What is a Vertical Market Software Company (a.k.a a VMSCo)?
According to Gartner, vertical market software is the largest category of the overall software market with over $100B in sales in 2013 and representing 28% of all software sold that year. This category is a huge chunk of the software market, but what exactly is a “vertical market software” company?
The Wikipedia definition of a Vertical Market is "a market in which vendors offer goods or services to an industry, trade, profession, or other group of customers with specialized needs.” So it follows that a Vertical Market Software Company (VMSCo) aims at addressing the software needs of any given business within a discernible vertical market. This typically means that the VMSCo has developed software that is highly customized for a specific industry and often wraps up all of a single business’s application needs into a single software package (i.e. a software solution).
Vertical vs. Horizontal
In contrast, Horizontal Market Software Companies (HMSCos) sell software that can be useful to a broad range of industries and often deploy software that addresses a single but common need across their customer base. Most vertical markets are too small to be of interest to large horizontal software manufacturers who create software targeted toward hundreds of thousands (or millions) of buyers.
Some well established vertical markets for software include automotive, education, insurance, real estate, religion, retail, agriculture and various areas of government including justice, appraisal and transit. Even a market as specific as municipal transit is served by an array of different and overlapping products, offered by multiple VMSCo's. For example, most municipal transit agencies use a form of workforce management system to schedule and pay staff. Employees are scheduled and paid in many industries ranging from airlines to retail and so some might say this is a type of horizontal software. The reason municipal transit workforce management software is considered ‘vertical’ is because of the highly specialized needs of a transit agency related to specific union rules, schedule types, buses, trains, seasons, etc. General-purpose workforce management software often cannot capture the required use cases of a transit agency, without extreme customization.
What about a management system for say, doctor’s offices or lawyer’s offices; one might think the software systems for these two industries would have much in common. They both have a roster of client files, billing, document management, etc. In fact, from a software perspective, they actually have very little in common. At the very lowest level, management systems for these industries might share some basic technology components such as menus and security, but the users of these applications would require almost entirely different workflows, data types, reports, algorithms, etc. In order to be successful with a new management system, a doctor's office (or law office) would require training and support from someone with deep understanding of the challenges they face and the industry standards to which they must adhere. This need for VMSCo’s to have deep domain knowledge is actually fundamental to successfully serving a vertical market.
Many VMSCo’s are smaller (ultra nano-cap) privately held businesses that operate in any one of 100’s of vertical markets. However there are several large public VMSCo’s that are made up of many smaller vertical software businesses, each targeting specific industries. For example, Constellation Software Inc. (TSE:CSU) is made up of VMSCo’s selling domain specific software to a wide range of vertical markets, including: agriculture, public transit, insurance, auto dealers, golf courses and many more. While Tyler Technologies (NYSE:TYL) has VMSCo’s selling into public sector industries such as higher education, municipal government and justice.
Horizontal Market Software Companies on the other hand are much more widely recognizable as they are often larger (i.e. because they have a much larger target market) and they market themselves to a much broader audience. For example, Salesforce and Microsoft could be considered HMSCo’s, as they both sell software that solves common problems, found in many industries. Generally speaking, HMSCo’s like Salesforce and Microsoft have a single version of their applications that they do not customize for market-specific use cases. Instead, they would typically attempt to configure parameters to meet the needs of their respective users. Whereas Tyler or Constellation would approach a municipal government customer with software that has been customized specifically for municipal government, companies like Salesforce or Microsoft would approach a municipal government customer with the same software they had sold to many other markets. This distinction is evident in the relative size of each company’s customer base; while Tyler and Constellation run businesses that have hundreds, or sometimes thousands of customers, Salesforce has over 150,000 customers and Microsoft has millions of customers.
Characteristics of Vertical Market Software Companies
Categorization of a software company as either vertical or horizontal is not always clear cut however, it can have a profound impact on the understanding of the economics of the business, its value, and both the operational and strategic opportunities that lay ahead. I’ll discuss the economics of VMSCo’s and their value in a future post, but for now, here are some of the typical characteristics that one should think about in determining if a software business is a VMSCo.
Product or Company name is often “Industry Name Management System"
Founders possess deep domain expertise; have worked in the industry for many years and know the customers and competitors very well.
Rarely attracts venture capital early on (too small); typically bootstrapped by two (or a few) founders putting their life savings on the line.
First few customers pay for the vendor’s learning mistakes; early versions are sometimes 100% custom but the learning curve helps a few VMSCo’s become dominant within the vertical.
100’s of customers; maybe 1000’s or maybe <100 but rarely more than 10,000; it is difficult to have more than 10,000 customers without including adjacent use cases and a level of standardization that makes the software less domain specific.
Relatively small market size means VMSCo’s can have a ‘named’ list of target customers and manage personal relationships with each; much of the sales effort is spent on ‘back-to-base’ sales to existing customers.
Low spend (relative to HMSCo’s) on Marketing due to their narrow focus and relatively ‘fixed’ market size.
Target markets often grow in line with CPI.
Customers are often technology laggards; they may have IT staff but technology is not their core business and the managers and users usually do not have deep technical experience.
Vertical market software is readily identifiable by the application specific graphical user interface that defines it. VMSCo’s rarely invest heavily in UI/UX as the focus is on meeting core functional requirements (i.e. it can be very ugly). Customers typically do not seek consumer level UI/UX.
Software requires a significant level of effort by Professional Services teams to deploy (i.e. configuration, training); these are often non-commoditized services that require specific domain expertise.
Highly centralized data. VMSCo’s usually deploy an initial ‘core’ software application followed by add-ons that all run on the same database.
Some VMSCo’s also have the follow characteristics:
Deployments may require a high level of customization and/or configuration; R&D often has to get involved to get the software ready. Note that there are also instances of VMSCo's selling more packaged products highly tailored to a specific industry.
‘Sticky’; relatively low attrition (<5% for on-premise installations and <12% for hosted).
Sales cycles of 6 months or more; often require RFP responses and multiple on-site sales visits. Note that there are also VMSCo's with shorter sales cycles, particularly for lower price point offerings.
Implementation cycles of 6 months or more; degree of customization and integration with other (often physical) systems results in protracted deployments. Note that this is not always the case as there are many VMSCo's out there offering prepackaged products for niche markets (usually at a low price point).
Legacy technology; overall stickiness makes replacement a costly endeavour.
Mission critical; the software is essential to the customer’s business operations.
VMSCo’s are particularly interesting because there are tremendous opportunities for entrepreneurs and investors in this segment of the software world. Since the majority of the $100B software spend is on legacy software, many of these ‘verticals’ are ripe for disruption. For investors and professional operators, there are tens of thousands of VMSCo’s out there to be acquired and made to run more efficiently by taking advantage of the unique characteristics of VMS businesses.
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