Internet Maturity & the Growing Importance of Network Effects

Software has already eaten the world; now network effects are eating software

John Luttig, from Founders Fund, recently wrote a great post outlining the macro-level challenges facing the startup ecosystem. It is worth reading in its entirety, but here’s a summary for the purpose of this post: Over the past decade, the surge of consumer and enterprise software startups has been fuelled by rapid growth in internet adoption. Now as adoption nears saturation (or maturity, as described by Carlota Perez on her Technology Surge Cycle), the tailwinds pushing the market forward are getting weaker. At the top of this S-curve, there is less opportunity to create new markets by targeting “non-consumption”. Instead, startups will need to challenge incumbents who were themselves VC funded startups until recently. In other words, the pie has stopped growing (or its growth has slowed), so now everyone needs to fight for a slice. While there is certainly a lot of truth to this, it is in the nature of macro-level analyses to obscure micro-level details. And these details often present the most valuable opportunities.

Let me begin by saying that increasing competition is a reality that startups will need to get used to. However, this does not mean that the technology industry needs to settle for commoditized software and “predictable” revenue streams. Since incumbents are now either deep-pocketed technology companies or well-funded VC startups, access to growth capital is no longer a significant advantage for startups. In this environment, it is more important than ever to scale organically and build powerful moats to keep cash-rich incumbents at bay. How can startups achieve rapid, organic, and sustainable growth in the face of tough competition? This is where network effects come in.

The definition of a network effect is that the addition of a user makes the network more valuable for all users. Increasing adoption makes it easier for startups to organically acquire customers and the cost of customer acquisition drops. In addition, network effects also create strongest moats as users no longer have the unilateral ability to switch products — utility depends on the presence of other users, not the software itself. When implemented the right way, network effects result in rapid organic growth and strong defensibility — an unfair advantage over incumbents.

This is a broad explanation of the problem and the solution. However, it is still not specific enough. What do incumbents look like and how can network effects help displace them? Let’s take a look at one type of incumbent and how startups are challenging them.

SaaS, Disruption and Network Effects

Over the past decade, growing internet adoption and increasing bandwidth led to the rise of numerous software-as-a-service (SaaS) startups. These startups replaced complex on-premise software with software delivered over the internet. This substituted an expensive software license and eye-watering integration costs with a simple and relatively cost-effective subscription. These SaaS companies have now grown to become immensely valuable incumbents worth billions. However, they have a weakness — while they are very good at streamlining workflows, they are not great at enabling communication, collaboration, or streamlining transactions.

This has become the attack vector for many startups born near the top of the internet S-curve. Incumbents’ products are purely designed for users to interact with the software — feeding information in and extracting it. On the other hand, network effect based products are designed to enable interactions between participants or end-users. This means that their value proposition is largely orthogonal to that of incumbents, i.e. their standalone functionality is often worse than incumbents’ to begin with, but their “multiplayer” functionality is far superior. This makes them disruptive in the classical sense, as described by Clay Christensen. At this point, Clay Christensen’s work is (rightfully) so widely read that (almost) everyone in technology knows how to respond to disruption — by creating a new standalone business that replicates the disruptor’s approach. However, it is not an effective response in this case because network effects grant a powerful first-mover advantage to the startup. As a result, disruptive innovation and network effects can be a powerful combination and present an evergreen model for entrepreneurship.

Based on this, there should be a massive opportunity for startups built on network effects to displace standalone SaaS, even at the top of the internet S-curve. This is not just a theoretical possibility. We are seeing the same pattern emerge across far-flung verticals. Let’s take a look at case studies from three completely unrelated industries that exhibit this pattern — design, medical asset tracking, and construction.

Case Studies of Networks Disrupting SaaS

Design Software: Figma leveraged real-time collaboration to challenge InVision

For years, Adobe’s Photoshop was the go-to design software for creative professionals. Photoshop was where designs were created. In this world, InVision began life as a prototyping layer on top of Photoshop — designers could upload their work to InVision, add animations, and share that prototype with co-workers or clients. For the first time, people outside the design team could understand the end product of the design process and provide feedback. In other words, InVision tapped into organizational “non-consumption” and created a new market out of scratch. To put it simply, InVision became the Microsoft Word of design in an organizational context. Soon, all design files shared in an organization were hosted on InVision. Due to its growing dominance, it raised $350M and was valued at $1.9B in 2018. Given its scale and funding, there was very little that competing startups could do to dethrone them… until Figma.

InVision allowed a single user to edit at a time before sharing with other collaborators. On the other hand, Figma enabled real-time collaboration and editing across the organization (h/t to Brianne Kimmel for helping me understand this). In other words, Figma built the Google Docs of design to enable true collaboration between designers and other teams.

In process, Figma essentially built a network effects-based product that I previously called “SaaS for network management” (like Slack and Github). Figma’s adoption within an organization begins with a few designers who use it to collaborate. However, these designers also work with other collaborators within the team and in other teams. They act as “network bridges” and help Figma gain traction within the organization, which then triggers conversion to a paid plan. This is a network effect in action as growing adoption within the organization increases Figma’s utility. In addition, freelance designers and design agencies act as cross-organization network bridges and help Figma organically spread across organizations (as we saw with Slack’s shared channels). As Figma’s adoption increases across organizations, it becomes more and more difficult for those who collaborate externally to use a different product. This also makes it extremely difficult for customers to move away from Figma.

Despite InVision’s position as the dominant incumbent in the space, Figma was able to use real-time collaboration as its attack vector to acquire customers. It then leveraged its in-built network effects to expand organically and create a moat. As a result, Figma scaled rapidly and recently raised a funding round, led by a16z, at a $2B valuation.

Asset Tracking Software: Medinas created a P2P marketplace to compete with Nuvolo

The healthcare industry and hospitals, in particular, are seen as technology laggards. But paradoxically, hospitals also own and operate extremely valuable technology assets, i.e. medical equipment. Historically, hospitals have tracked inventory, records, utilization, and maintenance schedules of these assets using legacy, on-premise software from vendors like IBM and Oracle. In recent years, these legacy vendors have been challenged by companies like Nuvolo that provide many of the same benefits via a simple online interface (and a more cost-effective monthly subscription).

Nuvolo has raised just under $25M in funding so far. While this may not seem like much, it is built on top of ServiceNow’s IT service management platform and is backed by both ServiceNow and GE. Nuvolo may be a startup, but it has many of the advantages of an incumbent. How can other startups compete with this? By leveraging network effects, as Medinas has.

Nuvolo is a single-player tool — it allows hospital IT managers to enter and retrieve information about medical equipment. But it cannot help hospitals replace old equipment or buy new equipment — this process remains cumbersome. Medinas solved this problem through a SaaS-enabled marketplace, following a “come for the tool, stay for the network” approach. Medinas first built a free asset tracking software for hospitals to manage their medical equipment. This gave Medinas visibility into the kind of medical equipment each hospital had, which it used to link hospitals together on a P2P marketplace. Hospitals could then use this P2P marketplace to buy and sell used medical equipment.

Medinas’ asset tracking software is certainly not nearly as feature-rich as that from “incumbents” like Nuvolo. However, the fact that it is free and the added benefit of the marketplace gives it an unfair advantage over those incumbents. This advantage gives Medinas the opportunity to continue improving its asset tracking software to gain feature parity with incumbents. At the same time, network effects between hospitals (thanks to free software) will make it very difficult for incumbents to replicate their value proposition.

Construction Software: Schuttflix built an end-to-end hyperlocal marketplace to expand into Procore’s territory

Construction is a massive, legacy industry and not one that is commonly thought of in the context of technology. So when Procore built a project management software for the construction industry, it created a brand new market. Procore’s software allows various stakeholders in a construction project — construction companies, project managers, contractors, vendors, etc., to share information and documents related to their projects. What previously required pen and paper or dispersed email threads could now be centralized and managed on a single system. In other words, managing a construction project became dramatically easier with Procore — unsurprisingly, both customer adoption and investor interest skyrocketed. As a result, Procore has raised nearly $650M and was last valued at $3B in late 2018. How could any startup challenge an all-in-one solution like Procore? Enter Schuttflix.

Procore allows construction project managers to streamline every aspect of their project, but this also means that it is too broad to be an end-to-end solution. For example, materials vendors still need to submit bids and arrange for payments and fulfillment. While Procore handles bid submission and documentation, the process itself can be cumbersome. Schuttflix used this as their attack vector to build an end-to-end hyperlocal marketplace connecting materials vendors and freight forwarders to construction companies and project managers. Schuttflix controls not just information exchange, but also transaction, payment, and fulfillment.

Schuttflix is not meant to be a substitute to Procore today as it only captures a sliver of workflows involved in a construction project. In fact, they may even look to collaborate in the near-term. However, growing customer adoption will open up opportunities for Schuttflix to integrate more SaaS elements into its marketplace. This will not only enhance defensibility and scalability but can also help it gradually encroach on more of Procore’s use cases over time.

Each of these three examples follows the same, familiar pattern — great SaaS products with strong market positions increasingly face competition from startups that bring in true “multiplayer” capabilities. These incumbents were either too broad to create an end-to-end solution or were not built for collaboration. This created an opportunity for specialized B2B networks or marketplaces to disrupt them. This is happening even though broader internet adoption is slowing — software has already eaten the world. Now network effects are eating software.

What you should do next…

1. Pitch me: No warm intros required

I invest in pre-seed/seed-stage startups as a Venture Partner at Speedinvest and also via the Atomico Angel Program. If your startup is built on network effects and based in Europe, pitch me here.

2. Apply for my Reforge course

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3. Take the network effects assessment

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4. Book a consultation

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