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How SaaS Companies Can Compete Under Commoditization

“Well, in our country,” said Alice, still panting a little, “you’d generally get to somewhere else – if you run very fast for a long time, as we’ve been doing.”

“A slow sort of country!” said the Queen. “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”

– Lewis Carroll, Through the Looking-Glass and What Alice Found There

Alice and the queenOne of the main challenges facing the leaders of B2B SaaS companies is accelerating commoditization. This is not a bad thing. Commoditization is a sign of success, at least for the industry overall, but it represents a change in phase state for software entrepreneurs.

What is a commodity? Basically, a commodity is a successful category – one in which the buyers and sellers have a clear understanding of the value propositions, there is a standard product definition, and the different offers can easily substitute for each other. That doesn’t mean there is no longer any innovation. In a commoditized market innovation can be intense, but it takes the form of a Red Queen Game. Innovation is continuous, quickly copied and what one company does the others soon meet. Innovation erodes profit rather than increasing it. Value chains become more efficient, there is often less profit to share, and what profit there is, generally flows to the part of the value chain in direct contact with the end user. Differentiation disappears.

Why is commodification accelerating?

There are three main reasons.

1. Innovation is better understood than ever before.

Everything from Steve Blank and Lean Innovation to Clayton Christensen and Jobs to Be Done to Tom Nagle and Value-Based Pricing has helped us understand how to build products and get them to market. Venture Capitalists have picked up on this and whenever they see success they help to flood the market with ‘me to’ companies. Buyers are also more sophisticated and read the same blogs as the investors and innovators. To some extent, differentiation depends on information asymmetry and information asymmetries get driven out of markets quickly these days.

2. Everyone is using the same building blocks.

How many applications are being built on Ruby on Rails and hosted in the Amazon cloud? (I could not find the answer but a search found 1.6 million results of which the first five pages were all telling me how to do this.) Is there a big difference between apps in Microsoft Azure and Amazon? (Not that anyone from Microsoft can explain to me.) Once upon a time, JS was a hand tool. There are now many JS frameworks giving us polished and repeatable user experiences. This is all good. It makes innovation faster and easier. And it leads to rapid commoditization.

3. Artificial Intelligence is driving commoditization.

A decade ago, modern AI was a mystery understood at a small number of places like Geoffrey Hinton’s University of Toronto Lab. Five years ago, startups were piling in and finding all sorts of interesting ways to use AI to get a competitive edge. Today AI is everywhere. There are great open source tools (such as TensorFlow) and all of the IaaS (Infrastructure as a Service) companies offer AI as a service. AI is helping us understand our customers, optimize our systems, segment our markets and build all sorts of functionality. It is not a differentiator. It is table stakes.

The fall back advice from pricing experts is to find differentiation and that even in highly commoditized markets smart companies will find ways to differentiate. I give that advice a lot myself. But let’s face it, differentiation is not always possible, and as we saw above, commoditization is a sign of success.

So what do you do when your application becomes commoditized?

There are three basic strategic choices: build a brand, rely on regulation, become an OEM vendor.

1. Build your brand.

Consumer products companies have dealt with differentiation for a long time. Does anyone really think there is a difference between laundry detergents? Could you reliably tell the difference between Coca Cola and Pepsi Cola? Yet Proctor & Gamble had a market cap at time of writing of US$87 billion and Coca Cola of US$46 billion. These are massively successful companies because they know how to build brands. B2B SaaS companies are spending more and more on brand and customer loyalty as they mature. (What did you think those dressed up user conferences were about?) Brand building will be one of the core skill sets B2B SaaS companies build as their markets commoditize.

2. Rely on regulation.

The second path to success under commoditization is regulation (and its close cousin, technical standards). Generally speaking, regulation is used to make competition more predictable and to slow the pace of the Red Queen game so that more cash flow can be siphoned off into profit. Companies in maturing industries will develop and impose more and more complex technical standards. (How many technical standards get simpler over time?) Look at the people involved in standards committees and you will find that they come from areas that are commoditizing. B2B SaaS companies in commoditizing markets will spend more time and money lobbying governments and refining standards.

3. Become the OEM provider of choice.

Many commoditized applications are used to build other applications. Think databases. How many applications today use a relational database? How many of those databases come from Oracle? Oracle is no longer a straight database company; through a string of acquisitions it has become one of the dominant business software vendors, but that success is built on the top of databases. Expect the same thing to happen in many other software sectors, from digital asset management (DAM) to customer relationship management (CRM), differentiation will shift to new applications built on the base of the commoditized functionality. In many cases, it will be a new company building the new value on top of an OEM solution. Providing a stable, predictable inexpensive set of basic functions to as many different segments as possible can be a winning strategy. This is the strategy Microsoft has been using to slowly erode Oracle’s market position. At the same time, open source options are slowly gaining more and more market share.

An alternative strategy is to use a commoditized solution to disrupt another market by constructing a two-sided market. This is what Zenefits did in HR software as we noted back in 2015. The basic play is straightforward, but difficult to execute.

  1. Choose a commoditized class of software that gathers data relevant to other business functions.
  2. Use that data to create value for the other business function while offering the commoditized software for free in exchange for access to the data.
  3. Monetize the data.

Zenefits did this by providing free HR software in return for the opportunity to sell benefits packages. With all that AI power out there waiting to be harnessed, many other companies are looking at this business model in the learning, recruiting, digital asset management, customer data and other spaces. This will be one of the defining business models in a period of commoditization.

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