The Hallmarks of Vertical Disruption
new architectural paradigms
Hey folks,
It’s been a blast writing this newsletter and getting to spill digital ink on ideas I have been thinking about for a while.
Lately, it’s been really fun chatting with founders, investors, and others in the community who are all thinking about vertical SaaS, different industries, and how to build/invest in an incredible companies. There’s so much to learn and it’s made me appreciate not only the idiosyncrasies of each individual industry, but also the commonalities that everyone involved with vertical SaaS faces.
So once again, thanks for being here. And if you ever want to jam, just give me a shout.
The Innovator’s Dilemma
Partly because of these conversations, a lot of my headspace these days has been occupied trying to develop a framework for predicting which vSaaS companies win and why. How do you win when you face an onslaught of software, both vertical and horizontal solutions? And more than just winning, how do you predict which vSaaS companies will really end up being disruptive and actually transform their industry?
And so as part of that, I’ve been revisiting The Innovator’s Dilemma, which is up there as one of the most influential books on business strategy of all time. It’s chockfull of case studies where legacy companies underestimate startup and end up shutting their doors.
But nobody reads TID simply for its case studies. For innovators, it’s a war manual in the tradition of Sun Tzu on how to actually disrupt the incumbents in an industry. And meanwhile, incumbents read it to keep themselves paranoid enough about seemingly insignificant startups to ensure they fend off the disruptors.
Because what TID reveals is that disruptive technologies often get ignored. Legacy companies have plenty on their plate and often just don’t consider the insignificant entrants to the market. They have customers to serve and systematically end up dismissing new technology as trivial when in reality it may threaten their core business altogether.
In fact, it’s precisely because of their existing customers that legacy companies can delude themselves into thinking they are incapable of being disrupted. These customers demand improvements to the existing product and often not reimagined products altogether.
Established firms are really good at these types of advancements; what Christensen calls “sustaining technologies.” Sustaining technologies don’t fundamentally rewrite the rules of how a business works or the market for its existing products. Instead they simply enhance existing performance or quality of the solution. And so, established firms are quite adept at sustaining technologies developed alongside their customer base.
It’s disruptive technologies where they get cooked.
Disruptive technologies in Christensen’s view are the province of startups. Usually disruptive technologies appear on the market unheralded and aren’t in demand by the customers of established firms. If by chance an established firm tries to develop a disruptive technology, it generally gets deprecated fairly quickly.
Christensen’s example here is the disk drive industry. Disk drives used to be huge in size. Now they are not. Established firms were really good at squeezing out performance enhancements out of the same size disk drive (sustaining technologies). They were really really bad at bringing smaller disk drives to market (disruptive technologies).
It wasn’t that they didn’t have the technological prowess to develop smaller ones. It’s that they couldn’t predict that smaller disk drives were going to disrupt the entire market. Their customers were demanding performance enhancements to the existing drives, not smaller ones altogether. But due to developments in the computing industry, smaller disk drives were indeed needed!
And so every single time, disk drive size decreased, the established firms lost to the entrants.
Christensen’s work doesn’t map perfectly onto vertical SaaS or software more generally. But it does give a helpful jumping off point and its terminology is useful. The key question is how do we know that a new vSaaS startup is disruptive?
After all, if new vSaaS companies simply adopt the mentality that workflows = product-market fit, I think they mostly end up developing sustainable technologies which may or may not actually end up disrupting the legacy vertical firms. Something else is needed beyond just a series of workflows.
We need new disruptive forms of architecture.
Architecture and Transformation
The key idea that I want to develop here is that vertical companies are disruptive to the extent that they are enabled by their architecture to fully digitize their respective industries in ways that legacy software solutions have historically been unable to do.
Digital transformation is a loaded term, so let’s simplify it. Digital transformation happens when businesses are able to frictionlessly use software to manage every aspect of their business.
This mostly hasn’t happened. Legacy vertical software has been unable to really do this. And it comes down to their architecture.
James Clear has a great quote:
“You do not rise to the level of your goals. You fall to the level of your systems.
We can rearrange this slightly to capture why:
“You do not rise to the level of your vision. You fall to the level of your architecture.
If the software can’t support transformation, it won’t happen. And it definitely hasn’t happened with legacy solutions.
To capture the key reason why, in legacy vertical software firms like Constellation, business units are highly capable of developing sustainable technologies (workflows) in conjunction with customers.
But while these companies have built tons of features and workflows, their architectural choices, tech debt, and more leave them with a huge conundrum: the product itself doesn’t feel coherent. The solutions function more as a series of point solutions versus a highly integrated solution designed to optimize how companies perform business functions. They were never architected to be an actual platform.
It’s no surprise then that the industries they operate in are still highly analog. Oftentimes, the friction of the product experience is far greater than the value of the software. The existing solutions never brought compelling products to market that enabled digital transformation of the industry and so the industries simply haven’t bothered.
So in short, mere workflows are insufficient. Industries don’t just simply transform due to workflow aggregation with a vision for transformation slapped on. Not all software is created equal. Something else is needed at the architectural level that is truly disruptive.
And that’s what brings us to Rippling, as an exemplar of disruptive architectural innovation.
Compound vSaaS Startups
“In fact, I think some of the biggest problems and therefore the problems that potentially could give rise to the most valuable companies tend to be things that span a lot of different point solution products within a business. And therefore, only building one point solution product can't really address them.”
- Parker Conrad
Rippling is on a tear, coming off an 250m funding round at an 11.2bB valuation. The reason? Rippling is creating a super platform for employee management. It’s not simply an HRIS, it’s far more expansive and has ambitions to touch every aspect ok employee management. Parker calls this types of company a “compound startup”. The idea is that a platform vision combined with the right architecture unlocks a non-obvious product that disrupts the market.
Rippling is highly instructive for how vSaaS companies should think about their identity as disruptors. Fundamentally, vSaaS entrants are developing vertical compound startups and the best ones tend to correlate with Rippling’s real innovation: the architecture.
Parker Conrad realized that if Rippling rebuilt the employee graph as the fundamental primitive throughout the platform, they could reimagine how different and disparate solutions that involved employees could operate together. What this means is that every single workflow and product uses the same employee graph as the fundamental primitive on which to build. Payroll, Device management, spend management, and more are suddenly able to operate out of the same platform and workflows start to accrue value from other platform workflows operating on the same set of primitives. This is incredibly disruptive at scale as suddenly every other HRIS system begins to be forced to compete on Rippling’s value but without Rippling’s architecture.
In Parker’s words, “the product is the integration.” The disruption is the employee graph integrated into every aspect of the product from day 1.1
Rippling’s competitors can attempt to build sustaining technologies in conjunction with their customers which mimic functionality to some degree, but rearchitecting their entire product around extensible primitives is off the table. And this is the key difference between a series of point solutions and a true platform. Existing solutions do not have the luxury of rethinking industry primitives and becoming a true platform, only entrants can.
By taking a grander vision, innovating at the architectural level, and building the correct primitives, Rippling now gets to connect different products and workflows that were never fully appreciated as interconnected.
Much like Rippling, vSaaS entrants have an opportunity to disrupt through simply having a grander vision of what software is capable of for their industry and connecting disparate technologies in a far more cohesive way.
Fintech comes to mind as perhaps one of the greatest examples here. Even when legacy solutions have some payments component, it usually does not cohere with the platform. At best, it allows some invoicing and billing functionality and at worst, it is borderline unusable. Fintech changes all of that.
By fintech, I simply mean the idea that building payments, lending, and more is far more efficient and that the very financial functions that a platform performs cohere with and inform the rest of the platform.
Never before has this been really possible and the result is that vSaaS companies with platform visions and the right primitives to connect financial data to workflow data are disrupting not only software but the way their customers obtain financial services.2
So while the value of a vSaaS platform is derived from the whole gamut of workflows, the disruption comes from the coherence stemming from primitive selection. Architecture matters greatly for disrupting legacy solutions.
The Hallmarks
So with both the TID vernacular and some of the background on Rippling in mind, I’ve been sketching out what I think are the hallmarks of vertical disruption. As always, these are subject to expansion, but I think this list gives a really good starting point for framing which entrants will win.
Primitive Selection
It all starts with primitive selection. Every vSaaS company gets to pick the fundamental units upon which it will build its entire solution. You only really get to do this once and so, it is fundamental. It’s your primary lever into the industry and building workflows upon the right set of primitives allows you to execute in a way that your competitors can’t.
The best vSaaS startups all take this seriously and it gives a huge advantage in creating coherence across the platform long term.3
Platform Vision
The selection of the right primitives then allows you to build workflows in a cohesive manner and in non-obvious ways. The right data flows seamlessly across the platform, workflows build on top of each other, and gradually a platform forms. Since the key value of vSaaS solutions is the ability to generate these second-order insights and create workflow coherence, a platform begins to develop and customers begin to grok the value of the entire platform for far more than some narrow workflow.
This then gives you a solid claim on not simply being a series of point solutions, but really having a platform vision to become an industry partner that your customers can rely upon.
Design
This one may feel out of place and I will do a longer writeup on this at some point, but I really do think that great design is a necessary tenet of disruption to existing industry players. Look, there is nothing that is user friendly, well-designed, or cohesive about the UI of legacy solutions. As such, great design ends up being highly disruptive.4
When you think again about why industries haven’t digitally transformed, I firmly believe that a lot of the reason is because nobody wants to use solutions that view their users as mere data entrants.
Look, humans don’t want to be treated like that. Employees want their labor to be dignified. Great design does exactly that. Design disruption dignifies employees and their labor, encourages the use of the software, and highly impacts the ability of the software to fulfill its goal of digitizing all workflows.
Market Redefinition
The great disruptors never enter on the incumbent’s terms. The most disruptive vSaaS solutions will initially start by defining an industry niche or under-appreciated workflow and dignifying it with fantastic software.
In my view, this coheres with Christensen’s hypothesis that disruptive solutions enter less lucrative segments of the market (smaller customers) but also gives a more accurate account for vertical disruption. In many verticals, you don’t get the luxury of having a ton of new businesses being formed that are willing to try your software. You may have to go into the more complex companies in your industry from day 1.
The vertical disruptors disrupt by redefining the problem space within the industry on their terms and then designing great software to solve the problem. Cross-reference here, Whoosh going after “golf operations.” That wasn’t a thing. They created it in order to crack the industry who probably wasn’t ready for a full displacement of club management systems.
Ability to go Up-Market
When it is possible to enter and penetrate SMBs, the disruptors never lose focus on being an an industry platform that can serve all segments. The challenge of going up-market is real, but I think vertical SaaS platforms have an advantage over horizontal disruptive startups whom face the same issue. While the problem set grows in complexity as you work with more complex industry businesses, the core remains unchanged. Typically, I think the danger is not defining this in the company’s values early enough and prematurely limiting the company’s reach into far more lucrative deals.
Winning Incumbent’s Customers
In some ways, this should be obvious. If you are disruptive, eventually you should be able to win direct conflicts with the legacy players.
I don’t have this incredibly well thought out yet, but one of the signs that I think a vertical entrant will be able to do this effectively is by identifying how industry consultants market their work around technology implementation.
I don't know whether it's totally a lagging or leading indicator of industry transformation, but the best disruptors eventually develop huge advocates amongst consultants. In fact, they become the favorite.5 One interesting tracker of how disruptive a vSaaS solution can be is to watch how quickly an implementation ecosystem starts to develop around it.
Integrations as a First Principle
Parker’s right. The product is the integration. And so, the most disruptive vSaaS companies will spend a lot of time ensuring that their own workflows integrate cohesively and a lot more time ensuring their APIs are robust and coherent for other sources of data to integrate with. When this is done well, data flows into the platform, developers can build features and products on top, and your solution becomes the source of truth for all industry data that affects your customers.
There is a key difference in how sustaining vs. disrupting technologies think about integrations.
I think sustaining vSaaS technologies focus heavily on ensuring their data can integrate into other software or that they can integrate with every possible point solution a customer wants, disruptive vSaaS companies tend to focus on ensuring they can bring external data on platform while choosing select solutions to integrate into.
When entrants integrate, it must be strategic. Until the platform vision is realized, integrations are usually a conscious tradeoff around where the product is at in development or part of a GTM strategy.
Importantly, great APIs and a coherent integration strategy create strength in the company’s longterm ability to take advantage of future disruptors.
For instance, imagine that there is some advance in ML/AI that really does impact your industry. It becomes table stakes for companies to start thinking about how to leverage these AI insights. Customers want it, but also ML/AI platforms need the right data sources in order to generate models and insights. If you have developed a platform with all the data, you end up becoming necessary for both your customers and the ML/AI platforms. So, vSaaS platforms with great APIs and infrastructure function more as partners for the next phase of disruptors than direct competition.
If it makes more sense for these disruptors to take advantage of and leverage data on platform, vSaaS companies end up accruing the benefits of future disruptive technology rather than getting wiped out. There’s always disruption risk, but I’m bullish on the ability of vSaaS to take advantage of it instead.
Ecosystem Player
When you do all of this extremely well, then you finally get to move into perhaps the most interesting aspect of the product lifecycle. And that is in ensuring your platform isn’t solely viewed as valuable by your immediate customers but by enabling more seamless shared workflows between different aspects of the industry. But more on vertical ecosystems here.
Digital Transformation
When vSaaS companies display some or all of these hallmarks, not only can you predict a successful vSaaS startup, but you will get digital transformation throughout their entire industry.
I’m confident that this sort of digital transformation is what lies ahead as startups begin to develop compound startups, non-obvious workflows, and a platform vision.
At first, it may not look disruptive, but over time it will be highly evident. And customers will vote with greater wallet share to have industry platforms service every aspect of their business needs.
Next Up
Next week is one I am really excited about: a legal SaaS duel. It’s an industry I have thought a decent amount about in the past but I was really surprised to discover the extent of the warfare in 2022.
It’s a fun one to analyze because it involves two different approaches to building a platform, each starting with different workflows.
Rippling rolled out spend management with the fundamental insight that if you create an employee graph, you can also associate job function, seniority, and more with rules around spend to create a far more streamlined administrative experience.
To look at last week, Whoosh is building “the golfer graph” which allows them to create coherence for operations throughout the entire club. And it’s why they will eat the legacy solutions lunch.
There is a potential incentive misalignment issue here. If your implementation is far easier and thus less lucrative for a consultant shop, maybe you end up with problems, but I think in the majority of cases, consultants do gravitate towards the solution that ultimately accrues significant benefit for their clients.
For a fun example of where this isn’t true, I am closely watching the Recharge vs. Skio war for ecommerce subscriptions. Anecdotally, agencies don’t love Skio, while DTC companies do. The reason? It’s way easier to implement for smaller ecomm companies. It’s pretty much the secret to Skio’s disruption thus far. But as they get into more complex companies and probably need agencies to implement, I am extremely eager to see how they correct the agency incentive alignment issue.