Xero – Network Effects?
I have previously blogged about Xero, with an objective to structure my random thoughts about the Xero’s prospects and therefore its potential valuation. Along the same objective, this is my analysis of network effects that could affect Xero and the market for online accounting solutions. For an explanation of the network effect and two-sided markets, please see my network effects blog entry.
When considering the users of Xero, I think we can break them into three distinct user groups: SMEs; Financial advisors; and Third-Party Applications.
First it is worth considering Xero as a product with a single set of users: SMEs. In this case there are some small network effects. As the number of SME customers increase, it becomes easier to employ someone to do the book-keeping who understands the product. This makes the product more valuable to the business. We experienced this a number of years ago when we selected Moneyworks over MYOB as our accounting package. In hindsight we realised that if we had chosen MYOB, it would have been reasonably easy to find a student through Student-Job-Search to do some of our book-keeping. However, since Moneyworks is less widely adopted, it is difficult to find someone proficient in the software. This same small network effect will apply to Xero, both working against it while it is small and for it if it succeeds in becoming popular.
Now consider Xero as a product with two groups of users: SMEs and Financial-Advisors. In this case there is an element of a two-sided market. Each group of user has quite different requirements. The SMEs need a day-to-day accounting package that will give them a snapshot of their financial position and performance, track their debtors, etc… The Financial-Advisors need a package that will allow them to easily receive a coded ledger from their clients for processing GST or end-of-year. I think there are elements here of a two-sided market since the value of the network increases as the number of members of the other group increases. This is something that we experienced with our previous choice of Moneyworks as an accounting system. We discovered that there were a number of chartered accountants who work seamlessly with MYOB, though we didn’t find the same with Moneyworks. Therefore we could have gained greater benefit from using the more popular MYOB over Moneyworks. This network effect, though only small, will benefit Xero as its user-base and financial-advisor base grows.
Finally, consider Xero as a product with three groups of users: SMEs, Financial Advisors, and Third-Party applications. In this case Xero becomes more than a stand-alone product; it becomes an accounting platform. That is, imagine Xero as the general-ledger platform for the cloud. Integrated into this platform are third-party SaaS applications as well as desktop applications. Xero becomes an ecosystem of customers, financial advisors, and complementary third-party applications integrating all functions of a small business. If this is achievable then I believe there is the potential for significant network effects. The value of Xero to end-users increases as the number of applications increase that use Xero as their general-ledger. On the flip-side, as the number of end-users increases, the value of Xero as a platform increases to application developers.
Xero already has a basic REST based API for third-party applications. There are already a few third-party applications that integrate with Xero, which are predominantly new SaaS and web products: iPayroll and Flexitime for company payroll calculations; WorkflowMax and ProWorkflow for job and project management; WebWidgets for integration with an online shopping cart; and Acclipse for accountants. These are compelling examples of how applications can be integrated with Xero. There are many more compelling and existing applications that could potentially integrate with Xero, such as existing point-of-sale, inventory-control, procurement, and credit-management systems.
Even though this may seem to be a fantastic opportunity for Xero, this network effect is just a property of the online accounting market. Since any competitor could leverage this network effect, it is a potential opportunity as well as threat to Xero.
To summarise, I believe there are potential network effects that Xero could take advantage of. There are some standard network effects that all of the accounting products, such as MYOB, Moneyworks, and Xero currently enjoy: as their respective products become more popular the software becomes more valuable since it becomes easier for SMEs to find people who understand the software. Xero has another potential network effect that it can leverage, and in my opinion this one could be far more valuable. That is, by providing a network API and allowing third-party applications to integrate with Xero across the Internet, Xero becomes more than a stand-alone product; Xero can be the platform that enables SMEs to integrate their stand-alone systems. If this is possible and achievable, then this network will be very valuable and will allow a premium to be charged over other me-too SaaS accounting products. So the potential network effects with Xero could have a significant impact on any valuation of the company.
Disclosure: I am a Xero shareholder and one of many delighted Xero customers!
