Earlier this year, I penned a piece on why I’m NOT a B2B SaaS investor. I stand by my position that the landscape has evolved due to heightened competition across software companies, making it increasingly difficult to scale traditional B2B SaaS companies. The truth is, it’s never been easier to start a software company (especially with the advent of on-demand infrastructure and microservices), but while it’s easier than ever to build a software platform, it’s become increasingly difficult to maintain a successful, competitive advantage against its peers. For most companies, idea and execution simply aren’t enough, which is partially why today’s enterprise SaaS companies raise such obscene amounts of capital with the vast majority of those resources being spent on “fueling growth”. This becomes more difficult with scale as the efficiency of sales and marketing spend tends to deteriorate as you spend resources on less attractive channels (i.e. diminishing marginal returns). The aggressive sales and marketing spend of these companies ultimately competes away any operating profit, leaving the businesses hungry for cash until the market winners are anointed. Simply put, competition is bad for business.
One of the most successful ways for startups to avoid (or at least limit) competition is to attack a particular vertical. My colleague Eric Ong penned a fantastic piece on why we think vertical software is a terrific category, so I thought it would be worthwhile to expand upon his work to discuss certain conditions that may make a particular vertical software category attractive.
In general, the following conditions tend to enable attractive vertical software opportunities:
Nuanced: The need for vertical software largely exists due to the uniqueness of workflows and data sources in that given industry. The more unique and nuanced, the better. Traditional software systems (particularly in sales, marketing and procurement) are built to satisfy the largest base of customers possible. For industries that operate significantly differently than others, however, heavy degrees of customization are needed to make these horizontal platforms remotely functional. While it’s true that all industries are indeed different, certainly some more so than others. For the most part, traditional ERP and CRM platforms operate relatively effectively in areas like CPG/retail, business services and technology, which is why there may indeed be less of a need for verticalized products in those arenas.
Heavily regulated: While regulation is usually seen as a detriment to economic activity, it can be a great boon to vertical software companies. Regulatory conditions (especially ones that evolve fairly frequently) often drive sectors to outsourced vendors that can standardize those workflows and provide assurances (or at very least a scapegoat) that systems are compliant. The trucking sector is a fantastic example of this where the looming electronic logging device mandate has created an incredible catalyst for vertical software adoption with players like FourKites, Project 44, Turvo and KeepTruckin emerging in recent years. As you can see, it’s no coincidence that heavily regulated industries like financial services, healthcare and life sciences have (and will) represent some of the greatest opportunities for vertical software.
Macro Shifts: Sometimes, buyers will only shift behavior if they are forced to and major macro shifts in their industry can be a primary call to action for vertical software. Changes in labor / human capital, commodity price pressure, increased competition from adjacent industries can all be catalysts for management to shake things up and rethink technology strategy. More often than not, the prior success of these industries is a primary driver for why they are so heavily paper based. The oil and gas industry is a great example of this where business software had a particularly low penetration rate prior to prices falling dramatically over the last decade leaving suppliers eager to find procurement and distribution software that could help them compete in a heavily constrained market.
High SG&A: Environments with high SG&A provide fantastic opportunities for vertical software to power automation driven cost savings. This is particularly true in industries with high sales/marketing spend or have notably inefficient transaction processes. The commercial P&C insurance market (especially brokers) is highly effective at demonstrating both these qualities which is why SG&A can represent upwards of 80% of revenue for even the strongest players in the industry. As a general rule of thumb, if most business is still done on a golf course, chances are there is vertical software opportunity available to streamline the process.
Again, the premise of a vertical software strategy is to own the entirety (or most) of a software category in the face of limited competition. One particularly effective way to find attractive market categories is to examine leading enterprise software players like Oracle, SAP, or Salesforce to determine if there are industry segments that are underrepresented in their revenue. For example, Salesforce’s relatively non-existent presence in commercial P&C insurance was a major driver behind our thesis for Riskmatch (which was recently acquired by the industry’s leading software platform Vertafore). Similarly, Ariba’s (SAP’s procurement platform) limited penetration in the oil & gas industry seems to have left the door open for companies like Rigup. McKinsey released a report in late 2015 highlighting the level of “digitization” across a variety of different sectors and this is a great place to start for identifying a markets ripe for improvement.
I’ve had the chance to work with software businesses across several intriguing verticals (insurance, oil & gas, education, logistics, etc.) and the above conditions largely hold for each, however the paths to success for a given company differ significantly across business models. Determining the software category (e.g. CRM, procurement solution, DaaS, API, etc.) requires deeper insight than determining the market itself, so it’s incredibly important to bring the appropriate industry expertise to the table when determining how to execute a vertical software opportunity.
As always, if you are a great founding team looking to go vertical, drop us a line.
NOTE: Lightbank is an investor in Riskmatch and I am a personal investor in Rigup.