The Coase Line
A framework for thinking about API-first businesses and their emerging opportunities.
If markets are truly efficient, why do individual companies exist? Why not just contract out every single function of your organization?
This was R.H. Coase’s provocative question in “The Nature of the Firm” — in which he essentially asked: why do individual companies even exist? Ultimately, Coase found that firms exist because doing most tasks in-house was cheaper and had less friction than contracting out for every single job that needed to be done.
Imagine having to write a new contract for every single deck that you needed made vs. just paying a first-year college graduate a salary to make unlimited decks for you. The transaction costs of the former are almost prohibitive and are more expensive relative to in-housing that functionality.
This suggests that there’s something like a “Coase Line”, where, any task that needs to be done with a transaction cost higher than the Coase Line should be in-sourced, and anything that costs less than the Coase Line should be out-sourced where possible.
SaaS businesses were the first inning in a broad trend that has pushed more and more company functions below the Coase Line. By leveraging the internet and instantaneous software deployment, the costs of performing tasks that companies were once forced to do in-house (e.g. HR software, on-prem server hosting, Excel-based CRMs) have dropped so much that it has become feasible to outsource some of these tasks.
And where are companies outsourcing these formerly in-sourced jobs to? Salesforce, Workday, Oracle, Amazon, Google, Loom, and others. This means that opportunity lies in current company functions that are mostly in-sourced, which could be made cheaper with internet-enabled software to justify outsourcing them. This is a boon for SaaS startups who are still attacking the myriad functions that have yet to be simplified.
And so, more and more company functions are being outsourced, meaning that firms are increasingly being focused around core creative work, with fewer individuals specifically, but with more individuals enabled to begin enterprises of their own more broadly.
The API-First Opportunity
However, this was just the first inning; API-first organizations go even further, pushing transaction costs and frictions to near $0, as software interacting with software requires minimal human intervention.
API-first companies improve on “traditional” (i.e., uses a user-facing GUI) SaaS companies because API-first businesses can add levels of automation and integration with other providers in ways that some SaaS companies are limited in doing. By being able to apply *leverage* on your outsourced software, the firm becomes further reduced to pure creative work.
In the financial technology space, this has been readily apparent with the functionality offered by the likes of Synapse, Plaid, Dwolla, Trulioo, and others. Whereas before, the transaction costs of integrating with individual banks were extremely high — think of Mint and how it built out its own integrations — API-first businesses like Plaid have brought that cost down such that emerging fintech players in the consumer space have ultimately outsourced that functionality.
API-first businesses enable sectors to become more generative and dynamic overall, as more players are able to leverage the software x software transaction cost reduction and experiment at the margin.
Finding the Coase Line
Finding the Coase Line is key to understanding the market opportunity of an API-first business. As we explore a range of sectors, we’re especially keen on those that have large manual processes in both internal and external workflows. It’s important to look at what companies in a specific sector outsource and what they insource because it allows you to answer:
- What are the sensitive functions that the company is keen on in-sourcing and “getting right”?
- What do companies deem reasonable to outsource because they trust the counterparty?
- What is the ratio of the cost of in-sourced core functions to out-sourced functions? In effect, what’s their cost threshold? (This is their Coase Line)
By answering these questions we can begin to uncover where new company opportunities can be found, and this orienting thesis — by sector — allows us to seek out early-stage companies and founders who map on to these opportunities. For where there are multiple Excel spreadsheet-based trackers and email chains, there is an API-first company waiting to be built.
Tradeoffs
However, outsourcing comes with associated tradeoffs; decentralization is not an inherent virtue. Interfacing with API-first organizations comes with questions about privacy and identity management, liability considerations, and a whole host of other concerns.
For API providers the product roadmap and go-to-market should be centered around the most narrow user pain point at the lowest level of abstraction possible. From there, providers can expand to cover more and more use cases within their scope of solutions.
For businesses leveraging APIs, it’s important to find your firm’s individual Coase Line, and be prescriptive around what areas are central to your business and could hurt your operating leverage, brand, or earnings potential by taking the convenient route of interfacing with an API. Sometimes doing the work and owning the functionality is more defensible to your business in the long run.
Towards an API-First World
This framework and thesis have been useful to us at mutable, and we look forward to meeting and partnering with founders, product teams, and investors working in the space.
As we press on towards an API-first world, we will keep an eye on crypto-based solutions as well; common sources of truth, interledger connectivity, and smart contracts that can execute above these API-ified business functions hint at a future of work that is more inclusive for more people of all walks of life, irrespective of locale, creed, or demographic; allowing us to automate away the “bullshit jobs” and focus on the core creative work that fulfills and enables us all.
