Vertical Market Software is the Best Opportunity in Tech
Why are Vertical Market Software Companies (VMSCo’s) so interesting? It’s a good question. Most people have never heard of them. Even people who work in the software industry often struggle to rhyme off more than a few. VMSCO’s are usually relatively small (less than 100 employees) and the vast majority are privately held. So why bother writing about them at all. Well, aside from the fact that I spent the past decade working in (or with) hundreds of VMSCo’s and hence I have a specific interest in them, I believe that VMSCo’s are a tremendous opportunity for investors and entrepreneurs alike.
A Huge Untapped Market
The sheer number of VMSCo’s out there (tens of thousands!) and the relative size of the global VMSCo market (over $100B in annual sales according to Gartner) warrants some attention. Not to mention, VMSCo’s can participate in extremely favourable market dynamics including: fewer competitors, ‘sticky’ software with relatively high switching costs (versus Horizontal Market Software Companies - HMSCo’s) and stable recurring revenue streams. The size and privacy of businesses in vertical software markets mean that VMSCo’s can be hard to find, but that also means there are fewer potential investors at the table and hence opportunities for more conservative valuations.
A quick scan of the public markets for ‘software companies’ reveals that there are a few thousand listed, but very few are VMSCo’s. So how can this market be worth over $100B in annual sales? There are tens of thousands of small, private VMSCo’s in niche markets around the world. You’re unlikely to find them in the news, they have virtually zero brand recognition (outside of their respective market) and you’ll rarely hear of a big Private Equity investment in a VMSCo. Scanning sites like TechCrunch doesn’t help much either, as few VMSCo’s have raised venture capital. You likely haven’t heard of these businesses at all because they operate in segments of unsexy niche markets like waste disposal, public transit, cemeteries, agriculture, tool rental and metal recycling, to name a few. If you work in a vertical market you’ve likely only heard of the VMSCo’s that operate within that market.
Constellation Software Inc., a Toronto-based publicly traded acquirer of VMSCo’s, claims that there are more than 25,000 VMSCo’s globally. If Gartner is correct and VMSCo’s represent over $100B in annual sales, then the average VMSCo has approximately $4M in annual sales. This number feels about right based on my experience and looking at the more than 200 acquisitions of vertical market software businesses completed by Constellation, the vast majority have been in the $3M to $7M revenue range. The crazy part is just how little Constellation has had to pay for these businesses. Across all of these deals and hundreds of millions of deployed capital, Constellation rarely had to pay more than 1x net recurring revenue. It’s hard not to get a decent return if you can pay just 1x net recurring revenue for a business with a stable recurring revenue stream. Even if the acquired business has marginal revenue growth, if attrition is low and costs can be managed, it only takes a couple of years before investors see a nice return.
Not all VMSCo’s have stable recurring revenue streams and Constellation is extremely selective. However, keep in mind that they are selecting from a huge pool of potential businesses (over 25,000) to acquire. There also aren’t that many bidders for businesses with less than $10M in revenue, especially in the niche non-sexy markets within which most VMSCo’s operate. That being said, as the dynamics of vertical market software companies become better understood by investors (and entrepreneurs), the competition to invest in these businesses will likely increase and those ‘1x net recurring revenue’ opportunities will become increasingly difficult to find.
Grow Your Own
The perception that the total addressable market (TAM) for VMSCo’s is very small has probably been the primary reason that so few investors or entrepreneurs are interested in these businesses. What I think makes vertical markets so interesting is that many VMSCo’s are actually able to significantly grow their TAM by expanding their offerings deeper into the customer base (i.e. within their vertical). While the number of customers in each vertical generally doesn’t change much, VMSCo’s that address a 'mission critical' problem for their customers are so tightly integrated into the customer’s core business that attrition is extremely low (i.e. less than 3%). With the comfort of knowing it’s difficult for customers to switch software vendors, VMSCo’s can leverage their deep domain knowledge to invest in product add-ons that address virtually all of the problems within their industry - their software truly “eats” the respective vertical market.
The first ‘core’ application built by a VMSCo becomes the single version of the truth for important (i.e. mission critical) business data that can be leveraged in new ‘adjacent’ applications. Just think about how much easier a sale can be when a VMSCo goes back to its customer base and says something like “Here’s our new XYZ application that solves your ABC problem. We understand your business really well and all you have to do is turn it on. No new databases or infrastructure required.” The implementation of the core product (and database) is often so customized and so fundamental to the operation of the customer’s business, that the sheer complexity and duration of the projects scare the customer into not wanting to go through the process ever again. It’s an understandable fear, especially since historically many of the people running businesses in niche vertical markets are not particularly tech savvy themselves and perhaps don’t fully understand the software implementation to begin with. VMSCo’s that sell a truly mission critical product can have extremely low attrition because of the high switching costs faced by their customers.
The degree of a VMSCo’s ‘mission criticality’ falls on a spectrum. Not all VMSCo’s sell highly mission critical software as the work flows and use cases in some businesses are not unique enough to warrant a domain specific solution when any standard ERP package could do. Point of Sale software in the retail world comes to mind. It often doesn’t matter whether you’re selling auto parts, picture frames or soap, you may possess deep domain knowledge and focus on a specific market but fundamentally all of theses businesses are gathering customer information and performing a retail transaction. The software required to run the business does not have to solve a problem with unique (or complex) business rules. In general, this also usually means that it would be relatively easy to change software vendors, as switching costs are low. It probably only took a few weeks to deploy the system initially and there’s almost certainly a competing POS system available that can easily import your existing data and get you up and running quickly. Typically, these are low cost solutions (i.e. less than $10k per year) with no custom development or 3rd party integrations. When all or part of a software application could be replaced by a horizontal solution, the VMSCO’s software is almost certainly of lower mission criticality and hence the vendor will probably have higher attrition as a result of the lower switching costs. For obvious reasons, the higher the degree of mission criticality, the more interesting the VMSCo should be to potential investors.
Another interesting aspect of vertical software markets is that there is so little competition. In many ‘verticals’ there are only a few (say, 3 or 4) major vendors that combine for 80%+ share of the market. With so few options, customers in these markets are often forced to accept products that are vastly inferior to consumer grade software. This aspect of VMSCo’s is particularly apparent in the UI/UX of their products. There is simply not much reason for VMSCo’s to invest as much in UI/UX innovation when they know that with ‘good enough’ they can still keep attrition low and maintain steady recurring revenue streams. Incidentally, this is also one of the reasons VMSCo’s can be run with relatively low Research and Development expense; the market dynamics mean that customers can be lulled into expecting a lower pace of innovation.
Founders of VMSCo’s are rarely competing against a well-funded, professionally managed foe. Most market players are bootstrapped family owned businesses with tens, hundreds or very rarely, a few thousand customers. These markets simply aren’t big enough to attract the big HMSCo’s of the world like Microsoft, SAP or Google and so there is less risk of being disrupted or enveloped by a competing product. The domain knowledge required to attract and keep customers in a niche market makes it is hard for large, well capitalized software businesses to compete because they just aren’t focused enough to address the niche use cases.
Opportunities for Entrepreneurs
Entrepreneurs should find the overall dynamics of VMSCo’s of particular interest. While the smaller TAM’s and (in some cases) relatively long sales cycles should be a concern, the opportunity to disrupt vertical markets with new business models and new technology is compelling.
Consumer technology is increasingly influencing the level of tech savvy in vertical markets and in time, buyers are likely to demand more from VMSCo’s. For example, most VMSCo’s are technology laggards themselves and will have trouble responding to competitive pressures from new vendors offering better user experiences in cloud-based hosted, multi-tenant solutions. The pricing of VMSCo software is also an opportunity, as many VMSCo’s ask for a high up-front perpetual license plus an on-going annual maintenance fee equal to 20% of the perpetual license. SaaS is still a relatively new concept in the VMSCo world. While the level of customization required to address vertical market problems is unlikely to go away, entrepreneurs willing to take a fresh look at vertical market challenges will likely find opportunities to offer more innovative solutions at a much lower price.
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