By James Green
One of the first lessons I learned in investing was the beauty of vertical software-as-a-service, or SaaS. The notion that one player could dominate a market, own more than 50 percent of the potential revenue and produce almost endless free cash flow is absolutely fascinating. In basically no other market is there this characteristic — monopolies theoretically are not supposed to exist but are actually commonplace in vertical SaaS.
However, for a long period of time (outside of a few exceptions), vertical SaaS felt like the purview of private equity (PE) firms or strategic buyers. The commonly held belief was that vertical SaaS companies didn’t compound at scale to produce venture-like outcomes as they often had constrained market size. In 2020, to go public as a SaaS company you needed to have ~$210M of last twelve months (LTM) revenue, growing 40 percent year-over-year which means you need to comfortably be able to add $60M of net new bookings while still accelerating.
In the past you had dominant companies like Sparta Systems, T2, Tritech, Vertafore, etc. — all multi-billion dollar companies in their own right — but not growing at the rates where you can go public. They were instead PE owned, cash flow producing machines.
So how has this changed? Clearly no longer are only a few vertical SaaS companies returning venture style returns. In the public markets, we have companies like Duck Creek, nCino, Procore and Veeva all leading the way with many more to come. In the private markets we have seen the rise of companies like Benchling, Built, Squire (a CRV company), Toast, etc. all on their way to becoming enduring companies.
In this blog post we will break down the trends of the new wave of vertical SaaS companies — what they’re doing and why this is leading to outsized outcomes as truly enduring companies, instead of PE or strategic exits.
How Do The Best Address A Constrained Total Addressable Market (TAM)?
Let’s take auto repair shops for example — new entrants into this market are companies such as Shopmonkey, Shopware, Tekmetric, etc. There are roughly 164K auto repair shops in the US. At Shopmonkey’s second cheapest offering of $2.7K a year, they have roughly a TAM of ~$440M. Big, but not the venture size of $1B+ TAM. So how do these companies increase their TAM?
More Software
Without oversimplifying the process to create more software and increase annual contract value (ACV), all the best vertical SaaS companies do this over time. They do it in many ways (more on that later) but mostly this is by selling more software, but to the same buyer. In the case of Shopmonkey they have a slow push to graduate customers into higher “tiers” of pricing. In many cases this can 2x the software ACV.
Price Increases
It’s worth quickly noting that price increases in SaaS continue to be shockingly uncommon. The United States just went through one of the largest stimulus packages in memory, my coffee is now $100 and inflation is clearly happening in the market. Yet, SaaS prices often remain stagnant. Within CRV’s portfolio the best software companies regularly review their pricing and include annual price increases during renewals.
Payments
This is an overdone suggestion but one that continues to be a large driver of value. The spend in the auto industry is astronomical. In 2020, the US economy spent ~$175B on auto repair services. Even if only 10 percent of this is addressable ($17.5B total payment volume) and with a 3 percent take rate, this can add ~$500M in TAM.
Lending & Insurance
Many vertical SaaS companies have access to more data than traditional underwriters. As a customer, why would you take money from a slow, legacy financial institution if you can access capital from a company with best-in-class customer service and competitive prices?
In venture we often ask, “What is your unfair advantage?” — Here it’s clear that speed, pricing and ability to underwrite allow for unfair advantages in vertical SaaS.
Even with interest rates at historic lows, it’s possible that this could add at least ~$100M+ to the TAM even in conservative assumptions. Offering embedded insurance to customers further increases the lifetime value (LTV) of customers — this similarly could add $100M to potential bookings.
Embedded Commerce
This is where the world is going for vertical SaaS and likely a larger accretion of value than many of the other categories we have already mentioned. Imagine a world where you could buy all your equipment for your barbershop through Squire. But not only were you finding, picking and ordering equipment through your vertical SaaS solution, you could also pay for it, deploy buy now pay later (BNPL) against these items and then use it in your shop the next day.
Why would you ever purchase equipment elsewhere? When your point of sale (POS), website, booking system all work seamlessly, it makes total sense to have commerce running through the same system. This isn’t unique to only the select few companies. Imagine car washes, laundromats, recycling trucks, barbershops, construction firms — basically every vertical software market shares these characteristics and embedded commerce can add a meaningful amount to the TAM. Perhaps more than the software itself. This is the collision of a perfectly curated marketplace, with the recurring nature of SaaS.
So from an initial TAM of ~$440M, even with pretty conservative assumptions, we ended up over $2B — well into the world where venture style returns start to become a reality. Becoming the dominant market leader places you in the realm of a public software company at ~$235M of annual recurring revenue (ARR).
So now that we have confirmed you can sustain a venture scale TAM when layering on adjacent products.
So what? What are the commonalities from what the best do well and where are the common mistakes?
Focus on Renewals, not Retention
Over the past few years, net dollar retention (NDR) has become a common place term. Public market investors are finally starting to understand this and often valuations are pegged to companies’ terminal NDR. However, the best companies focus on their gross, logo and net renewal rates. As pricing and packaging have become more complex, one, two and three year deals have become commonplace. This can often lead to a bloated retention number.
For example, if you have 100 customers and 90 are on three year deals but 10 are on annual deals and then five churn after one year, you’d have 95 percent retention, but actually only 50 percent renewal. This would clearly be bad, but it would be easy to dismiss this issue as you’d have 95 percent logo retention — best in class! The best companies, especially in constrained end customer TAMs, focus on their renewal number and not their retention number.
This often means their customer success groups are more expensive than a horizontal SaaS company. This should not be feared when scaling your company. There are only a limited number of customers in your known universe and often they speak to each other. Making sure the customers are happy should be an overweight focus relative to a horizontal SaaS company and more than you might expect.
Avoid Burning Through Their TAM
As we have discussed, vertical SaaS companies clearly have a constrained market from the number of buyers. So why, when you have a clearly defined list of buyers, do people run up a large adword bill, spend endless money on email campaigns and hire a team of new college grad business development reps (BDRs)?
Buyer fatigue is much more commonplace in vertical markets, especially when early companies bombard customers without a fleshed out product. An account based marketing (ABM) like approach, with curated messaging and positioning is a much more effective way to build long term enterprise value — especially as a seed to B stage company. As we’ve discussed before, much of the long term enterprise value is created with upsell bookings so you need to acquire the customers without them dismissing your brand long term.
Focus On Product Velocity
Working backwards from the assumption that long term value is created through upsell, you clearly need to have more product to sell to this constrained number of customers. The derivative of this is product velocity and product leaders within these organizations. Having spent time with 1000s of vertical software companies, I firmly believe this is one of the most important hires a young vertical SaaS company can make.
The product roadmap, the ability to deliver on time with high reliability is key to capturing increased LTV over time. The truly best vertical SaaS companies have implemented tools like Airtable, Figma, GTMhub and Productboard from the very earliest days so product velocity is very much part of the culture from day one.
Embrace M&A
While product velocity is key to long term growth in vertical SaaS, it does not always have to come from in-house teams. In Silicon Valley, M&A (mergers and acquisitions) has almost been a dirty term for many years. It was long assumed that if you couldn’t build it yourself then it perhaps held inferior value and M&A was a distraction from the core offering. This has rapidly changed.
There’s something extremely simple and yet elegant about M&A instead of only organic product creation. If you’re acquiring a company with customers and revenue then a couple of things happen.
The product often already works and you know there is demand. Clearly the willingness to pay is already there if there is revenue and this is not always the case in the organic path. Moreover, you often are acquiring a team and this can accelerate hiring in a world where hiring is not easy. Lastly, it can also provide a path to new geographies which in vertical SaaS often shows levels of geographic fragmentation.
The M&A muscle is one that growth stages companies flex, but not often enough. As the capital markets continue to thrive, equity is a strong way to compensate people. Instead of cash, all stock purchases in the private market — with performance based earnouts — will become a common skill in the private technology markets. Thus, M&A can move the needle in many ways the organic path cannot.
Team Structure
As we think about Vertical SaaS companies, the team structure has become increasingly more important. Traditionally in software companies, functional groups are split by the following roles:
- Executive Office
- Technology
- Product
- Sales
- Marketing
- Customer Success
- Finance
- Internal, Corporate Development & HR
However as the world of vertical software in particular has evolved, these functional groups have not sufficiently covered each of the functions these companies now need. Today, as vertical SaaS companies scale, they also need the following:
VP of Fintech
If we believe that the world of SaaS and fintech are colliding, then why do we not have someone in charge of that functional group? The language, team needs and operations of this side of the house are fundamentally different to that of the SaaS business. Terms such as PSP, merchant acquiring vs processor, gateways, balance sheet lending, TPV etc — the list of acronyms go on and on. As vertical SaaS businesses scale, and the collision of financial services and SaaS become table stakes this role will become as common as many of the other roles laid about above.
VP of Pricing
In the old version of software there was a large upfront fee and then 20 percent of that you paid annually for maintenance. Today almost every company has different product lines, different contract lengths, different ways of paying, consumption versus fixed etc. — this is the whole reason a whole cast of players have been born to support new sales compensation structures.
Yet despite this issue so many companies do not hire a pricing lead early enough. Instead, they are reactive to what becomes an issue almost certainly by the series B stage. This often results in a slow down of value creation and limits a company’s ability to thrive.
To Summarise:
- Vertical SaaS markets are almost always bigger than you originally think and embedded commerce will drive the next big wave of vertical SaaS expansion.
- Focus on renewal, not retention and the vice president of customer success is a more important earlier here than in horizontal SaaS
- Product velocity through inorganic and organic means drive long term LTV and enterprise value.
- The organization needs to be structured slightly differently, with new important roles, to maximise long term operational efficiency.
If you’re building the next generation of vertical SaaS we want to talk to you! CRV is an early-stage venture capital firm that has backed over 400 startups in its 50-year history, including Airtable, DoorDash, Drift, Postman, Twitter and Zendesk.
