The way I see it, there are two scenarios:
1. Your co-founder is right, your competitors have created something way beyond what you could ever create, and your venture is not worth pursuing. If this is the case, you must either rethink your approach or shut down.
2. Your founder is wrong, and has been scared away by a little competition. Many people can be scared away when competition comes up. These people are not the ones you want as co-founders. Do NOT drag these people along for the ride! This person will drain your energy and slowly sink your company. There are bigger bumps than competitors showing up, and a founder that will bolt at the first sign of trouble is not who you want on your team.
The problem is that discerning between the two can be difficult, if not impossible for someone so closely involved as another founder. Have family, friends, and colleagues you trust talk to you about your situation to help gauge which of the situations this is. Also keep in mind that it is not necessarily one or the other. It could be mix of both 1 and 2, so be aware of this.