Xero – A Disruptive Innovation?

I have been considering Xero, a provider of online accounting software, and whether this is a disruptive innovation for the SME accounting software market. Please see my overview of Clayton Christiansen’s book An Innovator’s Dilemma for a distinction between a disruptive and sustaining innovation and why disruptive innovations can significantly alter the market structure.

The SME accounting market to date has been desktop-computer installed software, with the major competitors being MYOB (NZ and Australia), Sage (UK), and Intuit (USA). Each of these companies offers small companies a choice between basic cash-book software, single-user double-entry systems, and higher-priced client/server multi-user systems. Xero is a radically different offering, since instead of installed desktop software it is a SaaS (Software as a Service) accounting solution. A SaaS solution offers customers benefits that are not possible with installed software: frequent and automatic software upgrades; accessibility from any machine running any OS; offsite backup at all times; distributed multi-user with unlimited users located anywhere with an Internet connection; and a monthly fee instead of an upfront capital expense. Xero has further leveraged these SaaS advantages and have provided some innovative features such as:

  • Seamless integration with your bank for automatic bank reconciliation.
  • Various user roles, including special access for your accountant to log directly into your live accounts.
  • Seamless integration with other third party web services through the Xero network, such as Payroll, Project-Management, or Time-tracking.
  • A cut-down interface to access your accounts from an iPhone or Windows-CE device!

So Xero is definitely a discontinuous and radical break from the existing desktop accounting software. It would be intuitive to assume that Xero is a disruptive innovation. However, as defined in An Innovator’s Dilemma, the distinction between a disruptive innovation and a sustaining innovation is not based on the actual technology but on how the market values the improvement. If the improvement is in the dimension that the main market already values, then it is a sustaining innovation. If the improvement is actually a degradation in performance in the dimension that the main market values, though has other benefits that a fringe or new customer’s value, then it is a potential disruptive innovation. To evaluate whether Xero is a disruptive innovation we need to consider the SME accounting market and what the dimensions of product performance are.

In my opinion, the must-have small-business requirements are invoicing, compliance with GST/VAT and end-of-year filing, and the ability to produce standard management reports. The various SME accounting offerings then compete in the dimensions of ease of use, feature set, and reliability. These are the dimensions that the main market values.

Xero is a product that improves ease-of-use, provides innovative new features, and increases reliability. Xero provides integrated and automatic bank reconciliation which greatly increases ease of use. It provides enhanced features such as iPhone interfaces, and improves reliability for the customer with its automatic upgrades and offsite backup. Therefore Xero is improving SME accounting along the dimensions valued by the main market customers.

In the customer acquisition data provided by Xero recently it was interesting to note that nearly 50% of customers were not previously using an accounting system – instead either no-system, a spreadsheet, or just pen-and-paper. This could indicate that Xero is providing a product to an under-served market that values the new features of a SaaS product. In my opinion Xero is a high-margin product that provides enough standard functionality to cater to the main market, and provides benefits that are in the dimensions that the main market values. Therefore I conclude that Xero is a sustaining innovation.

With sustaining innovations, Clayton Christiansen has found that the leading and dominant firms recognise the value of the technology, invest in it, and are able to master and lead with the new technology. This would lead to a prediction that Xero will face significant competition in the near future from the existing incumbents such as MYOB, Sage, or Intuit. In trying to predict what this means for Xero, I think there are a number of other factors to consider: first-mover advantage; network externalities (Metcalf’s law); and switching costs. I think some of these could be significant factors for Xero, though better addressed in separate blog entries!

Disclosure: I am a Xero shareholder and one of many delighted Xero customers!

13 thoughts on “Xero – A Disruptive Innovation?”

  1. Thanks Rod, I am very excited about Xero’s potential. Over the coming weeks I plan to do some further analysis as I structure my thoughts about Xero’s opportunities and threats.

    Cheers,
    Kelvin.

    [Reply]

  2. Kelvin

    I think you are absolutely correct to conclude that Xero is a “sustaining” rather than “disruptive” innovation. But I came to that conclusion for slightly different reasons to you. However, I am not as excited as you by Xero’s potential. I think it faces some very real challenges.

    Xero is one of many new SaaS accounting products that have appeared in the past 2-3 years. While it appears to be the leading New Zealand-based SaaS accounting provider there are many similar companies around the globe. In the UK market alone there are at least 15 SaaS accounting or cashbook products that Xero is directly competing with plus the existing desktop players Sage and Quickbooks.

    Some of these companies like the Dutch company Twinfield have been around for much longer and have many more customers than Xero.

    Being a disruptive innovation surely implies being first to market or at least being the one company that changes the market place? Because there are now so many SaaS players it will be difficult for any one company like Xero to be defined as “disruptive” unless it gets to clearly dominate and lead the market or develops some product features that are truly revolutionary.

    Xero certainly wasn’t first to market in the SaaS accounting arena. Even a traditional provider like Intuit had Quickbooks Online on the market before Xero existed. So Xero could not be considered to be disruptive by being first to market.

    Based on Xero’s recently released customer numbers it is still a very long way from its hoped for market domination – even in the New Zealand market. There is about 600,000 SMEs in New Zealand and countless millions around the world. Xero has attracted perhaps 3,000 SMEs in New Zealand plus another 1,000 or so in the UK. These small numbers rule it out from being disruptive on that criteria.

    From a product development point of view Xero is a well-designed and featured product. But the majority of its features (and resulting benefits) are shared in common with other SaaS products. Perhaps the one area where Xero is different to most other SaaS products is its ability to pull in bank data – but the non-SaaS product BankLink, which is very widely used by accountants and small businesses in New Zealand and Australia has been doing that since the 1980s. Again Xero misses out on the third of my criteria for disruptive technology.

    I know this is a slightly different way of approaching “disruptive technology” to Christiansen’s method that you have used but I think it is a valid way of assessing disruption.

    In the SaaS market the true disrupter may be a company like Ubikwiti (www.ubikwiti.com) which is giving away for free what Xero is trying to charge for.

    You note that Xero will face significant competition in the near future. I think it already faces significant competition – not just from these other SaaS companies but also from the traditional desktop companies such as MYOB, Sage and Intuit who have also launched SaaS products.

    There is already downward pressure on price in this market. Xero’s float document was based on a monthly fee of $75. It is now charging $49 per month for its Standard Edition customers and much less for its Accountants Edition customers. UK pricing has also been dropped. Similarly, pricing for Quickbooks Online has been slashed recently. Companies like Ubikiwiti will place even more pressure on Xero.

    The problem with a business model where there are few barriers to entry and where new customers can be added on at relatively little cost is that there is continual downward pressure on pricing from competitors who are desparate to get customers.

    Despite being a company with talented people and a well designed product, Xero has a real battle on its hands to ensure it is not just another company with a “me too” product struggling to make money. It will be very interesting to see its financial results for the year to 31 March and see how much revenue it is earning compared to its expenses. Based on the customer numbers Xero has released my guess is it will still be burning cash at a very quick rate.

    Kelvin, I note you are are going to carry out some further analysis of Xero in the coming weeks. I will be very interested to see the results of your research.

    [Reply]

  3. Wonder if iXero/MyXero is coming down the track? (Xero for personal finance)

    Probably best for them to stick with SMB for the mean time, but something I would definitely use…(although its not something that I would pay much for, maybe its something that they could sell to banks as a value-add for the banks customers)

    I think Xeros’ potential is going to come to light on the 1st of April when they are next ‘due’ to report progress. I believe that their latest announcement re:customer numbers is only going to be the tip of the iceberg

    [Reply]

  4. Hi Vince,

    Thanks for the insightful and informative comment. I agree, there is already significant competition from other similar start-up companies, some of which are offering similar services and some of which are free. You bring up a good point too about the pricing of these products and how there is already pricing pressure occurring. However the online offerings offered by MYOB and Sage currently seem to be a poor comparison to Xero, though being a sustaining innovation I imagine that Xero will be faced with far more competition going forward.

    I do see some competitive advantages that Xero can benefit from, and despite the significant competition this will be an extremely fast-growing market; a fast growing market usually results in less direct competition. I suspect there will be enough varying requirements and potential product differentiation for a number of the online accounting products to have a place in the market. Also, the resources that Xero have will give it competitive strength against the 1 or 2-man bands that make up the majority of the competitors, so I’m more concerned about MYOB, Sage, and Intuit than some of the offerings. I’ll need to think through and structure my ideas a bit more before I articulate them, and I’ll post these to the blog in the next few weeks.

    Thanks again for your thought-provoking comment.

    Cheers,
    Kelvin.

    [Reply]

  5. Hi Rodger,

    Interesting thoughts. I currently use Xero for my personal finances since they offer a $10 a month option for a non-GST registered entity, as long as you’re an existing customer. It is a bit of overkill though since I’m not doing accrual accounting for my personal finances.

    In my opinion, I think the personal finances market is quite different to the SME market. As you point out, the personal finances market is very price-sensitive, though people don’t require much functionality. The SME market is less price-sensitive and are often time-poor, but have very specific requirements. For example tax compliance is important such as GST and provisional tax calculations. They also rely heavily on their financial advisor for recommendations. So I think they are quite different markets.

    There are already a number of companies offering services for personal finance. For example, have a look at Mint. I personally would prefer to see Xero maintain their focus on the SME market for the moment.

    Yes, will be interesting to see their conversion rate at the 31 March 2009 cross-over point.

    Cheers,
    Kelvin.

    [Reply]

  6. Kelvin – awesome post – I follow Xero and the other SaaS accounting apps pretty closely and it’s great to have your take on these things. Despite being very postive about the Xero product and it’s market potential, I’d have to say you’re a little misguided in your assesment that Xero is up against primarily one or two man bands. Twinfield has already been mentioned here, as has Ubikwitii which is a multi decade veteran of this sort of stuff and has a model which is really interesting. There’s a bunch of others – FreshBooks (nvoicing, not accounting but still worth following) has a similar size team to Xero. The incumbents are trying (thus far unsuccessfully but dont write them off).

    The more interesting question is whether or not the land grab is causing a flight towards zero – where downwards price pressure will see vendors cut subscription rates in an ever descending spiral…

    [Reply]

  7. Thanks for the comment Ben. Yes, I agree, I might have been misguided in my assessment of some of the non-incumbent competitors. As you point out, there are a number of other online accounting companies of a similar size to Xero. There are also other SaaS competitors that could move into the SME accounting space. The next 3 – 5 years are going to be quite interesting as this plays out!

    Concerning the land-grab and product pricing, I’m not sure I agree that there will be flight towards zero. I think sufficient potential differentiation exists, especially geographical, to avoid the commoditisation of functionality. However, I think there could well be an argument for multiple versions of the product, with some of the commodity functionality being provided in a ‘lite’ version at little or no cost. The differentiated functionality can then be available in the complete version at the regular price.

    [Reply]

  8. Hey Kelvin,

    furthering the Xero chat we started in Waiheke, I think the major risk for Xero is simply the reality of running out of cash. I think Xero is a great product, and I am sure there is a ready market for it. However, I think reaching and selling to that market will take more resources than Xero currently has. It will not be a simple sell, and I think its too soon in the game for network and other effects to have a significant impact.

    I’d love to see Xero do well. Im not sure the other SaaS competitors are Xeros significant problem, I think it is simply a cashflow issue. I expect Xero in some form will go back to the market for cash, but it will be a hard sell in this climate.

    Disclosure: I also own Xero shares and am a enthusiastic user!

    [Reply]

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  10. Hi,

    I agree with you completely on XERO and have no second opinion. You might also want to check out another online accounting framework ‘COAST’ being used by a few accounting firms in UK and Ireland. This framework helps the user create his contract/placement, timesheets, invoices and interfaces with almost any payroll and accounting software in the world. I sincerely feel that COAST clubbed with XERO will be a deadly combination. I wish XERO a complete success in its quest.

    [Reply]

  11. I am not sure the comparison to Quickbooks is correct…or fair. Quickbooks also has an SaaS solution which I implemented for my brother’s company several years ago. He has been extremely pleased with it and has run it himself very successfully for his business. The pricing is comparable to Xero last time I checked.

    [Reply]

    Kelvin Hartnall Reply:

    I’ve just signed up for a free Quickbooks online account. I agree that it is feature-rich and it will be one of the incumbent solutions to watch as the online accounting market grows. In my opinion, I think Xero is a nicer and better solution, which may be due to it being a startup with no desktop legacy. Does anyone have any numbers as to how many paying customers have signed up for Quickbooks online?

    [Reply]

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