Vertical SaaS Moats, Pt 2: Network Effects
In part 2 of our series on vertical SaaS moats, Fractal senior associate Evan Gabriel explores one of the most powerful moats of them all: network effects. Missed part 1? You can read it here.
Economic moats are a vital source of competitive advantage for all growth-minded companies, but not all economic moats are equally suited for every industry. Nowhere is this more clear than with network effects, an economic moat that is uniquely advantageous for internet-enabled companies. In fact, by some estimates network effects account for a staggering 70% of all the value created by tech companies since the early 90s.
Broadly speaking, a network effect exists when each new customer increases the value of a product for all existing and future customers. As we saw in the previous article in this series, moats are defined by having both a benefit and a barrier. The primary benefits of network effects are that they enable companies to charge higher prices than competitors because of the higher value that comes from more users. The barrier arises from the fact that network effects make it virtually impossible for competitors to grab market share given how challenging it is to establish a network effect in the first place.
More than a dozen different “flavors” of network effects exist, but not all of these network effects are created equal. For vertical SaaS companies, there are two types of networks — marketplaces and app ecosystems — where their industry-specific focus gives them a large advantage over horizontal SaaS providers. While these are hardly the only network effects that vertical SaaS companies are well-positioned to build (community and data networks, for example, are also powerful levers), they are far and away some of the deepest moats they can create.
MARKETPLACES
In general, marketplaces are incredibly hard to get going due to the “chicken-and-egg” problem of attracting vendors and customers, also known as the “cold start” problem. But vertical SaaS companies have a unique advantage over horizontal marketplace providers due to the fact that they are already attracting potential marketplace participants through their core workflow software. Since vertical SaaS companies already own the customer relationship for one side of the market by providing a product that drives value to their business, this makes it easier to attract both buyers and sellers to the marketplace, no matter which side their original software customer sits on.
And because vertical SaaS companies focus on a particular industry there are going to be similarities in the transactions between marketplace participants. The idiosyncratic ways that customers do business in a particular sector means that vertical SaaS companies are well-equipped to build those specific processes into the structure of their marketplace and make it the go-to option for their industry. Depending on the industry their core software serves, either a B2B or B2C marketplace might make the most sense. While of course vertical SaaS companies are B2B businesses, if their customer’s customers are consumers, B2C marketplaces might be the most promising opportunity to build a network effect-based moat.
Arguably the greatest strength of marketplace networks is that marketplace take rates are significantly higher than take rates of industry software spend. In general, take rates are largely determined by how much of a workflow process the software provider owns. By combining the already substantial takerates for vertical-specific workflow software with the takerates of a vertically-oriented marketplace, a vertical SaaS company can greatly increase the TAM for the vertical SaaS provider and establish a deep moat.
A great example of a company that has leveraged this type of network effect in the vertical SaaS space is Mindbody, which provides software for the wellness industry. Mindbody offers its fitness center and spa customers a booking marketplace where their customers’ customers can make appointments. This makes it incredibly challenging to compete with Mindbody because their marketplace drives new revenue and customer relationships to their users, which makes them unlikely to switch to an alternative solution.
And here we also see the importance of the relationship between the vertical SaaS vendor and their customers. Mindbody’s marketplace and other vertical SaaS marketplaces are particularly valuable because their customers are already using the core workflow software in their business. Those businesses are more likely to use a marketplace that is provided by their core workflow software vendor rather than deal with the hassle of bringing a third-party marketplace-only vendor, which also risks disrupting the ability for these businesses to own the relationship with their customers. This is readily seen in Mindbody’s acquisition of ClassPass, which had previously existed as a standalone marketplace for fitness classes and salon appointments, but recognized it could drive more value to its customers by merging with a workflow solution.
APP ECOSYSTEMS
A similar dynamic is at work in the case of app ecosystem network effects. Although a vertical SaaS company provides the core workflow software for a given industry, they might not provide a lot of ancillary services that can drive real value to their customers. Vertically oriented point solutions may provide these services, but their customers may be reluctant to adopt many different apps, especially if they don’t interface with their core workflow solution.
The fact that vertical SaaS providers control key workflow processes puts them in a strong position to become a platform for these point solutions. By creating APIs that allow point solutions to integrate with the core workflow platform, they create a straightforward path for these point solutions to reach potential customers without “app overload” that leads to workflow inefficiencies. The more apps that can interface with the core workflow software the more valuable that software becomes to users, which entices more app developers to build solutions that interface with it. Importantly, it also makes existing customers less likely to churn in pursuit of point solutions not provided by the core workflow and it creates a higher barrier to entry for potential competitors who now have to build equivalent integrations to provide the same value to their customers.
This dynamic is readily seen in the “app orchard” provided by Epic Systems, a provider of software for hospitals and other clinical organizations. Epic has become the largest EHR vendor in the industry in recent years by providing both a superior core workflow experience and the ability for point solutions to integrate with their software. Today, Epic has hundreds of apps that integrate with their software, which handle niche or edge services that aren’t provided by their core workflow product. The strength of this moat is apparent in Epic’s multibillion dollar revenue that grew 13% last year alone.
One of the beautiful things about network effects as a moat is that compared to other moats, they tend to grow stronger on their own once they reach critical mass. This doesn’t mean that network effects are trivial to get started. They frequently require substantial effort and strategic decisions in product delivery, such as offering a discount on the core workflow software to initially attract customers to the marketplace, but once they’re going they are incredibly hard for competitors to overcome. And because vertical SaaS companies provide the core workflow software for their industry, it allows them to tap into pre-existing customer relationships to jumpstart network effects that both drive substantial revenue and create a nearly impenetrable moat.
While network effects are a particularly strong competitive advantage for vertical SaaS companies, they are hardly the only economic moat at their disposal. In the next installment of this series, we’ll look at how vertical SaaS companies can create high switching costs by driving value to customers through their core workflow software and use this position to keep potential competitors at bay.
