Cloudflare, AI, and the Innovator’s Dilemma
Cloudflare and the Innovator’s Dilemma
From Clayton Christensen’s Disruptive Innovation Theory:
Disruptive Innovation describes a process by which a product or service takes root in simple applications at the bottom of the market—typically by being less expensive and more accessible—and then relentlessly moves upmarket, eventually displacing established competitors.
That theory became the foundation of Christensen’s The Innovator’s Dilemma, the defining framework for how great companies are disrupted. And every so often, a company emerges that maps onto that model almost perfectly. Cloudflare is one of them.
When Cloudflare was founded in 2009, the internet’s leading CDN incumbent, Akamai, was optimized around the largest customers. Akamai was built around high-touch enterprise relationships and bespoke implementations. This enabled Akamai to charge premium prices to its customers, leading to high ACVs and LTVs in return for a high CAC, a model that made perfect sense for serving the largest websites in the world.
Cloudflare, by contrast, started with a freemium model, instant onboarding, and a product that any small developer or website owner could adopt in minutes, which allowed Cloudflare to win smaller customers like personal blogs and e-commerce sites. Fundamentally, Akamai was structurally disincentivized to pursue that part of the market. The lower ACVs from small customers meant that Akamai’s long sales cycle and bespoke implementation process could not return the high LTV a Fortune 500 customer could. Therefore, the customers Cloudflare went after were almost immaterial for Akamai. As a result, Akamai largely ignored Cloudflare as it built a massive user base.
And once Cloudflare established itself at the low end of the market, the rest of the story is familiar. Cloudflare layered on additional functionality, expanded into a broader platform, and steadily pushed upmarket. Because Cloudflare had already built a massive user base that loved the product, Cloudflare turned that adoption and credibility into larger enterprise contracts as its customers scaled alongside it.
It’s also worth noting that Cloudflare is a reminder that the software and internet markets have historically been unusually unforgiving because distribution is not a limiting factor, as it is with other industries. As a result, once a product becomes the default choice for developers or operators, it can move through the market far faster than incumbents expect.
Software, the Innovator’s Dilemma, and AI
From Gavin Baker on Invest Like the Best:
If you’re trying to preserve an 80% gross-margin structure, you are guaranteed not to succeed in AI.
SaaS companies are making the exact same mistake that brick-and-mortar retailers did with e-commerce. They clearly saw customer demand, but they didn’t like the margin structure. Now Amazon has higher margins -- margins can change.
SaaS companies have their 70-90% gross margins and are reluctant to accept AI gross margins -- a good AI company might have 40%.
In some ways, this is the same Innovator’s Dilemma Cloudflare exploited during its rise. As Baker argues, SaaS companies might be unwilling to accept the lower gross margin economics that AI agents require because these companies are too married to the high gross margins and exceptional unit economics of the software model, which in turn creates an opening for AI-native startups that are willing to operate with lower margins to disrupt incumbent software vendors.
Under Baker’s model, the most exposed companies are not weak companies; they are some of the strongest software businesses in the world. ServiceNow reported a non-GAAP subscription gross margin of 83.5%. Atlassian reported 87.5% non-GAAP gross margins for Q2 FY 2026. Both ServiceNow and Atlassian are great businesses on a gross margin basis. But that’s precisely the point Baker is making. Namely, the higher the quality of the legacy model, the greater the temptation to defend it rather than reinvent it.
And just like with Cloudflare back in the 2010s, software is a winner-take-most game due to the lack of distribution limitations. If a software solution can win credibility with users, it can move from niche to dominant far faster than in other industries. We are already seeing evidence that this transition can happen at an absurd pace. In November 2025, Sierra reported $100 million ARR only seven quarters after launch, one of the fastest growth trajectories in software history.
There is, however, an important distinction between the disruption that software is experiencing today and the CDN market Cloudflare disrupted in 2010. As Baker notes, there is already clear customer demand for AI agents. It is not as if agentic solutions from companies like Sierra only appeal to the low end of the market. In fact, Sierra’s customer base already includes Fortune 500 customers like CDW and SiriusXM.
However, while the margin-side mechanism of the Innovator’s Dilemma still applies, the demand-side mechanism is weaker. While Akamai’s core customers had little reason to care about the lower-end product Cloudflare initially offered, the customers of incumbent software companies like ServiceNow and Atlassian have clearly shown demand for AI solutions. Therefore, while the mechanisms of the Innovator’s Dilemma still apply to today’s incumbent software companies, as McKinsey notes in their article, The AI-centric imperative: Navigating the next software frontier:
For incumbent software companies, the imperative is clear: becoming AI-centric is no longer optional—it is essential to remain competitive. Those that can successfully adapt and thrive will help define the next era of software.
Cloudflare and AI
What makes Cloudflare so interesting, though, is that it may be one of the rare incumbent software companies for which this exact dilemma applies even less. For many software incumbents, AI is threatening because it may abstract away the interface, collapse seats, or reduce the importance of the legacy application layer. For Cloudflare, its value is derived not from seats but from internet activity. And AI is not removing activity from the internet; it’s adding more of it.
Cloudflare’s own recent data makes that clear. In its 2025 Radar year-in-review, Cloudflare reported that AI crawlers accounted for ~20% of verified bot traffic. In a separate analysis, Cloudflare said AI and search crawler traffic rose 18% from May 2024 to May 2025, with GPTBot traffic up 305% over that period. In other words, AI is only increasing internet activity, and Cloudflare is still the software securing it.
In that sense, Cloudflare is not a classic application incumbent defending a high-margin seat-based workflow against a smarter interface. It sits lower in the stack, in a position where it benefits as long as there is more internet activity, regardless of whether that activity is generated by humans or by AI agents and crawlers.
Just as importantly, Cloudflare is not complacent; it is actively building to meet the AI shift. During AI Week 2025, Cloudflare introduced Web Bot Auth so sites can distinguish agent traffic from other verified bots and decide what to allow or block. Cloudflare has also seen success in its products around AI security, crawler controls, and agent authentication. In July 2025, Cloudflare announced that over a million customers had enabled its one-click AI crawler blocking option since its launch in September 2024. Rather than defending a legacy model against AI, Cloudflare is actively trying to become the infrastructure layer that governs how AI interacts with the web.
In a sense, it is quite ironic. Cloudflare was once the disruptor that exploited the Innovator’s Dilemma against incumbents like Akamai. Today, as Cloudflare has become the incumbent, AI has created a new version of that dilemma for large software companies. However, instead of being disrupted by it, Cloudflare looks more like a beneficiary of the AI transition.
Ultimately, the Innovator’s Dilemma punishes incumbent companies whose existing economics make it irrational to fully embrace new technology, which is why AI is so dangerous for traditional software incumbents built around beautiful SaaS margins. And that is why Cloudflare is so unusual: the company’s existing strategic position is already aligned with a world where AI creates more internet activity, not less. In 2010, Cloudflare won because CDN incumbents could not justify becoming more like Cloudflare. Now, Cloudflare may win because the next internet looks even more like Cloudflare’s world than the last one did.