How to Find Great Vertical Market Software Investment Opportunities
September 30, 2016
Suppose you’re looking to invest in or outright acquire a Vertical Market Software Company (VMSCo), where do you begin? How does one go about finding VMSCo investment opportunities? Sourcing VMSCo investments is a relatively little known topic compared to more traditional private equity investment deal sourcing. A quick Google search reveals hundreds of articles on the best practices of private equity funds for originating investments however, almost all of these articles are focused on finding high growth, early stage businesses. There is very little information on the best practices for sourcing great VMSCo investments. As I discussed in my previous post, I believe the main reason for this is because many in the investment community haven’t yet realized just how much of an untapped opportunity the VMSCo market represents.
As more investors look at the VMSCo market, proprietary deal origination will become increasingly important in order to succeed in the space. The reality is that just like private equity investments in startups or growth stage companies, only a very small percentage of the VMSCo’s targeted will ultimately result in a transaction and so in order to be successful, the investor must find as many potential targets as possible.
Hard to Find
It’s not easy to find VMSCo investment opportunities. By their very nature VMSCo’s are in niche markets, relatively small (usually less than $15M in revenue) and only market themselves within their domain. Unlike early stage businesses looking for venture investment, VMSCo’s rarely proactively look for investors and they probably don’t have a pitch deck. In fact the best VMSCo’s are likely to be quietly operating their company in virtual anonymity, enjoying modest but steady revenue growth in a not particularly competitive environment. As such, effective VMSCo deal sourcing requires creativity, discipline, strong relationship building and adequate domain knowledge of the vertical market in which the target company operates.
First let’s look at the industries where great VMSCo investments can be found. In a previous post I described the characteristics of VMSCo’s and their industries in detail, but I will provide a bit more context here, as any investor would need basic industry knowledge in order to source efficiently within a given vertical. Perhaps even more importantly, investors looking to acquire VMSCo’s will require domain knowledge of the target industry in order to establish themselves as a credible owner/operator of the target business. It could also be argued that specialization in one market (or just a few markets) can be a point of differentiation for investors. Such focus can help deal originators develop a greater understanding of the target vertical thereby enabling them to perform more meaningful diligence and better understand the value of the target business. Finally, research into the industries within which VMSCo’s operate may translate into an investment thesis; for example, segmenting a particular industry can help investors identify ‘platform’ buys and/or roll-up opportunities that could build value within a particular vertical.
Here’s a recap of some of the characteristics of industries where great VMSCo investment opportunities may be found:
Overall industry growth isn’t significantly greater than CPI growth in the respective geography.
Customers within the industry are often technology laggards and technology itself is not a core competency of industry players; customers may have IT staff but managers and end users rarely have deep technical expertise.
Software may be used to automate a mission critical aspect of an industry specific operational activity.
From a software perspective, only a few major vendors (say, 3 or 4) combine for 80%+ share of the market.
There are fewer than 10,000 potential customers within the target industry/geography and usually only a few hundred.
Growth in the industry does not depend on social progress (think gas station management software, not electric car charging software).
There are hundreds of industries within which VMSCo’s operate but here’s a short sample list of industries that fit many of the characteristics listed above. Perhaps in a future post I’ll provide a more exhaustive list.
Municipal Snow Removal
While there are many such industries that generally fit these characteristics, the key to finding great VMSCo investments is identifying VMSCo’s that sell truly ‘sticky’ software within these industries; a topic that I’ve discussed in previous posts and will continue to expand on.
Knowing which industries to look at is a great start, but how does one find the actual named target VMSCo’s? Let’s look at the public markets first because if you’re looking to invest in VMSCo’s in the public markets, the search is much easier compared to finding private VMSCo’s. Unfortunately there are also far fewer publicly traded VMSCo’s.
Hidden in Public
Not surprisingly, most public VMSCo’s are on nanocap or ‘venture’ exchanges, simply because of their relative size. That being said, there are some great public VMSCo investment opportunities out there because of how little attention these businesses get. Running a basic stock screen on the NASDAQ Nanocap or the TSX Venture Exchange will reveal a number of interesting businesses and usually the challenge is digging through the annual reports of public VMSCo’s to find the pertinent valuation information (hint: most small public VMSCo’s don’t even mention annual recurring revenue in their reports; also note that the Frankfurt stock exchange lists some interesting, albeit considerably larger VMSCo’s). The other challenge is the lack of liquidity of these stocks, which ironically is a big reason why one can find such great investment opportunities in the first place. Most public VMSCo stocks don’t receive any analyst coverage and the only people trading them are employees, friends, family and early investors. Over time, if you're tracking enough public VMSCo’s it is not uncommon to find businesses trading at 1-2x annual recurring revenue. Perhaps in a future post I’ll review some of the nano-cap VMSCo’s that I track.
Big public VMSCo’s are the easiest to find because any filter on ‘software’ or ‘technology’ on a large public exchange will result in a relatively short list of targets to sift through. I won’t go into much detail on big public VMSCo’s here because frankly they are so well known that I don’t think there is anything particularly unique about them as an investment opportunity. Examples would include - NYSE:TYL, TSE:CSU, NYSE:GWRE, NYSEMKT:MJCO, TSE:ENGH, etc. etc.
In general, public VMSCo’s are less interesting to me because only the outright acquisition of a VMSCo enables the investor to fully realize the value of this type of business. In future posts I’ll discuss vertical market software operating best practices and restructuring in detail.
The Exciting Part
Investors looking to acquire privately held VMSCo’s need to do a lot of digging but I would suggest that the effort is well worth it. There are tens of thousands of private VMSCo’s and this is where the really exciting investment opportunities may be found.
These are not they types of companies that are founded with venture money where the founder moved to a technology hub, joined an accelerator and socialized with well known investors. VMSCo’s won’t likely be found in Boston, New York or San Francisco. These are founders that started organically, in a very cost effective location, close to their customers. In North America, think of cities like Cedar Rapids, Boise, Tampa, Calgary, Dayton, Omaha or Ft. Worth. It’s far easier to identify entrepreneurial ideas in markets where you have expertise and so the majority of VMSCo founders have worked in their respective verticals, often for many years. The bootstrapped origins of most VMSCo’s, as well as their distance from financial markets, also means that they are rarely found through intermediaries, as few brokerages or search firms have heard of them.
Investors must be extremely creative in tracking these businesses down. Sourcing VMSCo’s is both science and art, and certainly a broader topic for a future post. However, here are a few of the primary sources for finding VMSCo targets:
Industry technology conferences (exhibitor and attendee lists)
Software review sites (i.e. Capterra)
Word of mouth (i.e. competitors)
Google searches (often several pages deep)
Programmatic web crawls (an ongoing project of mine)
Annual reports (see ‘carve outs’ below)
Note that deal sourcing by word of mouth through other VMSCo investors isn’t in the list. Unlike in venture capital markets, co-investing isn’t common practice in the VMSCo space yet. This is because there aren’t (yet) very many investors targeting VMSCo’s, investors often want to outright acquire and operate the target company, and the deal sizes are often small (average VMSCo is $4-6M revenue).
Relationship. Relationship. Relationship.
Developing professional relationships is the best way to drive the majority of VMSCo deal flow once the target has been identified (which is often half the battle). Compared to the owners of larger horizontal market software companies (HMSCo’s), owners of VMSCo’s typically have fewer potential buyers and in addition to the financial terms of the transaction, finding a ‘soft’ landing place for their employees and customers is usually a key motivator. VMSCo entrepreneurs commonly develop deep relationships with their customers and staff, having relied upon them to fuel early growth. Many VMSCo’s also employ family and friends of founders. All of this points to how important establishing trust is when dealing with a VMSCo owner.
Purchasing a VMSCo is truly a relationship ‘sale’ and the strength of the relationship can have many benefits including, the ability: to perform more meaningful diligence on the business, to gain a better understanding of what can be done with the business operationally post-close and to help steer the negotiation away from a purely financial discussion. Some VMSCo owners will socialize their business with potential acquirers over the course of many years and as an investor it is important to be a known, well trusted option when an owner decides they want a liquidity event.
The other important aspect of nurturing strong relationships with VMSCo owners is that such relationships increase the likelihood of a sole sourced transaction. ‘Sole sourced’ is a great thing for investors because more bidders almost always increases valuations. Transactions with fewer buyers and private information (i.e. privately held VMSCo’s) usually results in better returns for the investor as the buyer is better able to tailor the pricing and terms of the deal. This is just one of the reasons why deals sourced through brokers are generally bad (I’ll list the many other reasons in a future post).
‘Carve outs’ are such a great VMSCo investment opportunity that they’re probably worthy of an entire blog post. These can be incredibly profitable investments. In the context of VMSCo’s, ‘carve outs’ are deals where the vendor is usually a large corporate entity that owns the VMSCo, typically as a somewhat independent subsidiary. When a corporation decides that the VMSCo assets are no longer part of the overall corporate strategic direction, they may choose to divest these assets, sometimes hastily. For example, think of a huge corporation like Boeing that over the course of several large acquisitions may have inherited a small ($5M revenue) software subsidiary that sells metal recycling management software. A business this size is essentially a rounding error for Boeing and it could be seen as a distraction to Boeing’s core business. The savvy VMSCo investor that finds this Boeing subsidiary may be able to acquire the assets at a tremendous valuation, especially if it is the investor themselves who can convince Boeing that the VMSCo asset is not strategically important (i.e. ‘sole source’). While trying to source these deals can seem like finding the proverbial needle in a haystack, I’ve seen investors strike gold with this approach, acquiring long-term predictable revenue streams for virtually nothing.
Acquiring private VMSCo’s can be a lengthy process because they’re very hard to find and success requires developing and nurturing relationships with owners. From initial contact to close, it can take many years to get a deal done which is why it is important to be continuously nurturing a large number of VMSCo’s. It’s hard to predict exactly what will trigger the sale of a VMSCo, but here are a few of the typical reasons a VMSCo changes hands:
Owner seeks one-time liquidity event (i.e. kids going to college, new home purchase, etc.)
Owner wants to retire
Market downturn; owner wants exit because of poor market outlook
Change in market dynamics (i.e. regulatory changes, new competitors or existing competitors with new business models)
The 3 ‘D’s - divorce, disease, death
As I mentioned, creating a list of target VMSCo’s by industry is just half the battle. Once you’ve found them, what do you do next? How to contact VMSCo owners, establish relationships and nurture those relationships into real investment opportunities is a topic for a future post.
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