The Importance of Defensibility

In 1999, Salesforce launched what is now widely considered the first true software-as-a-service (SaaS) company. In the 25 years since then, SaaS has grown to become one of the dominant business models of tech, and for good reason. SaaS companies have a number of strong inherent advantages.

On the product side, it’s relatively cheap and easy to build and launch a SaaS MVP, onboard customers; and iterate towards product-market fit. On the customer side, SaaS is easy to deploy, and compatible with a number of different go-to-market motions: freemium, self-serve, product-led-growth, inside sales, enterprise sales and more. And finally, on the economic side, SaaS firms enjoy recurring revenue, low cost to service, and upfront payments.

But these advantages come at a cost. The very same growth attributes that make building and selling SaaS attractive in the short run, make SaaS companies vulnerable in the long run. The easier it is to build and scale a SaaS business, the easier it is for competitors to emerge and do the same. There are no strong barriers to entry in “vanilla” SaaS, beyond first-mover advantage and customer inertia. As a result, many mature SaaS companies tend to see their profit margins competed away: either through rising customer acquisition costs, or through price competition among vendors.

And while unprofitable hyper-growth might have satisfied a previous generation of investors, the venture ecosystem has changed. Today, growth alone is insufficient; the market demands sustainable, profitable, efficient growth. At Merak, we believe that the best way to deliver such “healthy” growth is through structurally defensible SaaS.

Specifically, our thesis is that SaaS companies with clear and sustainable sources of defensibility outside the core SaaS component, tend to win. Competitors cannot displace them merely by replicating their software; customers will not churn just for a better deal elsewhere. As a result, defensible SaaS companies have lower attrition rates, more pricing power, and lower acquisition costs: all of which result in dramatically better long-run, at-scale economics.

Where Does Defensibility Come From?

Where does structural defensibility come from? We’ve identified a few sources of defensibility in SaaS. A key to all of these is that they’re structural – they’re inherent to the business model or product usage, not merely bolted on as an afterthought. Also, they’re not mutually exclusive; indeed, the best companies often have 3 or 4 of these patterns in play.

1. System-of-record effect

Some SaaS solutions act as the “system of record” or “single source of truth” for critical enterprise information: sales & marketing data, or employee data, or engineering data. It’s usually very hard to migrate that data to a new vendor or platform, and so these solutions tend to be sticky.

2. Workflow integration

SaaS solutions that are tightly integrated into enterprise workflows are hard to disrupt, for multiple reasons: switching costs, user familiarity, organizational inertia, and risk aversion.

3. Surface area

Solutions with a large “surface area” – that is, solutions that are used by multiple users and roles across the enterprise, or solutions that bridge different functional areas, or solutions that do a lot of different things for the user, are hard to displace piecemeal.

4. True technological innovation

Most software solutions are easy to replicate, but some are not. Companies whose product involves genuine technical innovation gain defensibility from that innovation.

5. Non-software component

SaaS companies that incorporate a non-software component – hardware sensors, say, or physical logistics – are hard to replicate; there’s an associated cost, expertise, and barrier to entry for competitors.

6. Network effects: users, data, marketplace, ecosystem, standards

Network effects are well understood, albeit usually in the context of marketplace, social network, or platform businesses. But examples also exist in SaaS:

• Data learning loop: the SaaS gets smarter and better, with more users and data
• Users: customers benefit from the presence of other customers
• Marketplace / ecosystem: app store and integrations on top of the basic SaaS
• Standards: define a file format or protocol that everyone has to use (e.g. PDF)

Each of these network effects make it harder for customers to stop using the SaaS product. Note however that many of these only kick in at scale.

7. User experience

Some SaaS companies retain customers because they have a genuine edge in user experience or capability that competitors simply cannot replicate. Usually, this stems from deep domain expertise, which allows these companies to continually stay one step ahead of the competition. (Brand is often the channel through which this type of defensibility operates.)

Investing in Defensible Companies

How does one recognize defensibility? We use frameworks like the above to actively filter for SaaS companies that exhibit one or more sources of defensibility. We also expect true defensibility to show up in the metrics: net revenue retention, for example, is a strong proxy.

Ultimately, we believe that the best defensibility comes from investing in exceptional founders. Merak typically invests at the pre-seed, early revenue stage. At that stage, every aspect of the company, from product to market to distribution, is fluid and evolving – but exceptional founders find a way to build sustainable, healthy, defensible businesses. Our guidelines on defensible SaaS are not just a set of filter criteria; they are also a vision exercise and execution template for what a particular startup could become, under the right leadership.

So, if you’re a founder building a new SaaS venture, start thinking about defensibility now! Explicitly architect your product, solution and positioning so that defensibility is foundational to it, not just a late add-on. And if your SaaS business has strong conceptual as well as measurable evidence of defensibility, we’d love to hear from you. The next generation of SaaS startups is going to be amazing!