I was struck by a few quotes and posts this week that centered around the future of the application software business. Several investor friends wrote about the changing topography in application development leading to a changing landscape for venture and private equity investing.
What used to take lots of people to accomplish, can now be completed with the effective use of AI assistance and just a few people. An entrepreneur with deep subject matter knowledge but limited engineering skills used to have to rely upon a team of engineers to realize their dreams, but now they can deliver a meaningful embodiment of their idea with AI doing the engineering heavy-lifting.
Sales and Marketing teams used to require SDRs to generate and nurture leads, but now AI bots do most of the work. Customer support has been similarly impacted, and even accounting functions such as accounts payable and accounts receivable processing have become AI enabled. The bottom line is that building an application business requires a lot fewer people, which has traditionally been the single largest expense. As a result, businesses need far less money to get going, and traditional SaaS investment metrics have become outdated.
At the same time, the efficiency gains have also lowered the competitive barrier to entry. If something was easy for one entrepreneur to create, then it may also be easy for a competitor to emerge. The entrepreneur and potential investors need to be clear about what the special sauce is that will prevent the next competitor from just covering the innovation? A potential investor needs to balance the efficiency with which the entrepreneur launched their business against the defensibility of the market position. It is not just about capital efficiency anymore.
A third trend is an increase in the pace of innovation and replacement. The demise of the large-scale SaaS enterprise systems like Salesforce or SAP is greatly overstated. Mark Twain famously said, "The report of my death was an exaggeration," and the same can be said for enterprise SaaS. However, the add-ons and extensions and vertical-specific applications are a different story. We often differentiate products as either vitamins or cures. A cure is a foundational application, while a vitamin makes things better. The vitamins are under pressure as a result of the changing dynamics leading to accelerated innovation and replacement. Buyers are not as invested in their ‘vitamins,’ and when a new one comes along it is easy to switch. Creating new ‘vitamins’ has become easier and faster, so switching is accelerating.
A quote from Yogi Berra sums up the bottom line “the future ain’t what it used to be.” During this transitional period, while we are all adjusting to the pace of change, I’m reminded of the great movie title “Back To The Future.” It made me think about the fundamentals of prior tech eras and what guidance they can provide now. One of my favorite adages is “too much money makes you stupid.” Investors are in the business of deploying capital, and when they find a promising business opportunity they want to fuel it with money to help it grow and increase in value. Unfortunately, when a business takes too big of a slug of new capital, it can bring out the stupid.
The less money you have, the more often you count it, and the more you worry about conserving it. Some of the most successful businesses bootstrapped their early years and resisted accepting outside capital until the business was mature enough to deploy it wisely. Admittedly, it may have held back their initial growth and market dominance, but there is a lesson for the current market. Today, businesses do not need as much capital to get going, and as discussed above, it is more important than ever to prove that the foundation is defensible before pouring on capital to scale.
I have noticed an interesting phenomenon in companies that raised lots of money and then hit hard times. When the investment spigot was shut off and the bank account dwindled, these high-flying companies started cutting back operating costs. For most, the initial cuts were rarely deep enough, so things got worse. However, the companies that responded by performing a deeper analysis of their unique value proposition and strategic direction, and concentrated on only funding the core of their business, were able to make the right cuts and emerge stronger than they ever were when they were awash in money. In fitness circles, the phrase is “no pain, no gain.” These companies discovered that they had too many boil the ocean efforts underway, or way too much anticipatory hiring before the business actually needed the scale. With lots of cash in the bank, they lost sight of the profit motive and attempted to buy their way to growth, or “gain” with no “pain.” It was not until they felt the pain of actually creating a sustainable business that they earned the gain. All of this is reminiscent of the dot com bubble era where we focused on all the wrong metrics and bought what we thought was success.
The lesson for the modern era is to recognize that the innovation and funding equation has changed, and so has the competitive landscape and defensibility of bright ideas. We have to rethink what the real competitive moat is, and recognize that the obsolescence schedule may be shorter than we think, and therefore the investment return may not align with prior expectations. “The future ain’t what it used to be.”