SaaS and Barriers to Entry

Earlier today Zaid Farooqui tweeted that some of his hedge fund friends think Software-as-a-Service (SaaS) companies are over-valued due to low barriers to entry:

While I agree that some SaaS companies are priced to perfection due the expectation of massive growth, I don’t believe low barriers to entry plays much of a role. Here are a few thoughts on SaaS and barriers to entry:

  • Once a software product works well, especially at a reasonable price, people are reluctant to switch (look at how many people are still using antiquated Microsoft software)
  • Set-it-and-forget-it SaaS apps are more commonplace than realized, such that credit cards keep getting billed and no one notices unless something goes wrong
  • App marketplaces, like Salesforce.com’s AppExchange, create a network effect of other products that integrate (products like the Kevy integration platform are working to decrease this network effect)
  • Achieving scale in a market results in significant sales and marketing resources that only grows as the company grows
  • If SaaS was susceptible to low barriers to entry, more upstarts would have to have successful businesses in the same market as category leaders

The hedge fund partners would do well to talk to their B-school classmates that have started SaaS companies and hear first-hand just how difficult it is to get one off the ground.

SaaS startups encounter a number of barriers to entry, especially in markets with dominate category leaders.

What else? What are some other thoughts on SaaS and barriers to entry?

One thought on “SaaS and Barriers to Entry

  1. It seems to me this post is an exercise in talking past one another (Full disclosure: I’m a Hedge Fund analyst).

    Hedge Fund investing (though not well defined), presumably in this case is assuming something close to a value investing approach. Hedge Fund investors can’t afford to have a big investment be a $0 (or even get cut in half). Thus, barriers to entry (the downside protection) are extremely important. For something trading at P/E multiples >50x ability to believe in future barriers to competition are particularly important. It doesn’t matter how difficult it may be for a single company to compete against your investment, if there are 100s of companies attacking your space with Billions of $ of financing, it’s hard to be confident your chosen investment won’t be at risk for dis-intermediation well before it grows into its lofty multiple.

    Angel or earlier stage investing faces the same business fundamentals, but the potential return profiles on individual investments is different. you can have 90% of the portfolio be a $0, as long as 10% of the investments are 20x.

    On the actual statements in defense of SaaS, I don’t see the arguments as particularly compelling for a public equity investor, and I perceive some as contradictory:

    “Once a software product works well, especially at a reasonable price, people are reluctant to switch (look at how many people are still using antiquated Microsoft software)”
    – the aside ‘especially at a reasonable price’ seems to concede that you may not have pricing power (high barrier to entry companies have pricing power (think cancer drugs))
    – The point about historical network effect (Microsoft) is apt, but you will later make the point that even network effects are being attacked (by Kevy in this instance)

    “Set-it-and-forget-it SaaS apps are more commonplace than realized, such that credit cards keep getting billed and no one notices unless something goes wrong”
    – One could read this as you saying that sometimes the customer just pays you and doesn’t even realize it (perhaps I’m being cynical). A business plan the relies on the customer being dumb is not a great start to a long pitch.

    App marketplaces, like Salesforce.com’s AppExchange, create a network effect of other products that integrate (products like the Kevy integration platform are working to decrease this network effect)
    – The aside at the end seems to support that network effects – which are the long-term barrier to entry that allow for apparently very high Near-term earnings multiples – are going away or being diminished.

    Achieving scale in a market results in significant sales and marketing resources that only grows as the company grows
    – No dispute, but the ‘barriers to entry’ question is the fundamental debate on whether or not the companies will ever be able to realize the benefits of their scale; (We seem to be at least a decade away from Amazon showing off it’s P&L flexibility)

    If SaaS was susceptible to low barriers to entry, more upstarts would have to have successful businesses in the same market as category leaders
    – I don’t think it necessarily follows that start-ups would be directly attacking entrenched businesses if their barriers to entry are low.
    – Even if the barriers to entry are low most smaller competitors would rather not be noticed while they are still too small to impact the Giant in the room.

    – it would make more sense for competitors to build a strong business in an adjacent niche (and establishing themselves) before directly attacking their ultimate goal and destroying my investment.

    I don’t believe it’s easy to generalize SaaS companies, but any time I hear “network effects” as the only barrier to entry, I think it’s wiser than not for public equity investors (especially if you have value approach) to be cautious.

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