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I was listening to a podcast from a16z recently which got me thinking about how the technology / software value chain might be changing going forward. This is such an important topic as it is central to the nature of technology investing; I have found that understanding a software company’s value chain and determining how it is positioned relative to others, and how it will change in the future, is the best predictor of future returns. So much equity value is derived from future expectations and concepts like ‘mean reversion’ does not really play a part in an industry that is systematically changing every other industry around it.
Furthermore, from an investing perspective, we’re firmly in the market regime where investors are discriminating between real (secular) winners on an ongoing basis and actively shorting companies that are losing out or where growth is seen as temporary, including for technology companies.
So here’s my breakdown of the key changes that are taking place within software value chains.
I still think the best way to segment software business models is around the type of service they offer and who they sell to. This decision ultimately fundamentally impacts every level of the business. Within that broader meta differentiation, it then makes sense to disaggregate software business models according to scale, such as using Aggregation Theory for internet focused businesses.
Things to watch out for:
In larger organisations, decision making power for paying for and implementing software is moving purely from technology team to a hybrid of technology and business management. In many cases, corporate boards may also get involved in the purchasing decision or have a view on the general budgeting process. Ceteris paribus, this introduces greater complexity into the sales process. At the same time, there is a much sharper focus on the payback period and ROI of new technology deployments.
Greater tolerance / acceptance of software products that are customised to specific use cases. The level of atomisation is getting smaller as size of functional teams gets smaller (e.g. in the past, it would have been acceptable to just buy subscriptions to Microsoft Office 365 for everyone and expect them to make do, whereas now, each team can have its own specific SaaS solution designed for their workflows). With new technology shifts such as 5G around the corner, the potential for atomisation grows gets even more granular.
Today (to simplify hugely), although network operators try to do traffic management, all traffic in the cell is fundamentally using the same capacity. 5G lets you create dedicated private capacity in the radio network with specific characteristics. So, you could sell a truck operator dedicated capacity on the two miles between a specific freeway exit and a specific warehouse. Or, you could offer an IoT operator (or alarm company) much lower bandwidth but over a wider area.
However, at the same time, since the complexity of managing software (particularly SaaS) doesn’t grow linearly with the number of software products being managed (rather it is exponential), decision makers at enterprises are biased towards solutions that can offer a generalised framework that teams can use to create specific, self made solutions (e.g. RPA, low/no-code platforms).
Expectations around what constitutes good quality software have increased dramatically. Taking a leaf from the consumer playbook, enterprise end user software needs to be slick, engaging, easy to use and improved continuously.
Organisations are becoming much more comfortable around utilising shared infrastructure. This is not only the ongoing use of public or hybrid cloud but it also extends out to other forms of shared infrastructure, such as specified data sharing (e.g. Snowflake’s offering), or participating in specific marketplaces (e.g. Unity’s in game advertising solutions).
A greater willingness to experiment with new approaches and new technology as long as the value proposition can be evidenced.
In the case of selling to very large organisations, a sharper focus on the underlying business model of the vendor to make sure that economic incentives are aligned well and underlying margins are not excessive.
Sales and marketing expenses are going to need to increase on average as the sales motion is going to get more difficult. The caveat to that is if the product has been explicitly designed with network effects in mind and/or there is a clear strategy to bundle products together to make decision maker’s lives even easier (a more coordinated form of the land and expand strategy).
Research and development costs are probably going to remain elevated for a longer period of time but as a % of revenue, they have the potential to reduce quickly if the right formula can be found that allows for rapid product creation and the creation of shared infrastructure or a marketplace. Signs of this occuring should lead to greater operating leverage coming through.
You will begin to see a greater broadening of revenue streams at an earlier phase of the company lifecycle. The best companies will also start to disclose performance of individual business lines and explicitly show how bundling of products is taking place.
Smaller team sizes, made up of cross functional members all aligned towards a particular business problem based on the microservices philosophy.
These are some of the best public companies that I’ve come across operating with these characteristics: Snowflake, Elastic, Cloudflare, Crowdstrike, Unity, Shopify.
Things to watch out for:
Its difficult to argue against the power of the large aggregators but there does seem to be a move towards specific platforms that are designed for specific purposes, especially when it relates to media content. This is itself seems driven by a desire by people to get quality content on specific verticals and the willingness to pay for it on a subscription basis. Perhaps this is a tacit recognition that aggregators can, at times, generate output that caters to the lowest common demoninator. Just look at Substack as an example of success!
The hybridisation of consumer and enterprise: consumers increasingly expect the power and functionality of software that would typically have been reserved for enterprise clients and often, a similar level of customer service.
Social elements are being embedded into apps that may not have traditionally been social as the need for social engagement keeps increasing. It actually makes me wonder - is there a need for an API led Twilio for social?
Abstracting this point further, I think we will continue to see more ‘mash-ups’ - the introduction of functional elements that cater to a specific type of behaviour continue to move from aggregators of that behaviour to other types of specific platforms (e.g. e-commerce and payments being more integrated into gaming, fintech solutions such as customised insurance or lending getting embedded into healthcare platforms, vertical specific platforms like Stack Overflow building a recruitment business model).
Similar to enterprise, the most successful companies will create products at a faster rate and try to create effective bundles around them that target specific user needs and behaviours. Apple’s family package is a good example of this.
Product teams are going to require more cross functional people; different areas of domain expertise being able to effectively partner and work together.
Expect to see an increase in competition to software encumbents in sectors that lend themselves well to the ‘mash-up’ approach. Alternatively, established companies in these sectors that have the ability to execute these ‘mash-ups’ should see a meaningful acceleration in their growth trajectory.
Much more emphasis being put on customer success teams (even more than now!). Unfortunately this is just a necessary cost of doing business. Without it, customers will slowly drift away. For example, take a look at how involved the user journey for a buyer is on Alibaba’s Taobao marketplace.
These are some of the best public companies that I’ve come across operating with these characteristics: Alibaba, Pinduoduo, Peloton.