At I2BF, we have several investment themes that we pursue professionally, but by and large, over the last decade some of our most notable performers were companies building vertical software products. Commonly referred to as "Vertical SaaS" this space includes “traditional” software service subscriptions but can also have marketplace, transactional, or even API-first approaches incorporated in the business model (in addition to or in lieu of subscriptions, this can also depend on the stage), some examples from our portfolio are GoExpedi, Partly, Makini, Peek Travel, Inbox Health and others.
Regardless of the specific business model, all companies in this category share a common objective: addressing challenges in often overlooked, largely analog industries that may not be considered “glamorous” or even known to the general public. It is no secret that despite the widespread impact of IT and software in all sectors of economy, the adoption is far from being uniform: some industries are on the bleeding edge of technology, while many others lag in terms of even the most basic and mundane (by today’s standard) digital transformation goals. We are always very excited to connect with founders who identify the latter opportunities and build solutions to move things forward in those industries.
Cloud Revolution
A bit of history: several factors have paved the way for the emergence of Vertical SaaS. This comprehensive memo from an investor at Alumni Ventures notes that key factors were slowing productivity growth, increased enterprise cloud adoption, and the rise of digitally-savvy enterprise buyers and end-users.
Since 2005, labor productivity has grown sluggishly at an average rate of around 1.3%, falling short of the long-term average of 2.1%. This slow productivity gain can be attributed to the lack of modernization and innovation since the late 1990s and early 2000s. Enterprises have become keenly aware of the importance of the digital transformation and its role in improving productivity gains, and have adopted cloud technologies, paving the way for SaaS products. Nearly 80% of IT professionals state that migrating to the cloud increases corporate productivity. By 2025, 85% of companies will run their applications in the cloud, and most will use multiple cloud service providers and products.
The last major trend revolves around enterprise end-users growing increasingly digitally-savvy. For example, an average chief procurement officer is now a millennial who expects a certain level of digital functionality as a baseline. Nearly three in four enterprise technology buyers state that end-users (likely younger and more digitally native) have a voice in the decision-making process. As a result, older technology or analog processes cannot suffice for too long.
Vertical vs. Horizontal SaaS
As we have mentioned earlier, with the widespread adoption of digital technologies, certain sectors emerged as pioneers in embracing the innovation, while others lagged behind, thus creating niche software markets with distinct unmet needs. In response, Vertical SaaS solutions emerged as a class to address holistically the specialized workflows of these industries. Vertical SaaS companies deliver industry-specific solutions that are fine-tuned to the unique demands of their customers.
This is in contrast to Horizontal SaaS, which caters to universal processes or functions, spanning multiple sectors or industries. Vertical SaaS companies prioritize understanding and catering to the wants and needs of their Ideal Customer Profile (ICP) whether it's in retail, banking, healthcare, or manufacturing, while Horizontal SaaS companies aim at creating the “ideal” product, that covers use cases in as many industries as possible, often on a more “superficial” level: without a deep specialization or fine details.
Another distinguishing aspect of Vertical SaaS is its focus on enablement. While many startups position themselves as “disruptors,” aiming to revolutionize their industries, Vertical SaaS businesses adopt a different approach: rather than trying to fundamentally change everything (a tough ask), they develop tools to enhance and augment existing business operations (a more achievable goal). In a way, this can be likened to the "Amazon" vs."Shopify" strategies in e-commerce: one wants to be the only store there is powered by a massive bet on technology, while the other is giving the necessary technology tools to all the existing stores.
Understanding the Vertical SaaS Rise
Almost always Vertical SaaS companies target sectors that form the backbone of the economy. In the past, Vertical SaaS companies were seen as the territory of private equity (PE) firms or strategic buyers. The common belief was that these industries could not compound at a scale to produce venture-like outcomes due to their often constrained market sizes. That’s why in its early days many VC funds did not invest in the vertical software products. But times have changed, and we now have some well-known public companies and unicorns in the Vertical SaaS space:
- Procore (NYSE:PCOR): An all-in-one construction management software with a market cap of $9.35bn in Jun’23 and $720m annual revenue in 2022 (+40% vs. 2021 revenue);
- Veeva (NYSE:VEEV): a cloud-based software for the global ife science industry with a market cap of $32bn in Jun’23 and $2.15bn annual revenue in the financial year ended on 31-Jan-2023 (+16% vs. previous year’s revenue);
- Toast (NYSE:TOST): A restaurant POS and management system with a market cap of $11.5bn in Jun’23 and $2.73bn annual revenue in 2022 (+60% vs. previous year’s revenue); and
- ServiceTitan (Private, one of our portfolio companies): A SaaS platform for field service businesses. ServiceTitan raised over $1bn from marquee investors including Battery Ventures, Bessemer Venture Partners, ICONIQ Growth, Index Ventures, Sequoia Capital, Thoma Bravo, Tiger Global Management, TPG, and T. Rowe Price.
Addressing a Constrained Total Addressable Market (TAM)
The focus on niche industries presents a key challenge for Vertical SaaS companies, namely dealing with a constrained Total Addressable Market (TAM). However, successful vertical SaaS companies have demonstrated their ability to dominate their respective markets and disproportionately absorb underlying growth trends. Unlike market leaders in Horizontal SaaS, that often face fierce competition and struggle to capture more than a single-digit market share, thriving vertical SaaS companies operate in less crowded markets and can capture 20%-30%+ of their target markets.
Furthermore, building industry-specific solutions creates opportunities for wallet expansions beyond traditional software charges. Vertical SaaS companies can expand their offerings by introducing financial products that allow for more seamless money flows for their customers. Recent fintech innovations have further lowered the barriers to introducing these revenue streams, allowing vertical SaaS companies to offer them earlier in the their development cycle.
Common Strategies for Vertical SaaS Wallet Expansions
- Payments: In industries with significant transaction volumes, Vertical SaaS companies can take a percentage of transactions (a take rate), thereby expanding their TAM. In some cases, payments can eclipse subscription revenues to the point where a Vertical SaaS company can offer its software for free and monetize largely through transaction revenue.
- Lending & Insurance: Many Vertical SaaS companies have access to more data than traditional underwriters, providing them with a competitive advantage in offering credit services or insurance to their customers. This additional revenue stream is often built on top of the payment infrastructure already established by the company.
- Embedded Commerce: By providing a comprehensive platform that meets all of business's needs, Vertical SaaS companies can establish connections up and down the value chain, potentially expanding in various directions. This creates an opportunity to bring these connections onto the platform, adding more value beyond the software itself. For example, if your business operations suite allows you to find, transact, track and integrate accounting with suppliers within your industry, there is little to no incentive for businesses to seek external channels for these transactions. And this then opens up new monetization opportunities for your Vertical SaaS company.
The Future of Vertical SaaS
Do we foresee the emergence of a new cohort of market leaders in the Vertical SaaS space? We agree with BCV that there are at least several reasons to answer "Yes":
- Automation Still Hasn't Reached Every Industry: Numerous industries, such as construction or trucking, still lack a widespread adoption of purpose-built software. Many rely on fragmented solutions or outdated desktop-run software tools.
- Reinventing Early Vertical SaaS Winners - Depth Over Breadth: Many early winners in Vertical SaaS expanded horizontally into adjacent markets to broaden their Total Addressable Market (TAM). However, there is potential for companies that delve deeper into specific industry’s challenges and provide a superior product tailored more closely to those highly-focused and complex needs.
- Reinventing Early Vertical SaaS Winners - Stagnation: Consider the case of "Zoom" but for a specific market, like healthcare. Several long-standing incumbents in the Vertical SaaS space have become technologically stagnant due to accumulated technical debt and focus on larger enterprise customers. Agile innovators can seize the opportunity to offer superior and more cost-effective alternatives, capturing the markets initially created by the previous generation of Vertical SaaS leaders. This cycle is virtually infinite.
In conclusion, we firmly believe that Vertical SaaS remains a very robust delivery vehicle for the digital transformation. The potential for industry-specific solutions to optimize and augment entire sectors and drive significant productivity gains is still immense. As an investment fund, we maintain a positive outlook and offer our support to entrepreneurs and teams who share our passion for depth over breadth. If you would like to explore the potential of building a vertical software business with us, please do not hesitate to reach out. Feel free to email Alex directly (korchevskiy@i2bf.com) or send a message to our shared inbox at info@i2bf.com (btw, we covered cold emails in our other blog post).