The Billion Dollar Question: Differentiating Good vs. Great in Vertical SaaS
Why purpose-built software will define the next wave of SaaS innovation (Part 2)
Today, a convergence of tailwinds is propelling forward a once in a generation transition across industries redefining the way that work gets done. COVID accelerated digital adoption at an unprecedented rate as workers across industries were forced overnight to incorporate digital solutions into their day-to-day operations in a socially distant, remote world. What they discovered was that technology not only enabled them to continue functioning in an increasingly unpredictable operating environment but actually operate more efficiently. This proved to be incredibly valuable as we slowly crawled out of the pandemic bunker only to find the weight of labor shortages putting further pressure on operations and margins. With a greater need than ever to minimize non-billable hours as the bodies to complete these tasks have become all but impossible (or at the very least, problematically expensive) to find, the previously tech-skeptical are becoming tech supporters. Looking ahead, the coming labor force turnover across legacy industries is likely to bring an increasingly tech savvy worker into critical decision making positions, and we expect this evolution to further accelerate technology adoption across industries of all shapes and sizes.
Beyond willingness to adopt, the ability to build, ship, and scale vertical SaaS solutions has seen a step change over the past five years. With the proliferation of embedded fintech platforms, more comprehensive cloud and 5G adoption, and advancements in AI / ML, solutions are orders of magnitude easier (and cheaper) to build than ever before.
In our minds, this confluence of variables is creating an incredibly opportune environment for new entrants.
Evaluating the Next Generation of Vertical SaaS
After spending time with dozens, if not hundreds, of startups in this space, we’ve developed a point of view on what opportunities have the potential to drive outcomes of mass scale. For us, this is driven by five important characteristics: (i) market size (ii) customer landscape (iii) product depth (iv) buyer mindset and (v) the opportunity to layer in financial services.
In our experience, successful vertical SaaS companies meaningfully expand the size of their target markets. While this can happen from expanding the types of customers that are a fit for the product, more often it is from monetizing additional products that they are able to cross-sell to the same customer base above and beyond the original workflow software. With this expectation in mind, markets that are at least $2 billion in size when accounting for software revenue as well as short-term adjacent monetization opportunities as a base case are generally more attractive to underwrite. We’ve gained comfort with this benchmark based on the belief that in the success scenario (i) market penetration will be significantly higher than for a more horizontal product given the purpose built nature of the software and (ii) that we are likely underestimating market size by orders of magnitude at these earliest stages of a company’s trajectory. Look no further than ServiceTitan as an example. The company, which initially landed with a desktop product focused on the needs of contractors, has since expanded into a cloud-based management platform for a large and growing base of home services fields ranging from HVAC installation to plumbing and electrical. While the company’s positioning as the operating system for its users has, in large part, remained unchanged, its scope and reach has grown far beyond what many early stage investors ever envisioned. This, in our minds, is not a story unique to ServiceTitan but instead a possibility that must be kept top of mind when evaluating potential vertical SaaS category captains.
Customer Concentration vs. Fragmentation
Another important input to the growth trajectory and longer term scale of a company is the depth of its potential customer base. At a more granular level, what we are looking to understand is how many potential customers there are, how fragmented (or consolidated) the industry is, whether the needs vary widely across segments, and what the relative tech adoption is across them. In most instances, a more fragmented industry means that there are more potential customers for a company to sell into without concentration risk from industry heavyweights who might threaten to aggressively negotiate down prices. At the same time, a long tail of smaller potential buyers can make it harder to efficiently aggregate and onboard critical mass of users. As a result, we’ve seen many vertical SaaS businesses live and die based on the effectiveness of their go-to-market motion, which also comes down to how uniform or company specific the sales pitch and corresponding implementation process is. Given that, we are attracted to businesses that can both justify five figure ACVs early on while also simplifying their product enough so that implementation can be completed in a period of hours and not weeks. Hard to find? Yes. But beautiful to witness when it’s truly working – and something that we’ve consistently seen from luminaries like Shopify and Autodesk who have configured their products in a way that enables them to be both discovered and implemented by anyone anywhere.
While market dynamics can go a long way in determining the potential scale of an addressable opportunity, the product itself is, in most instances, the make or break for vertical SaaS businesses in crossing the chasm between nice to have and business critical. Accordingly, we would prefer to see depth over breadth, as we believe it is critical for companies to be able to point to true operational transformation and, accordingly, ROI from day 1 to convert the earliest adopters. We have seen the power of early case studies and word of mouth evangelism to drive viral expansion across what have often historically been referral-based communities.
Importantly, not all wedges are created equal as the ideal entry points in existing workflows because some face more onboarding friction than others. As a result we are most excited about businesses that do not require onerous rip-and-replace processes, but instead offer easy to implement onboarding, shortening the time to value and initial investment required. Etsy & Tome have done this incredibly well – and this is a trend we expect to further accelerate against the backdrop of today’s evolving macro environment.
Buyer Mindset & Why Now
As most hardened salespeople will tell you, they would much rather replace an existing solution than convince a potential buyer to buy a new piece of software for the first time.
Accordingly, an important question we ask ourselves is – what is the catalyst that is driving buyers to adopt new workflow software? Internally, we frequently refer to this as the “hair on fire problem.” While current processes may be suboptimal, particularly from the point of view of tech forward investors, many of these industries have operated the same way (often via pen and paper…) for a very long time and the reality is *it works* – at least for now. Why would they be open to something new now? What is the catalyst for change?
Based on what we’ve witnessed to date, this openness is typically driven by an acute business need – either a meaningful desire and clear software-enabled opportunity to increase revenue or a tangible means of reducing overall costs, either in the form of capital or time required. Take Aurora, for example, which enables solar installers to create highly accurate solar designs without having to visit the site, both saving time and money during the quoting process, while also offering a transparent and frictionless experience for the end consumer that enables installers to close deals faster and at a higher rate. To us, this clearly underscores the win-win scenario we’re looking for in other areas of the market. While the sequencing can certainly vary market to market or company to company, overall we have found it to be important to truly understand the early buyer mindset and openness to change, as this is one of the clearest indicators of actual urgency and the likelihood of a speedy revenue ramp.
Opportunity to Layer in Financial Services
Finally, a topic that feels like it’s perennially at the tip of investors’ tongues when it comes to all things vertical SaaS is the role that financial services can play in taking a SaaS business from good to great. Just look at Toast, which today generates close to 70% of its revenue from financial products! While longer term success is, of course, contingent on a company’s ability to build and sell sticky, high impact software, the potential impact of financial services add-ons is important as they can expand ACVs by orders of magnitude. As a result, we get excited when we see a clear, short term path to embedding financial services into the core workflow solution in ways that add tangible value to the end customer, be it through invoice factoring and payments facilitation to payroll and insurance. In most instances, these customers have been perpetually underserved and / or ignored by traditional financial services providers, so the opportunity to materially expand the services available to them is a true gamechanger – and one of the dynamics that makes us most excited about vertical SaaS as a category.
Looking ahead, while we’re so excited by the economic and productivity unlocks that the first wave of vertical SaaS leaders have shepherded in over the past decade, in many ways we feel like this is only the beginning. As the pace of both product development and technology adoption continues to accelerate, we’re excited to support the next generation of founders and operators who are laying the foundation for the new ways of work.
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