Vertical SaaS: Back to the Spotlight?
Whenever we talk about SaaS these days, trending buzzwords of the day like ‘AI’ and ‘machine learning’ inevitably share the same breath. However, when coming back to business fundamentals, we will find that there are still many problems in various industries that thousands of emerging SaaS companies haven’t solved. As Tomasz Tunguz pointed out, the new era of SaaS is the shift from a displacer of incumbents to a disruptor of existing workflow. This evolution of paradigm returns our attention to vertical SaaS companies, which have been a neglected group in the past, due to their smaller markets driving lower public valuations than horizontal SaaS and their HQs located far away from traditional startup hubs.
A fundamental strategic advantage of vertical-focused enterprise software comes from improving workflow efficiency in major industries by structuring, integrating, and analyzing big data for knowledge workers — a product strategy that can only be accomplished by being vertical-focused. These companies also have the potential to develop into open infrastructures within verticals that allow for further third party innovation.
The aforementioned industries include energy, finance, healthcare, business services, transportation, and manufacturing; which are normally large in size but haven’t fully utilized their exponentially growing data to disrupt decision-making processes. Therefore, enterprise software companies that dramatically improve productivity in those industries present significant investment opportunities. The value of going-vertical strategy has been proven by successful IPOs of vertical software companies such as Veeva Systems, DealerTrack, and Fleetmatics. Key aspects for investing in these companies are:
· Targeting critical “front-office” workflow: Certain back-office business functions, like payroll and accounting, are similar across industries and therefore appropriately served by horizontal platforms (e.g. Workday, RelateIQ). However, front-office roles tend to be the main driver of business success and require specialized software that standardize best practices from the industry to identify and improve vital workflows.
· Integrating previously disparate metadata: Structuring data and drawing insights is vital for companies, while not all data is the same. A differentiated product is based on deep understanding of workflow and a focus on integrating industry-specific data to empower the workforce, instead of developing generalized black-box algorithms to make human decisions.
· Potential to build open platforms with proprietary data: Platforms typically begin as solutions for single problems. With access to more data, they form a network for third party developers and enable data contributed by additional clients to be used by a broader customer base.
The benefits of going vertical have been proven by public companies’ performances:
· Faster scale with lower costs and higher profitability: On average, EBITDA margin of public vertical SaaS is 20%-25% higher than horizontal SaaS, while SG&A expenses are 35% lower. Industry-focused strategy leads to more referred revenues, bottom-up sales strategies, and smaller sales/marketing teams, thus lower customer acquisition costs (CAC).
· Understand user patterns through deep data: It takes time to understand industry pain points, transform legacy systems, and identify relevant data. High-quality data is vital for machine-learning-based analytics. Industry-focused data with more consistent user patterns enable vertical SaaS companies to generate meaningful insights from behavioral analysis easier.
· Capture more revenue per customer with multiple-layer product strategy: After achieving deep penetration with its core suite, vertical SaaS companies can leverage inherent data to add new layers of functionality for a single customer, such as business intelligence, data management, and mobile solutions.
Successful vertical SaaS companies share hallmarks including: having a clear big problem to solve, an executive team with deep domain expertise and technical strength, and a high percentage of referred revenue. Key metrics for valuation are LTM, EBITDA and growth rate.
Exits opportunities lie in the inevitable trend of consolidation. With the potential for a single company to achieve market shares over 50%, we will see fierce competition with every new entrant, and ultimately a result of less than 10 large public companies per vertical. While public vertical SaaS companies trade at a median EV/LTM revenue multiple of 1.5x lower than the horizontal group, Oracle’s acquisitions of OPower and Textura represent opportunities for exits with higher revenue multiples through M&A.
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**Special thanks to William Fan!