AI is already changing how gov tech businesses are valued, diligence and financed — the only question is how quickly that will occur. We have seen this first-hand in our work with clients where the volume and nature of AI-related due diligence has changed considerably over the last few years. If we go back to 2023, a minority of firms would ask about AI and it was not the focus of their due diligence. Last year, 100 percent of firms asked about AI but the theme of those conversations was more “how are you using AI to accelerate growth and improve margins?” — AI was an opportunity, not a threat. In the current environment the conversation is equal parts opportunity and threat, fueled by the headlines around the long-term risk AI is presenting to traditional software models.
While AI will certainly reshape the gov tech market, we think the complexion of that transformation is going to look different than in the private sector. The most important dynamic is that government agencies’ purpose is to serve the population in an effective and transparent manner — not the relentless pursuit of revenue growth or earnings maximization that defines many companies in the private sector.
The below is a summary of a longer white paper comprising our thoughts on AI in gov tech.
NOT EVERY GOV TECH SEGMENT IS CREATED EQUAL
Gov tech is a large market comprised of dozens of smaller markets with varying degrees of size, fragmentation, technology adoption and maturity. These dynamics will dictate the pace of AI adoption, where certain market segments will see faster adoption of AI while others will see a more moderate pace. What we believe will inform this is:
- The maturity and fragmentation in the market today
- The size of the end-user base in each market — is it constituent-facing or not
- How routine or complex the underlying processes are, and
- Whether the data passing through the system has strategic value or not
TRADITIONAL GOV TECH BARRIERS TO ENTRY SLOW PACE OF DISRUPTION
Gov tech has been a sought-after category because of structural dynamics that create resiliency and product stickiness, and we believe those same forces will dictate the speed of AI adoption. The strong customer loyalty seen in gov tech will continue to be a major barrier to entry, as governments historically have looked to established vendors that provide high levels of customer service as they adopt new technologies. Gov tech also abounds with business model diversity whereby there is something else alongside the software that differentiates the delivered solution. These include:
- A proprietary data set generated by the solution
- A higher-touch service offering
- A hybrid hardware/software model (particularly prevalent in public safety)
- Embedded payments or transaction facilitation
- Legislation or regulation that defines the product requirements
AI ATTRACTS MORE VENTURE FUNDING, SPURS WAVE OF CONSOLIDATION
Gov tech historically was viewed as a market of slower growth and smaller component markets that could not produce venture scale returns. AI is changing this. AI-native approaches have shown a propensity to drive higher average selling prices and grow the underlying addressable markets. Larger markets and faster adoption means more areas of gov tech will be able to produce venture-scale returns and attract more growth capital — we are already seeing this in public safety.
We also believe we will see an uptick in activity. Across virtually every segment of gov tech you will find a private equity-backed or publicly traded business that holds the position of the large, established incumbent. We believe these businesses sit at a crossroads where they hold high share in their markets but, in some cases, are viewed as not as innovative as they were 10 years ago. As the AI threat and opportunity evolves, we anticipate that these players will look to acquire growth-stage AI businesses to capture the opportunity and head off threats posed by the AI-native startups.
PREMIUMS ACCRUE TO AI FIRMS THAT IMPACT OUTCOMES, NOT JUST EFFICIENCY
We distinguish between two types of value delivered by AI solutions: those that increase efficiency and those that impact outcomes. We believe that the true breakout, high-multiple stories in gov tech will be those that impact outcomes, rooted in the fact that government deploys technology to serve citizens better, not optimize profits.
REDEFINING "GOOD" PERFORMANCE: WILL THE RULE OF 40 BECOME THE RULE OF 60?
A “good” gov tech business is a Rule of 40 business, has mid-90s gross retention, low-100s net retention and has profit margins commensurate with the scale of the business. AI is a force multiplier for the Rule of 40 that has long governed the high-multiple outcomes in gov tech, and as these companies scale we anticipate traditional performance benchmarks to increase.
NEW INVESTMENT THEMES: EVERY BUSINESS IS A TECH BUSINESS
The final thought we have is that the buyer is reformulating how they think about deploying capital in the gov tech market. Four-letter words for software investors like “services” and “hardware” are suddenly highly attractive facets of business models because of the defensibility they represent. Because of AI, we believe that every gov tech business will be viewed as a potential tech business, where deployment of AI can eventually produce software-like margins.
THE PUNCHLINE
In summary, we believe that we’re entering a period of change in gov tech, but not one that’s going to happen overnight. We also think that what has made gov tech among the most attractive sectors in technology will persist and will only bring new entrants into the market as AI-native businesses redefine what good looks like. Most importantly, we believe that AI is not a zero-sum game — it has proven to show its strength by creating and capturing value alongside traditional software, not replacing it.
