Vertical Value Creation Vis-a-Vis VCs
There are many reasons why vertical SaaS is an attractive business model. My partner Andrew wrote in The Resilience of Vertical Software that vertical SaaS can better align with an industry’s needs, help streamline operations and drive profitability, enable skilled employees to make better decisions, and drive deeper more contextual and meaningful relationships with end customers. The specificity of the vertical solution is at the core of the value creation. However, when it comes to attracting outside funding, that specificity can also create challenges for traditional VCs.
Ultimately there are key philosophical differences in building a vertical business vs. a horizontal one, as well as structural limitations of VCs that can make vertical software and traditional VC a tough fit.
To explain, it helps to have a baseline understanding of what VCs are trying to accomplish. I’ve written about VC Economics And Why Fund Size Matters To Companies:
There’s a rule of thumb in traditional early stage VC that each investment must have the potential to return the entire fund. That’s typically what it takes to account for the high failure rates of investing in private, illiquid, unprofitable, early-stage startups […] for a $100M fund, every investment (of 15–30 total investments) should have the possibility of generating $100M of gross returns to the fund. For example, if the investor’s average ownership is 10% by the time of exit (which is generous — most would be happy with 5% after dilution), then working backwards, the underwritten exit needs to be $1B. If the investor doesn’t believe the market, product, or team can support that possibility, they can’t reasonably invest without changing their underwriting model.
Venture capital is at its best when taking cutting edge technologies with world-changing potential, e.g. AI today in 2024, web3 in 2021, smartphones in the enterprise circa 2010, cloud computing dating back to 2006, and applying those technologies broadly across sectors of the economy to find the “killer application(s).” The way to create VC-scale value in these types of businesses typically involves heavy amounts of funding before meaningful commercial traction, as well as the need to “cast a wide net” by selling horizontally to multiple industries at once. It’s not unusual to see a Seed or Series A company testing into 5–10 different end markets simultaneously (some of these may end up becoming vertical businesses). As such, it’s not a huge stretch to say that VCs back (horizontal) solutions looking for problems.
On the other hand, the way to create value in a vertical is the opposite: first by understanding problems at a deep level, and then by bringing to bear the best of available technology to solve those problems. The biggest of those vertical problems prove enduring; the same problems today existed 20 years ago, and will exist in another 20 years. Take for instance the ever-present coordination problem of labor, materials, GCs, subcontractors, owners, insurance, and govt permitting in the construction industry. This is why you’ll often see actual practitioners from the industry start vertical tech companies to solve the problems they understand at a very deep and personal level.
There’s a big difference in how you orient your strategy and team when building vertically vs. horizontally. That difference also has implications for the capitalization and exit strategy.
Practically speaking, conversations between a vertical SaaS company and a traditional VC tend to center on TAM and TAM expansion in order to find the $1B exit opportunity (since few industries lend themselves to $1B+ tech outcomes by themselves). For example, if you have a SaaS solution for physical asset mgmt designed for the airline industry, the question from VCs is if the platform can be extended to other settings with physical assets such as manufacturing plants, warehouse/logistics operations, hospitals, and the like.
Of course TAM expansion is a key part of business strategy whether vertical or horizontal. But it pays to be cautious in expanding beyond the beachhead so that the core product in the core market doesn’t suffer from the company being spread too thin. Therefore it pays to find investors who align around creating value in verticals — ultimately centered around understanding problems at a deep level, and then piecing solutions together. This can be a tough with traditional VCs who would prefer you expand markets faster, but may be a better fit with vertical-specific VCs or growth equity firms.
Granted, there have been plenty of vertical SaaS companies that have received venture funding and done well. And there are plenty of AI copilots for verticals that are getting venture funded today, e.g. for lawyers/paralegals, insurance underwriters, property managers, clinical decision support for doctors, etc. These can work if the company and investors are aligned on the method of building value around problems. See Andrew’s post on why AI is Not the Death of Vertical SaaS.
Furthermore, there are a handful of examples of multi-billion market cap public vertical software companies, e.g. Procore in construction, Shopify in eCommerce, Mindbody in salons and fitness, and Toast in restaurants to name a few. Some companies and investors point to these as reasons to seek VC funding for verticals. But the number of vertical companies among the top public SaaS companies pales in comparison to the number of horizontal ones that achieve much higher market capitalizations.
However you choose to build a vertical software business, it pays to have people around the table aligned around understanding specific industry problems first and foremost, and then putting together the best that technology and services have to offer to solve those problems.
