Vertical SaaS Decoded: Five Takeaways Investors and Entrepreneurs Often Overlook
By Anna Khan
Vertical SaaS has long been the black sheep of software investing. There aren’t that many investment opportunities that arise — and even the ones that break through the noise must execute to perfection to hit venture scale. But vertical SaaS has changed substantially over the last decade — becoming a fast growing market segment and investment asset for VC firms globally. There are many obvious reasons to like vertical SaaS — such as its winner take all potential in underpenetrated segments; its better capital efficiency due to fewer competitors; and its typically higher NDR rates than traditional software (often because it’s the most critical part of the software stack for the end buyer and has an easier path to upsell.) But these points are all common knowledge, and many investors have talked about them as more VC dollars move towards the space.
At CRV, we wanted to highlight some nuances we’ve learned by making several vertical SaaS investments over the last five years in companies such as Squire, Loop Returns, Archy, Clarent, Workstream and Northspyre to name a few. As the market and demand grows for vertical SaaS, we are also seeing where the success of one vertical SaaS company encourages the development of others. We hope the five takeaways from our experience investing in vertical SaaS contributes to this virtuous cycle.
- Initial TAM is still incredibly important, but incorporating payments is harder than you think. Over the last few years, vertical SaaS has seen a business model renaissance via the incorporation of multiple new revenue streams pitched as adjacent to the core software stack — primarily payments (or fintech more broadly). How did this renaissance arise? A number of generational vertical SaaS companies (e.g. Shopify, Mindbody, Procore) realized they were leaving money on the table by having a customer they acquired complete a task, become more efficient in their processes, with easier access to payment flows– but then having to leave their platform to complete said payment. As a result, Shopify and others incorporated payments within their stack to get more $$$ from each customer vs. give it away to multiple third parties. With their apparent success (read: definitely not overnight), vertical SaaS startups assumed adding payments necessary and …easy, but here’s the kicker. The companies referenced above were able to do this once they had built decent sized businesses, oftentimes after hundreds of millions in GMV was going through their systems. While the ability to incorporate payments is a unique advantage for vertical SaaS companies, you can’t take it for granted in the early years of a startup. In fact, in a world of limited resources, it’s smarter for a team to focus on nailing the product suite and app layer before going down the payment rabbit hole (setting up regulation & compliance, becoming a payment facilitator (PayFac), managing a third party, etc.) When assessing vertical SaaS investment opportunities, we exclude potential payment revenue in our base case assumptions — and instead incorporate it into our stretch scenarios. The initial product suite TAM should be large enough, without payments, to drive a venture return.
- Choose a selling lane, early. All software needs to be sold. Yes, there are some lucky companies that have success with Product Led Growth (PLG), but PLG is not a product — it’s a GTM strategy, and much harder than enterprise selling. Within vertical SaaS, the end buyer is usually one of two core groups: 1) a small business (think mom and pop owner or freelancer), or 2) a combination of owners (think a commercial cleaning enterprise vs. a 12 person cleaning business). The latter functions more like a mid market/enterprise buyer vs. the former. When I get pitched vertical SaaS startups, I often see entrepreneurs paint a vision of starting with the small freelancers to test out product market fit, and then moving upmarket. This can happen (never say never), but it’s much harder than picking a selling lane when you launch your product. Often the product needs of selling to commercial enterprises or franchises are very different from going door to door to SMBs. Additionally, the mechanisms of selling to an enterprise buyer in vertical SaaS are also specific. Enterprise selling can often require building out an industry association or conference strategy. This was very helpful to both ServiceTitan and Procore in their early years. You can’t be a bottom up and top down seller. This is true for most things in enterprise SaaS but even more relevant in vertical software. Focus is key.
- Workflow trumps analytics, and it’s rare to be both. Vertical SaaS companies at their core are one of two products: They are either 1) a workflow product that eases an existing manual process, or 2) an analytics product that takes important data from a number of tools in use and makes it more actionable. Everything else is usually a derivative of these two product archetypes, and in my opinion, less durable. Let’s dig into analytics first. The analytics layer is pertinent because it helps a business owner make sense of their business, which leads to more efficiency. Dashboards that you can visit daily and share with other members of your team are important. But usually the data that feeds into these analytics layers comes from another piece of software — which is usually the stickiest in the stack. For vertical SaaS buyers, the software stack is lean. They are different from other buyers who can easily use 20–30 pieces of software in their stack. Which means that when there is volatility in the markets — the dashboard is the first to go. The question I love to ask when digging into an analytics product in the vertical SaaS category is: Was this data input manually from the customer or retrieved from another complementary system? If inputted manually, it’s much more interesting to me and stickier for the customer.
In contrast, a product that is built around workflow is stickier as it usually replaces a manual process. The best part about manual processes is that it’s really hard to go back to it once you incorporate software. Think file uploads accessible in the cloud, approvals and permissioning, single sign on, the ability to send and receive invoices, versioning, built in tables and contact sheets — the list goes on.
4. Real outcomes are prevalent — comp set finally exists. Over the last few years it became clear that vertical SaaS companies could demand real exits. As cloud software at large became critical, software that sold only to a specific industry was often pegged as being too small for the type of outcomes the VC asset class necessitated. This belief is beginning to change in a real way, mostly due to a combination of IPO success and strong strategic outcomes. As an example, per @vSaaSToday, the total market capitalization of public vertical SaaS companies as of January 9th was $218.5 B, the average LTM revenue was $1.48B, and the average EV/LTV Rev multiple was 6.4x. The last decade has shown that vertical SaaS companies can very much contend with horizontal SaaS companies in the public markets to build long-standing generational products in meaningful markets. Another exciting development is private equity’s growing interest in the space. Between 2018–2022 alone, Vista Equity and Thoma Bravo made sizeable vertical SaaS acquisitions that included logos like Mindbody at $1.9B (8.3x revenue), and Instructure at $2B (7.7x revenue) in the low billions of dollars — all the way to Realpage at $10.2B (8.9x revenue). These exist alongside even larger strategic outcomes from non-PE players, like Black Knight Technologies that was acquired just last year (2022) for $13.1B by ICE, or Cerner which was acquired for $28B by Oracle.
5. A strong legacy incumbent is better than none. While it may be a bit contrarian, having a legacy incumbent is actually better for the vertical industry than not having one because it creates more competition. While that can result in tough bake-offs and complicated RFPs, it also means that your budget is already carved out. Your end buyer is used to putting aside money for software to fix a particular problem — and if your company arrived 10 or 15 fifteen years after this legacy incumbent, chances are your software is more robust, more accessible, and more user friendly. There are of course exceptions to this rule — where you find such an incredible niche, in a big enough TAM (hard to do because everyone is searching for it), and build a sales engine that convinces a buyer to allocate software where they haven’t before. Another exception is a legacy incumbent that already has more than 80 percent market share. This incumbency is tough because they’ve made the purchase of their software almost culturally “right.” Think Intuit in the early days selling in the US. Intuit, through Quickbooks and TurboTax, had amassed such incredible market dominance in the US — that while other (and sometimes better!) products came along like Xero — they became second tier quickly.
With its seemingly limitless potential to address industry specific challenges and pain points, vertical SaaS will continue to grow as quickly — if not more so — than horizontal SaaS and we at CRV are ready for it. In fact, one of the many advantages of CRV having been in the business for 52 years is that we can collectively share information and key learnings that enable our companies to leapfrog their competition. If you are an early stage founder poised for growth in either category, our team would love to connect with you.