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June 21, 2016

Written by Nic Poulos

Vertical SaaS has become a hot topic of conversation in the tech, startup and venture capital world over the two years. Big IPO stories like Guidewire, Opentable, Fleetmatics, Textura and (probably most notably) Veeva Systems have helped fuel the fire, as have the increasingly large pools of capital attracted by startups like Kenandy, Procore, Mindbody, CareCloud, and Doximity. Here at Bowery, vertical SaaS has become one of our most prominent investment themes. As we outlined in our presentation on Opportunities In Vertical Software, we believe a large number of industries are still overly reliant on legacy technology, personnel and services, and have yet to adopt (or have access to) next-gen cloud solutions.

But what really is vertical SaaS? The name itself is borrowed from the microeconomic concept of vertical integration. Visualize a chart where the Y axis represents a company’s supply chain (from gathering base materials to the customer point-of-sale), and the X axis represents every potential customer type in the market. By horizontally integrating, a company stick to whatever it does best (e.g. manufacturing, distribution, or sales) and aim to get as many customers as possible (grow along the X-axis). By vertically integrating, a company would look to own more of the process, but stay focused on a particular customer type (grow along the Y-axis). In this vein, vertical SaaS companies aim to stay focused on customers in one industry, but provide them with more, better-tailored solutions to establish market share. Often, this means that the overall total addressable market is smaller for vertical vs. horizontal companies. Because the target customer base of a vertical SaaS startup is more homogenous, however, they can sometimes achieve faster growth (as buyers look to stay competitive and mirror their industry peers through “copycat buying”) and higher overall market penetration (as there is usually less competition). Finally, in the early software world, founders looked to build widely-applicable (horizontal) solutions that would have huge markets; as a result, many big but industry-specific pain points remain unmet by modern technology like SaaS.

So now we understand what vertical SaaS is. But that still doesn’t tell us what the real differences are between a vertical SaaS company and a horizontal one in the real world. To get to that answer, I pulled a range of operating and financial data for 50 public SaaS companies, dividing them up between horizontal (33) and vertical (17). I then analyzed the difference between key data points for the “average” vertical SaaS company vs. the “average” horizontal SaaS company. Below, I’ll walk through the major differences around Ops, Revenue, Profitability (EBITDA) and Other (age and geography) metrics. See the above table to follow along:

Ops: The average public vertical SaaS company has 2.2k employees, ~500 more than the horizontal group. Both buckets, however, orbit around $1.6MM in Enterprise Value (EV) per employee, suggesting that both require a similar amount of man-hours to generate a dollar in top-line. The vertical SaaS group has an average EV $1.3B lower, but amedian EV $1.3B higher than the horizontals. This speaks to the fact that while verticals are generally smaller, they group consistently in the $1-3B EV range, whereas horizontals much more wildly (in part due to the fact that there are just fewer vertical SaaS players altogether). Most interestingly, SG&A spend as a percentage of revenue is, on average, 35% lower for verticals than horizontals. The effect doesn’t diminish if we weight the mean by EV (accounting for the reasonable possibility that SG&A margin increases with company size). Faster average revenue growth amongst horizontals partially explain their need for more sales & marketing resources. But even high-growth vertical SaaS players like Veeva and DealerTrack have maintained low SG&A margins in the 20-30% range, potentially speaking to the “copycat buying” advantage vertical plays can take advantage of.

Revenue: On average, vertical SaaS revenues are a bit higher but bit slower-growing than horizontal peers. More interestingly, though, vertical SaaS companies trade at a median EV / LTM Revenue multiple 1.5x lower than the horizontal group. While overall SaaS multiples have come down from 2014 peaks, only 2 vertical SaaS companies trade at >10x revenue (Veeva & Demandware), versus 11 horizontal high-flyers. This could either be a reflection of a perception of limited upside due to limited market sizes in vertical, or simply due to the younger nature of next-gen vertical SaaS models, from which we’ve seen few IPOs yet. No vertical company is within 50 points of FireEye’s astounding 130% YoY revenue growth, and 5 other horizontals top Veeva, the vertical SaaS revenue growth leader.

Profitability: Simply put, public vertical SaaS companies are more profitable than horizontal peers, by an average of 30 points on an EBITDA margin basis. Most vertical players are making money, while most horizontals are losing money. Again, part of the explanation is that there are many more horizontals who are newly public and high-growth. I would venture, however, that vertical SaaS startups have the opportunity to be more capital-efficient given the more homogenous nature of their target client base. Veeva, the perennial outlier, holds a margin of ~22%, for example (Ran Ding of Norwest wrote a great piece diving deeper into vertical SaaS efficiency here). Horizontal plays pursuing a broader, higher-volume customer acquisition strategy often require larger sales & marketing spend, contributing to big negative margins; prime examples are Box and Zendesk, both in the (50-60%) EBITDA margin range. Rocket ships, no doubt, but also cash bonfires.

Other: Finally, I took a look at two less financially oriented data points: age since founding and HQ location. Given the recent press hype around vertical SaaS, it might surprise you that amongst public companies, verticals are on average 6 years older than horizontals. Most of the “newer class” of vertical SaaS plays are still private, and manyare just now emerging. Well over half of the current public vertical SaaS companies were founded before 2000, which likely also helps explain overall lower revenue growth, higher margins and lower multiples. In terms of geography, the proving ground of horizontal SaaS companies that made it to IPO is clear: ~60% were founded in the Bay Area or close by. Only about a quarter of Vertical SaaS companies, however, call California home. 15% of verticals are East Coast-based, while over 60% hail from areas not traditionally known for their startup ecosystems (including one from Ireland and one from New Zealand). Of course, the sample size is smaller. But by my logic, successful vertical SaaS startups are likely to be founded by industry experts & veterans who could be stationed anywhere (another top vertical investor, Gordon Ritter of Emergence Capital, elaborates on that thought here). Horizontal plays are often founded by generalist technologists who are likely already in or around Silicon Valley.

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