. Ultimately, its scalability is based on the number of employees it has, its physical ability to deliver services, or its physical overhead.
Valuation models categorically segregate these two business categories. Founders typically wish to self-identify as tech companies to achieve software-type revenue multiples. Conversely, investors will wish to perform an analysis based on tech-enabled factors because, while virtual goods have infinite scalability, human services do not.
A True Tech Company Cannot Be Denied Financially
Financially, there is no way to disguise yourself as a tech company. The allocation of capital among tech organizations differs markedly from traditional business models, and their income statements clearly show this distinction.
R&D Intensity and Revenue Benchmarks
Technology organizations produce goods or services through their R&D departments. True tech organizations differ substantially from traditional S&P 500 companies in the amounts spent annually on R&D, which are typically between 2% and 4% of total company revenue.
Conversely, pure technology organizations within the internet/software categories are spending 13.6% of total annual sales revenue on average. Emerging and rapidly-expanding pure tech organizations typically maintain their spending in the range of 15% to 25%.
The R&D intensity of tech organizations varies greatly based on their stage of development and business category. For instance, the early-stage SaaS companies with less than $20 million in annual recurring revenue typically spend in the range of 25% to 35% of annual revenue on R&D.
As they progress through the growth stages ($20 million to $100 million) of revenue development, their R&D spending tends to stabilize between 18% and 25% of their revenue. Even established enterprise software giants with greater than $500 million in annual revenue remain committed to keeping R&D expenditure within the range of 10% to 15% of revenue.
Entertainment categories also support this concept of R&D intensity levels.
Social media companies have an average of 32% R&D intensity level, while other SaaS organizations show averages between 23%, distribution businesses at 18%, and hardware manufacturers at 13%. The R&D arms race is evident at the absolute spending level, as several of the major technology organizations (Alphabet, Amazon, Meta, Microsoft, Apple) invest collectively hundreds of billions of dollars each year in research. As such, these companies operate as innovation factories rather than traditional product manufacturers.
Gross Margin and Cost of Goods Sold
The zero marginal cost economic principle benefits tech companies through increased gross margin. After developing a software product or platform, the expense of recreating and disseminating it to another user is virtually nothing. In turn, this provides gross margins that cannot be created by traditional forms of business.
For companies who operate as a true software or platform, most of their COGS is attributed to support provided via cloud hosting, data storage, and customer support. Additionally, there are no physical items or huge supply chains linking each new sale to its cost. Therefore, these companies regularly experience gross margins of 70% to 90%.
In contrast, tech-enabled businesses will experience immediate margin erosion. For example, selling curated groceries online through a better app design may enhance the conversion rate of customers. However, with each order, the business must also fulfill the physical requirements of having items stored in warehouses and employing workers for packing in order to ship.
Shipping costs account for the gross margin cap of fulfillment for this business. As a result, tech-enabled businesses will typically fall under 20% to 50% gross margins.
The Line-Drawing Between Tech and Tech-Enabled
It requires a strict checklist to determine what is a tech company. To differentiate companies that are on the line between both categories, assess the core revenue engine, customer-facing technology, and proprietary intellectual property.
Evaluating the Core Revenue Engine
Look at the invoice. What is the customer actually purchasing? If a business uses Stripe for payment processing and developer API, they are purchasing a technology service. Therefore, Stripe is a tech company. Conversely, when a consumer purchases a ride through Uber, they are purchasing a transportation service; thus, Uber is a logistics and transportation company that utilizes technology to a higher degree.
A pure technology company is one that has developed its products around proprietary software, algorithms, or patents. In contrast, a tech-enabled company builds its competitive advantage on brand reputation, operations, or distribution while primarily utilizing off-the-shelf software and hardware to streamline internal operations.
Assessing Borderline Examples
Many brands take a hybrid position, making it more difficult for outsiders to accurately gauge their true nature and the market force each represents.
For example, Peloton marketed itself as a technology company with a focus on the interface and software for subscription-based service.
However, its primary capital investment was in creating a manufacturing and shipping business for heavy physical exercise equipment. Therefore, it should be classified as a tech-enabled fitness equipment manufacturer.
Similarly, WeWork considered itself to be a technology company, touting its ability to utilize data to optimize space allocation for customers. However, after much public scrutiny, the market ultimately rejected the company’s claims and instead viewed WeWork as a tech-enabled commercial real estate leasing company with high fixed costs associated with the physical properties owned and managed, along with significant personnel expenses.
By comparison, Shopify provides the complete software platform that supports millions of sellers worldwide in creating their online storefronts.
Unlike Peloton and WeWork, Shopify does not carry any inventory, pack boxes, or deliver goods. Rather, it offers commercial sellers a fully integrated digital commerce operating system, positioning itself as a pure technology business.
Different Types of Technology Companies in the Market
Today, technology encompasses much more than simply selling "hardware" or "software." Technology has splintered into a wide array of highly specialized verticals, which support disparate business models, human capital requirements, and metrics for assessing growth potential.
Software as a Service (SaaS)
When examining what is a tech company, Software as a Service (SaaS) continues to be the primary way modern software is delivered to end-users.
Companies that previously sold license packages are now offering apps in the cloud through subscriptions, with ongoing payments and providing a higher level of service than ever before. The next most critical layer of the tech stack is developer tools and infrastructure platforms. Many companies use platforms such as Databricks, Notion, and Figma to provide a massive data architecture and create digital workspaces for their customers.
Companies like Databricks are putting together large amounts of data architecture, using the cloud to host data models that will create digital workspaces for customers.
Databricks has created an ecosystem effect, where third-party developers create integrations that "lock in" their users to the product/platform.
Infrastructure and Model Labs for AI
The market for technology will be entirely dominated by companies built exclusively for AI.
These companies are not simply adding AI features to their existing apps; instead, they are building the foundational intelligence models that will drive software innovations for the next decade and beyond.
Two companies that create foundational architectures for AI models and provide the infrastructure needed to train those models are OpenAI and Anthropic, who are classified as model labs. Scale AI collects and provides the data infrastructure needed to train AI models.
Companies that apply AI, such as Anduril, are remaking technology in defense, showing that hardware and advanced AI software can work together to disrupt heavily regulated, legacy markets.
Digital Hardware, Semiconductors, and the Physical Layer
No software has any value without the physical layer. Digital hardware technology encompasses the design and manufacturing of the devices, chips, and servers that run the digital world.
Apple continues to set the standard for consumer electronics, while the semiconductor industry has become the leader in global innovation.
Nvidia recently became the first publicly traded company to reach a $4 trillion market value, not by selling apps, but by developing the precise silicon architectures necessary to train and deploy AI models, globally.
The Margin Multiplier Test
If your revenue grows solely in correlation to your physical inventory or human headcount, no software will give your company a valuation of technology. To answer what is a tech company, the ultimate test is whether its margins increase as its user base increases, or whether the physical limitations of delivery will inevitably limit its profitability.