The best-in-class

Chichén Itzá, Yucatán MX

Today I’m laying out my first-ever investing framework, and would love to hear your feedback or thoughts. It’s a lightweight, heuristic approach that works particularly well for B2B software. Here it is: standalone, best-in-class products are a delight and a reliable starting point for a profitable investment. Let me explain:

In the universe of technology companies, you can find a real bounty of business models, not to mention products that are inherently complicated or highly subject-matter specific. Think, for instance, about Zapier. You have to have some familiarity with APIs at a minimum, and preferably an informed perspective on product integrations and use cases. Who is the customer? Who builds the integrations? Sure, the thought exercise would have been worth getting into Zapier several years ago – this is, after all, just one evaluation framework – but you can see that the upfront contextual work takes some effort, and not everything needs to be hard from the get-go.

Now, think about Slack. I’m using an example almost everybody is familiar with, and it’s a shining example of my ideal “standalone best-in-class” company. With Slack, the product is simple: it’s a messenger application. The business model? Simple: B2B SaaS, mostly self-service (in the early years, at least). And most critically, how important is the need it serves? Workplace communication tools might not have the gravitas of e.g. cybersecurity, but they are mission critical, and almost any company needs them. This also makes the product sticky, since it requires some implementation and buy-in from the team. And finally, Slack has a massive addressable market that they can eventually monetise in other ways. What I’ve laid out is basically the quick check I would run on this type of company. If it passes the initial test, you can go deeper and start to form conviction around the market and strategy, the product, and the founder(s).

Four principles

(1) Sell something real and valuable.

How critical is the need? This is why business applications fit into this theme so well – businesses have all kinds of critical needs, and that makes them reliable customers. This criterion inevitably ties to product/market fit (PMF), but I don’t think it precludes investing pre-PMF. It’s more of a gauge on the complexity of the solution, with a bias towards products with straightforward, delightful solutions.

Square and Shopify fit this thread nicely, since a business literally can’t exist without a way to accept money. Delivering a critical need simplifies product development to some extent, because you’re no longer asking “how do I make this product valuable enough to keep paying for?” Instead, you’re solving for “why should I keep paying for this product versus a competitor?” As long as the product has a sufficiently large TAM, you have the possibility of a viable business. 

What makes this principle difficult is that most valuable services or products are already being sold. The hard work of entrepreneurship, then, is finding technological or societal inflection points with the potential to create new categories. For example: Kavak is a marketplace for buying used cars in Latin America. It was founded in 2016, and you could easily point to Beepi’s demise just a year later as a bad omen for the whole concept. But while Beepi has been described as “good idea, bad execution”, Kavak caught onto a couple critical needs in the LatAm market: the need for credit (not widely available), and a need for protection against fraud. Kavak’s approach created unique value and set them up for success. And it’s a great example of a best-in-class company that fits into B2C and marketplace (as opposed to B2B SaaS, where I usually apply this framework).

(2) Integrate into the tech stack if possible

I’m looking for “stickiness” to drive better retention and strong utilisation of the product (i.e. engagement). This can go at least a couple ways: 

  • Products built into the codebase (e.g. via SDK/API), serving a critical function within your tech stack. Stripe and Twilio are good examples
  • Products that serve as a node for information, aggregating many sources of data. I put companies like Slack, Snowflake, and Airtable in this category

In either case, the products obviously have to be high quality and responsive to customer needs – otherwise engagement won’t follow. I’ll also note that not every product fits neatly into this criterion. Loom is a great example – the product is useful enough to stand on its own, and much of their success has come without penetrating the tech stack in a meaningful way. But as an early winner, Loom must now build some moat – and indeed, they have loomSDK in a public Beta as of this writing.

(3) Short sales cycles

The standalone best-in-class concept has a bias towards simplicity, so I lean towards products that can accommodate a short sales cycle or have a self-serve channel. This is probably the least important principle, because plenty of companies with a longer sales cycle have phenomenal businesses, and otherwise fit my principles neatly. Snowflake, for example, is enterprise software and has a salesforce to match, but otherwise makes a great best-in-class business.

This principle tries to get at something deeper: flexibility. How much of a chore is it to deploy this product? In my mind, Palantir is the antithesis of this principle – that’s why it’s often described as a “consulting” business. It requires teams of engineers and highly-contextual solutions, and that’s tough to scale.

So, the best-in-class skews towards simplicity. Think about deploying Carta, for example – it’s a standalone product fulfilling a critical function (equity management), but it plays nice with your accounting software. And I don’t want to get ahead of myself here, but while you’re in Carta you can also ask them to do a 409a valuation, a requirement for private companies to issue stock-based compensation. That leads me to the final principle… 

(4) Expand your use cases and LTV

The best-in-class establishes a “beachhead” from which a more diversified business can be built. I’ve used the term standalone many times in this post, but we ideally want to have several avenues for longer-term growth. So unless the standalone product has a massive core market, ancillary businesses are a critical lever over time. This can be boiled down to one of the simplest business concepts: horizontal vs. vertical expansion. Unless you’re in a declining or sleepy market, you probably aren’t buying competitors to build out a business (horizontal expansion). Instead, companies can go after LTV (lifetime value) expansion by offering complementary products or services (vertical expansion). 

This principle is critical well before a company reaches scale with their core product, because once growth plateaus it’s a tough exercise to bend the curve upward again. I saw this tension firsthand at Dropbox, which has struggled to gain traction outside of the core file sync and share functionality. Dropbox checks every box on the best-in-class framework except LTV, and while their HelloSign acquisition was a promising step in the right direction, it hasn’t answered all the questions around their growth story.

Another amazing best-in-class company I see facing this problem is Zendesk. Having built a renowned customer service platform, they’re now working on a sales-focused CRM – basically going after a slice of the market Salesforce created and dominates. This is a bold approach, and if any company is set up for success, I do think Zendesk could be the one. The TAM is massive and they have the credibility to win customers – my sense is that we’ll start to see early signals in their 2021 sales results.

It’s about the business model

The best-in-class is a broad framework, and I laid out a reasonable variety of examples here. Crucially, it seeks to avoid convoluted businesses that don’t solve for a clear problem – it evaluates the business model and the problem-market fit. Importantly though, it doesn’t correct for an inadequate management team, the most important factor for most investors.

A bigger challenge emerges when we apply this framework to early stage products, because the best startups tend to create something new and unexpected, without a clear precedent. Especially pre-traction, this could be tricky. Taking all of this context into account, I’ll share a deeper analysis of some best-in-class companies in a future post. Thanks for reading!