Why I’m NOT a ‘B2B SaaS’ investor

People often categorize me as a ‘B2B SaaS’ investor, when in actuality I haven’t invested in a single SaaS company in years.

Why? Because I think it’s really hard for a traditional SaaS company to be successful in today’s market.

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Given the level of transparency and competition in the enterprise software market (and the VC activity willing to fund enterprise software companies), traditional SaaS businesses often don’t present significant enough moats to prevent competitors from replicating/underpricing their solution and competing away their profits. As a result, we’re seeing a plethora of niche SaaS applications that unfortunately aren’t that interesting.

But there is still hope for enterprise software founders — and possibly more opportunity than ever before. As the next evolution of the software landscape evolves, we are seeing a pivotal factor unfold as one of the largest determinants of startup success: Distribution.

In v1 of the enterprise software landscape, bigger was better. Large installed sales team pushed behemoth corporations down the sales funnel and retained integration consultants to plug the product into an existing system. For a product to be credible enough for enterprise, it had to come from a BIG provider. For a sales professional to get a meeting, they needed to come from a BIG company. If you were a startup, it was incredibly difficult to break into enterprise. If you were a BIG company, you bought the startup so you could sell their products across your entrenched and largely captive network of customers. Quality of product wasn’t the defining factor for a software company’s success, it was the quality and scale of your distribution network.

In v2 of the enterprise software landscape (aka the world of SaaS), software became infinitely more accessible. This made the audience significantly larger and opened the door for companies to circumnavigate the incumbent distribution networks of players like Oracle, SAP, and IBM. The advent of cloud-based SaaS delivery was the first crack in these legacy distribution networks as sales activity migrated from a sales funnel to customer lifecycle management where transactions are made continuously. Making software easier to deliver with other solutions was a major blow to these incumbents and the service providers living off integrating and customizing legacy on-prem applications (Villi Itchev from August Capital postulates that we’re actually seeing M&A volume come down now since the distribution synergies are no longer as valuable). Leaders in this class of companies have centralized data management (e.g. Workday, Salesforce), quality products, and customer success.

Now, though, we’re entering v3. New delivery methods are taking form as enterprise business models evolve. For businesses to succeed, they need to be more than just an improved digital interface. They truly need to entrap a customer to withstand the test of time. This is a scary and exciting opportunity for startups and investors alike – “better mousetraps” simply aren’t good enough.

v3 of the enterprise software evolution is about capturing data and its associated network effects, enabling products to grow smarter and more capable than they would otherwise. This can mean better quality, lower costs of service, or proprietary offerings available only to that platform (especially for B2B marketplaces), ultimately giving the vendor immense and often insurmountable advantages over competitors. The stakes are higher than ever before as these network effects tend to result in “winner take all” monopolies, where players have the chance to dominate an entire category (for those who haven’t read Zero to One, monopolies are incredibly lucrative businesses, which is why winning the market becomes the only thing that matters). However, as Matt Turck of FirstMark Capital noted, “data network effects are now becoming a possibility for a much broader group of companies, earlier in their development, as a result of the democratization of Big Data tools”. As these tools become more available, the defining factor for winning the market becomes increasingly more about acquiring data than your startup’s ability to crunch it.

For these software companies, distribution is not only a customer acquisition strategy; its a method of acquiring data and its associated network effects. In a competitive market where fast followers are readily funded, “winning” the data war is a matter of speed and efficacy. Companies that figure out distribution best can seize the network effects necessary to gain market share rapidly and own the market.

To advance their distribution footprint as fast as possible, these v3 software companies often go to market very differently than traditional SaaS businesses. In general, they attempt to remove friction from the market for early customers by subsidizing a component of their offering (or giving it away entirely). They also tend to focus on product quality in order to drive engagement and the associated data from that engagement. As a result, these businesses often require significantly fewer sales resources then a traditional SaaS business at scale and rely heavily on customer acquisition through organic and/or referral channels (further amplifying the relevance of product quality and customer success). These companies may deliver through API/SDKs, marketplaces, transactional/usage frameworks, or networked solutions, but in virtually all scenarios their models are centered on attaining network effects through a streamlined means of distribution.

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I find these businesses compelling for the same reason network-effect driven businesses are powerful in the consumer realm: At scale, they experience incredible defensibility, pricing power, and customer acquisition efficiency. Yes, this means they can be lucrative companies, but these business can also unleash massive quantities of value for customers. Because they spend their resources on the platform rather than customer acquisition, they can develop product capabilities and data insights beyond what may have been possible otherwise.

We see the immense power of these data-driven network effects not only in large consumer companies like Facebook, Google and Twitter, but in the B2B realm as well. When leveraged appropriately, these dynamics can help solve some of the most daunting challenges facing society, maybe even cure cancer. That’s exciting whether you’re an investor or not.

Determining how to evaluate and build these businesses creates new sets of challenges, but I couldn’t be more excited for the future opportunities this latest evolution in the enterprise software landscape will open up. There will be exceptions to the rule — with great founders able to carve out attractive market opportunities with traditional B2B SaaS offerings (and I am certainly tracking a few) — but the shift toward networked enterprise business is one that founders and investors alike need to account for.

NOTE: Thanks to Ezra Galston of Chicago Ventures, Farooq Abbasi of Mosaic Ventures, and Ali Afridi of Lightbank for their feedback on this post.

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Rick Zullo leads enterprise tech investments for Lightbank, a $200 million early-stage venture fund and studio based in Chicago.