How Second Acts Unlock Vertical SaaS

The present opportunity in vertical SaaS is the result of a persistent tendency in VC to over-index first order TAM. By definition, vertical SaaS companies target bounded markets that are typically composed of businesses that have similar workflow needs in a particular industry. In the past, many investors ignored these “niche” industries because they seemed incapable of producing venture-scale returns. But as we’ve seen time and time again over the past decade, this assumption is often way off the mark. In fact, several of the largest IPOs last year were vertical SaaS companies (e.g., Toast, Procore, and Blend) and there are now dozens of vertical SaaS unicorns.

Clearly, it’s possible to obtain incredible outcomes by selling into an industry-constrained market. An important question for investors and founders that are exploring opportunities in vertical SaaS is how it happens. To be sure, the broad digitization of all industries is a secular trend that has benefited vertical SaaS companies over the past decade. Businesses are increasingly aware that they need modern software tools to compete effectively, but many industries still lack an adequate solution. The proliferation of sophisticated developer tools and the API-ization of software has also significantly reduced the cost of building software applications, which has allowed founders to profitably sell digital tools tailored to the needs of customers in relatively small markets.

But digitization and better tools alone can’t account for the incredible outcomes seen in vertical SaaS. The main determinant is a vertical SaaS company’s ability to expand its addressable market through a so-called “second act.” This creates new growth opportunities beyond subscription revenue that accounts for the first order TAM.

Generally speaking, a vertical SaaS company’s first order TAM is derived from the software penetration and annual software spend in their target industry. But as we saw in Procore’s public debut last year, these metrics often underestimate the true addressable market. In Procore’s case, this is because TAM estimates for construction software don’t account for software that digitizes processes that aren’t served with currently existing software or the ability to sell software to multiple stakeholders working on the same project, which multiplies the company’s revenue for the same dollar of construction spend.

Second acts take these latent first order growth opportunities a step further with additional services or features that go beyond an industry’s core workflow needs. There are a variety of common approaches to a second act in vertical SaaS, but there are 4 main strategies that have proven to be particularly successful.

1. Expansion into adjacent verticals: While vertical SaaS companies focus on the workflow needs of a single industry, there is often significant overlap with the workflow needs of other industries. By entering those markets with products that are derived from a company’s core offering yet still tailored to the quirks of the adjacent industry’s workflows, a vertical SaaS company can dramatically expand its addressable market. This was a strategy successfully used by ServiceTitan, which started by providing software for HVAC, electrical, and plumbing professionals before expanding their services to verticals like pest control and landscaping through strategic acquisitions.
2. Embedded fintech: Many of the industries served by vertical SaaS have significant payment flows that can be tapped by software providers by embedding fintech services within their core workflow platform. Embedded fintech goes beyond payment solutions, however. Recently, a number of API-driven fintech companies like Lendflow have opened up new routes for second act TAM expansions by expanding the range of financial solutions that vertical SaaS companies can offer their customers to include services like lending and payroll management.
3. App ecosystems: For vertical SaaS companies that are building a core system of record for their industry, there is a lucrative opportunity to expand their addressable market by creating a platform for third-party applications. This effectively turns the vertical SaaS company into an aggregator in the sense that they now have a number of suppliers coming onto their platform to provide services that further increases the value of that platform. We have seen how this leads to market expansion and dominance in the consumer space with companies like Airbnb or Netflix, and similar dynamics play out in the vertical SaaS space, too. Procore effectively wielded this strategy by creating a marketplace for construction apps that can integrate with Procore’s core workflow software to extend its capabilities.
4. Point-solution integration: It is often the case that vertical SaaS companies start by building software tailored to the needs of their customers’ back office functions. But they can significantly expand their addressable market by integrating point solutions into their app that allow them to provide an end-to-end tool for their customers. The restaurant software provider Toast is a great example of this in practice. Its software not only helps restaurant owners manage their back-of-house needs in the kitchen and office, but increasingly also interfaces with the restaurants’ customers through point-of-sale services.

The second act strategy that is adopted by a vertical SaaS company will ultimately be dictated by the workflow needs of their customers. Expanding their TAM may only require one of the above strategies or may require a combination of the four. But one thing is certain: outcomes in vertical SaaS are largely determined by the successful implementation of some second act. First order TAMs may be larger than they appear, but they’re rarely large enough to sustain a vertical SaaS company’s growth on their own.