What is Vertical Software? What is Horizontal Software?
Vertical market software is software developed for and customized to industry-specific needs. These businesses focus on niche markets like spa & fitness or car dealerships with specific needs and processes. They traditionally aren't attractive to large tech companies like Google and Microsoft. They are highly customized to serve specific niches and can provide in-depth functionalities that general software doesn't offer.
Horizontal market software are things like word processors and spreadsheet programs that can be used in a wide array of industries. They cater to a software function or a department's needs rather than a specific industry.
Most people conflate SMB (small business) and vertical software together. The end merchant is often a small business like a local merchant, restaurant, dog walker, or retailer, but there are also large verticals. For example, the large auto insurance companies (some of the largest companies in the world) use vertical market software as well.
Why is software and software-as-a-service (SaaS) a good business model?
Let's start with why software is one of the best business models ever:
Recurring Revenue - SaaS businesses typically charge customers on a subscription basis, leading to stable and predictable revenue.
High Switching Cost - Mission-critical software makes up a small share of the customer wallet, so switching isn't worth the hassle, and revenue is durable.
Negative Revenue Churn - Once you have a good SaaS customer, the accounts naturally expand with usage-based pricing faster than customers leave.
High Margin - Software is mostly a 95% gross margin business. After the software is built, it can sold over and over again. No inventory.
Scalability: Once the software is developed, it can be distributed to many customers without increasing costs much. This allows for high margins as the customer base grows.
Global Reach: Since SaaS products are delivered over the Internet, anyone worldwide can be your customer.
Alignment with Customers: The subscription model means that the SaaS company's revenue is tied to ongoing customer satisfaction, aligning the company's and its customers' interests.
Why is Vertical Software (Vertical SaaS) a good business?
Vertical SaaS shares all the same business model quality benefits of SaaS generally from above. As well as:
Focused Customer Base - Vertical SaaS companies cater to a specific niche, enabling them to zero in on the unique needs and problems of that industry. This can lead to deeper customer relationships and a better understanding of their clients. Marketing and sales can be more efficient because the target audience is well-defined. It's easier to pinpoint and communicate with potential customers in a specific industry than to target a broad market.
Less Competition: By catering to a specific vertical, these companies often face less competition than generic, horizontal SaaS solutions. Fewer competitors can mean a higher market share and a premium price.
Less Likely Disruption: The differentiator in these markets is in knowing how the end customer operates. This makes it more resilient to AI or no code. Potential competitors have to understand how people work in the end business. It isn't as easy as just copying a product or code.
Premium Pricing: Because the software is tailored to meet the unique needs of an industry, companies can often charge a premium price.
Feedback Loop: Serving a niche market can create a tight-knit community of users. This can foster an environment where customers provide valuable feedback, leading to product improvements that closely align with the market's needs.
Multi-Product - Being deeply integrated with an end customer offers the opportunity to go multi-product and continue to offer more features and charge more to your existing customers. They can start small and expand beyond a single part of the value chain.
Impact on Clients - Running small businesses is notoriously difficult. It is satisfying to be able to add automation to make their lives easier and offer opportunities to make their businesses more money.
One example of this is Toast, restaurant software, during COVID when many restaurants were struggling. Toast was able to innovate by extending into online delivery, which was a big part of what allowed many restaurants to survive COVID. Small businesses play a huge role in America, and it is fun to be able to support that.
What are the downsides of Vertical Software (Vertical SaaS)?
Limited Market Size: Since Vertical Software targets a specific industry, the total addressable market is inherently smaller than that of horizontal solutions. Once the market is saturated, growth opportunities within that vertical may be limited. This has been challenged more recently. For example, Toast makes restaurant management software and is a $13 billion publicly traded company as of 2023.
Vulnerability to Industry Downturns: Being tied to a specific industry means that any downturns or disruptions in that industry can directly impact the Vertical Software business. For instance, if you serve the hospitality sector and there's a global event that hits tourism, your software business might face challenges.
Limited Growth Rate - Often, the stickiness is great from a churn perspective, but it also limits growth. Only a small percentage of the total industry is entertaining new software every year, which puts a cap on potential annual growth.
What are good examples of vertical market software?
Constellation Software is the most famous acquirer in the space. They have bought 500+ of these businesses, with 134 just in 2022. Here is a breakdown of Mark Leonard's empire.
FareHarbor built a $300 million business in tourism operator software. They used one of the most clever pricing approaches. Our podcast on it.
Broadlume built a $220 million business in flooring retailer software. This is easily the craziest pivot story I've come across. I love their inorganic acquisition approach as well. They basically took a VC-backed roll-up approach to the untouched flooring space.
Toast is a $13 billion public company that makes restaurant management software. They are about the most famous and visible vertical software company that most people have interacted with.
Scout is business management software for dog walkers and pet sitters. It was one of our vertical software acquisitions at Verne. Want to buy your own? Check out my acquisition course & community here.
What is the control point in a vertical software business? How do I find it?
A control point is the most important system in the business and the last to be turned off to save money.
This is important because business owners traditionally want one software company to partner with or "one throat to choke." They don't want a bunch of point (single feature) solutions to deal with. This one company then has the power over account control and can add expansion upsells and out-compete any other providers.
There are traditionally only one or two control points or systems of record in a business.
There is a front office system such as point-of-sale or CRM. This control point drives sales and serves as the cash register.
Then there is the back office, the home of the general ledger to which everything is reconciled to pay bills and file taxes.
To understand where the control point is, the questions to ask are:
· What's the most important system?
· What do you spend all your time in?
· What's the last thing you would turn off?
If you spend time with customers, you figure out where the control point is pretty quickly.
A traditional control point will usually have three types of strengths, also known as gravities.
Workflow Gravity - This is the system other systems integrate with. It provides integration value and surface area to cross-sell. Workflows that have the most engagement or that manage scarce assets like calendars (time) and invoices (money), tend to be the most valuable. This is where you go to get things done is what you're engaged in with every day.
Data Gravity - This is the system that creates and holds the most critical information and is the hardest to migrate. Customer, product, and transactional (particularly revenue) data can enrich offerings and customer experiences and make workflows intelligent. This is the last system that you would turn off.
Account Ownership Gravity - This maps to the importance of the user or sponsor of the system in the company. The higher the ranking of that individual in the organization and the more frequent their engagement, the stronger the account ownership.
What makes a market attractive for vertical SaaS?
How should you decide which markets to go after? What factors should you be thinking about? These factors influence the type of company you want to build and the fundraising strategy you want to pursue.
Total Addressable Market (TAM) – How big is the market? Market structures can vary widely. Big markets are things like restaurants with about 700,000 locations in the US, and smaller markets are things like laundromats with only 30,000 locations in the US.
Competitive Intensity – What does the vendor universe look like? Big TAMs tend to look more like horizontal markets where there are a lot of competitors.
Growth Dynamic - What is the growth dynamic within the industry itself? Is the customer segment growing? The more change there is, the more growth, and the bigger the TAM is, the more turnover there will be.
That's important because, in these industries, many of these merchants aren't natural software buyers and aren't changing software providers very often. They find a product and stick with it.
So if it is a very stable industry, there may be many locations, but if turnover is infrequent, then there will be few opportunities to take market share.
One way to think about it is that only ~5% of established companies in a vertical market reevaluate their software every year. Ideally, you want to be in the sales cycle of that 5% with the goal of winning 75% of that. Churn in the vertical markets is low, so it is often easier to go down market and get new customers as they are just getting established.
Trust - Trust is related to growth, risk, and ambition.
With a vertical SaaS, you start out with a control point, and you sell a number of products around that control point. The real homerun is to go deeper into the value chain and transactions.
For example, if you sell auto insurance and you win the market, then can you go deeper? Can you go from the auto insurers to the auto repair shops that are service providers to the insurers? Trust is important here because you are selling software to both sides of the transaction. You, as the software provider, are basically setting the rules of engagement in the market then.
What are the best approaches to marketing Vertical Software?
On the marketing side, it's different because you can know who all your potential buyers are in a vertical market. It is easier to build that list of people to go after. This is a lot easier than horizontal software like Zoom, where basically everyone is a potential customer.
Marketing vertical software is much less around discovery. It's more around Account Based Marketing.
1. PMF is Stronger
You're building a product for a specific type of customer. You want to really leverage that as it relates to the value proposition, the product marketing, and how you introduce yourselves to customers.
2. Careful Outstripping Leads.
These are smaller verticals. You don't want to bother all your potential customers so much that you burn out their leads.
3. Create a Flywheel
Word of mouth is more potent in vertical markets. You can win customers by overservicing to the extreme. You want to niche down to a specific ideal customer profile. Then, invest in the community and create customer evangelists.
In some verticals, there's enough density locally that you can start a flywheel. You can go city by city, and nail the tentpole accounts. There's a halo effect associated with it and you start to see that things get easier in your flywheel markets.
That's the opposite of horizontal software where the deeper you get in penetration, the harder it gets, because you have to step outside your Ideal Customer Profile (ICP). You lose the network effects you build in vertical software.
Why don't customers just cobble together horizontal software?
They definitely could, and many customers do at some point. There are only so many features that matter, and many of them are similar across industries. Things like invoicing, scheduling, and messaging are in most vertical market software. There's a reason why Robert F. Smith says "all software tastes like chicken".
Customers could cobble together a normal ERP, a normal CRM, and a normal communications tool, but there are industry-specific nuances for the last 20% or so of the product.
Larger customers do look at more horizontal offerings. But the smaller customers want immediate time to value which favors vertical software.
There's also an awareness aspect.
If you're running a restaurant or a hotel, you're looking for a tool that just works to solve all your problems. They want it done for them.
Even just small increments of customization and automation drive a ton of value. Restaurant owners rave about how much time Toast saves them for example.
Estimates and quotes in many markets are incredibly nuanced. If you take a horizontal tool and try to create an estimate for a certain end vertical, you're basically creating an entire data taxonomy, your workflows might be different, and your regulatory rules might be different.
These small details actually have an outsized impact in terms of ease of use and the creation of value for the small merchants.
What qualities make for the best founders in Vertical Market Software?
Credibility - The best vertical market founders often have real working experience in the operations of the merchants that they serve or at least a strong personal affinity for them. Often, we see a developer and a local industry business owner as the founding team here.
Having credibility in history to get tentpole customers is more valuable than in a horizontal market.
Sequencing - Vertical software businesses are inherently multi-product. They require focus to get started, like every other startup, to win the control point.
But then you need to start thinking about what are the next steps. The best vertical software entrepreneurs are thinking multi-product early in the company life.
How do you finance vertical software companies?
The sizes of these markets are very different. The maturity of these markets are very different. The company's growth can be very different.
1. Disrupter in Large TAM - If you're a disrupter in a very large TAM, you should be very aggressive to the point of being fairly sloppy with your economics. You should aggressively raise funds and grow fast.
2. Incumbent in Big TAM - If you're in a big TAM, and you're the number one player by a small margin, you should try to make it a larger margin. Raise more money and get big before others do.
3. Smaller TAM - If you're in a more modest category with a smaller TAM, and you've got to category leadership, you probably shouldn't raise more capital. Without some odd decisions by investors, you are unlikely to run into a super well-financed newcomer in your space.
What does retention mean? Why does it matter?
There are different types of retention in SaaS:
Gross Retention (also known as Logo Retention or Customer Retention):
GrossRetention = ( StartingMRR − ChurnedMRR) / StartingMRR∗100
Measures the percentage of revenue retained from existing customers over a specific period, excluding any upsells, cross-sells, or expansions.
It focuses on the stability of your existing customer base without considering potential revenue expansion from those customers.
If a company starts the year with $100,000 Monthly Recurring Revenue (MRR) and loses $10,000 in MRR due to customers churning, the gross retention rate would be 90%.
Net Retention:
NetRetention = ( StartingMRR + ExpansionMRR − ChurnedMRR ) / StartingMRR ∗ 100
Considers both losses (churn) and gains (expansions, upsells, cross-sells) in revenue from your existing customer base.
A key metric to assess growth potential because even if a company is losing some customers, it might still be growing its overall revenue if existing customers are expanding their contracts.
If the same company from the previous example added $20,000 in MRR due to existing
A net retention rate greater than 100% indicates that growth from existing customers is outpacing revenue lost from churned customers.
If you are selling to small businesses, there's a natural attrition from small businesses just going out of business, which hurts your overall retention.
In all businesses and all recurring businesses, there is a trade-off between total addressable market and cost of distribution with net retention.
Since almost nobody in these vertical markets looks at new software every year, it is critical that your retention is high to build a great business.
In all businesses and all recurring businesses, there is a trade-off between total addressable market and cost of distribution with net retention.
In more limited TAM scenarios, you want net retention higher than 100%. This is your gross retention, plus any expansion that you get from the existing customers.
The question is how you get there. The control point framework correlates highly to gross retention. The more gravity you have, the less likely the customer is going to turn.
Then if you think through this methodical framework of how you go multi-product and cross-promote, you start increasing the expansion and that gets you well over 100% in net retention. You start to see cohorts growing consistently over time, which is the goal of every recurring vertical software founder.
Where do these companies start? How do they grow?
Point solution - Most vertical software companies start as a point solution in an underserved market. They solve a specific problem for a specific group of people. Then, they continue to add features and expand the types of customers they can serve.
These point solutions have the option of expanding vertically or horizontally. Vertically is creating new tools that serve other problems their existing customers are facing. Basically offering more features to the same customer. Horizontally is using the same tools to serve a new set of customers with similar problems.
An example as the owner of scheduling software for dog walking, we could add payroll features for dog walkers (vertical expansion) or take our scheduling software and offer it to landscapers as well (horizontal expansion).
Multi-product - As the vertical software company grows, it will start to offer more features to its customers. This is a little different than the usual advice to focus relentlessly. Here, the idea is that it is better together. One plus one equals five.
One example can be seen in Toast. Most restaurants have a point-of-sale system and a payment provider. These two separate systems have to be reconciled.
Integrating payments and offering both a POS system and a payment provider works better and makes restaurant owners's lives easier.
Toast also benefits because it gets a lot of information on the financial health of the merchant as the consumer.
SMBs don't want a ton of vendors. They just want things to work. If they can buy an operating system out of the box, that is their ideal. Generally, the more you can handle for them, the happier they are.
Once these businesses have real volume, they can go after transactional revenue and make serious money there.
Platform - Once the company gets large enough, it eventually becomes a platform and allows an ecosystem of partners to build products and services on top of what is already offered. They are point solutions for new use cases that often begin the cycle again.
How much should you charge for vertical software?
Pricing is worthy of a much longer post. A quick software pricing shorthand is that you want to charge some fraction of the value you provide. There are very few incremental sales costs in software, so that isn't a large factor to consider.
If you are providing five dollars in value, you can in theory, charge up to five dollars.
Big TAM - If you are taking on a big market, you want to charge on the lower end to get the great compounding flywheel going in the market. If the customers are bigger, then you know you can sell them many more products over time. In the example, you would charge closer to one or two and give them three plus of the five of value.
Small TAM - If it is a smaller TAM, then you can charge a higher amount to extract more of the value provided. Maybe it is closer to $3 or $4 of the $5 value provided.
On-Prem - Older vertical market software businesses have different pricing. These are often on-premise (on-prem), not SaaS, so they are installed and run on computers on the premises of the customer using the software, rather than at a remote facility such as a server farm or cloud like with SaaS.
On-prem's economics tend to be a little different. They are often stickier because the customers are usually required to have the software on the premises for regulatory reasons. Upsells tend to be lower because the customers are more traditional and don't expand as much. The pricing is typically a large upfront fee for the software and an ongoing yearly update, support, and maintenance fee that equals about 20% of the upfront fee.
How long does it take to build these vertical software businesses? Do they grow faster or slower than horizontal?
Because these businesses tend to adopt and change software slower, vertical software businesses generally grow slower than horizontal software.
It helps to have a longer time horizon in this space. Churn is lower, which often means a smaller percentage of the market is up for grabs every year.
The benefit is that the marketing and word of mouth is stronger so once that flywheel gets going it can be more potent than in a horizontal market.
Is Vertical Software winner-take-all?
Vertical software doesn't follow a "winner-takes-all" dynamic to the same extent as horizontal software.
Companies serve different niches and fulfill different needs. Different industries have different needs, and even within the same industry, businesses can have varied requirements. There are not significant enough network effects to justify a dominant winner.
Even if one new software is clearly better, customers develop a strong loyalty to a particular software provider due to the specialized support and customization offered. Switching costs are high, not just in monetary terms, but also in terms of time and effort needed to adapt to a new system.
Even within the same market with similar customers, companies have different strengths and end up sharing the market.
In vertical software, almost everyone is playing with the same playbook. What differentiates companies are execution, vision, culture, and strategy.
Exceptional execution in a small bootstrapped company can beat out well-funded large VC-backed players.
How saturated is Vertical Software? Are there opportunities left?
Vertical market software is definitely more saturated than it was in the past. But there are still many markets that are either underserved or not served at all by software.
Many markets are served by ancient desktop productivity software that hasn't been updated in 20 years.
The big end markets like restaurants (Toast) or online stores (Shopify) have software well-built for them. But even in big verticals, there are sub-problems and pockets of opportunity if you dig in. The vertical software market has only grown larger as technology has been adopted in previously sleepy industries.
You could look at a NAICS (North American Industry Classification System) codes for market ideas. This is a system used to classify businesses based on industry in the US.
How do you value Vertical Software businesses?
The valuation of vertical software companies can vary widely. Many of the qualities around the business can quantified to give you a rough estimate.
The "Rule of 40" is a heuristic some investors and analysts use in the software-as-a-service (SaaS) industry to evaluate the health and performance of companies. The idea is to balance growth and profitability, which can be particularly important for software companies where high growth often comes at the expense of current profitability.
The Rule of 40 states that for a healthy SaaS company, the sum of its growth rate and its profit margin should be equal to or exceed 40%.
Formula:
Growth Rate (%) + Profit Margin (%) ≥ 40%
Where:
- Growth Rate typically refers to the year-over-year revenue growth rate.
- Profit margin can be defined in different ways, but it often refers to EBITDA margin, operating margin, or free cash flow margin.
Example:
- If a company is growing at 30% year-over-year, and its profit margin is 10%, then the sum is 40%, which meets the rule.
- If another company is growing at 50% but has a negative profit margin of -20%, the sum is 30%. This doesn't meet the rule, and it indicates that while the company is growing quickly, it's losing a lot of money in the process.
It's important to note that the Rule of 40 is a general guideline, not a strict criterion. There are many successful SaaS companies that don't meet this rule, especially in their early stages. The rule can be particularly useful for more mature SaaS companies or those in competitive markets where achieving both growth and profitability can be challenging.
Exit multiples vary widely. You can check out public companies to get an idea of where they are at today. Generally, public vertical software companies are trading at 6-12x revenue multiples.
Small private companies are quite a bit lower. Sub-$5m in ARR, you generally see 1-4x ARR, with most falling between 2-3x for decent companies. As you get bigger like $10m+ ARR you see them getting closer to 4-8x ARR.