Vertical SAAS Companies Are Becoming the Ubers of Software

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When you think about it, it was only natural that the first wave of SaaS and cloud companies went about their businesses in a horizontal way.

After all, they were making a run at disrupting the enterprise tech giants of the 1990s — Cisco, Microsoft, Oracle, SAP. The big legacy companies were all automators for horizontal business processes (think finance or HR) or core infrastructure (routing or databases). With the SaaS-ification of enterprise software, it followed logically that the SaaS and cloud pioneers would also be purely horizontal – simply moving the work from on-premise to hosted multi-tenant (like Workday for HR and financials or Salesforce for CRM).

But a funny thing seems to have happened on the way to building horizontal SaaS companies.  As venture capitalist Marc Andreessen has pointed out, cloud software didn’t just decide to eat on-premise software, it decided to “eat the world.”  And it turns out that the business world has many more “vertical” problems than “horizontal” problems.

Let’s define what we mean by vertical SaaS. Vertical SaaS refers to building a software platform, often enhanced by vertical data, to dramatically transform an industry or collection of industries. Guidewire (valued at $3 billion) transforms the insurance industry. Veeva (valued at $3.5 billion) transforms the pharmaceutical industry. Opower (valued at $500 million) transforms the utility industry. And Palantir ($10 billion +) applies data science and software to transform government. These companies don’t get the buzz of Salesforce, ServiceNow, LinkedIn or NetSuite (or even Slack). But they represent the true cases of “software eating the world.”

Data is the differentiator for many vertical SaaS businesses.  Because they don’t need to serve wildly different customers, they can invest in accumulating data that creates a disproportionate competitive advantage (some have taken advantage of this and some haven’t yet). Palantir can build a database of threats. Demandware has the opportunity to build a deep understanding of inventory across its customers. The data assets, when coupled with intelligent software, can do a lot more than automate a business process – they can transform industries.

The vertical SaaS businesses might just be better businesses than the pure horizontal ones. If we look at recent trading metrics, the median public horizontal SaaS company is expected to grow 28% in 2016 and have 2% EBITDA margins in 2015. The median vertical SaaS business is expected to grow 22% in 2016 and have 17% EBITDA margins in 2015.  Does it really make sense to trade an 8x difference in profitability for a 27% increase in growth rate?

Of course the root cause for the difference in performance here is the efficiency of sales and marketing. The payback periods on sales and marketing for a horizontal SaaS company are about 28% worse. That makes sense because the incremental sales and marketing cost-to-sell in an industry where “everyone knows each other” is significantly lower than in cases where customers are wildly different from each other.

Which brings us to Uber and a clue as to where SaaS is headed. A lot of what we could see from the vertical SaaS companies is being foreshadowed by next-generation, industry-specific consumer platforms.

In the 1990s, consumer software had a horizontal orientation. There was Microsoft’s desktop software and Adobe’s tools for creative endeavors. The first generation of cloud-based software applications for the consumer (like Google for search or Facebook for social networks) have taken broad consumer use cases and turned them into valuable software companies.

The more recent crop of consumer Internet companies have been fundamentally vertical – they have taken a specific industry and used software + data + integration with the real world to build highly valuable businesses worth tens of billions of dollars. Uber’s core differentiators include its easy-to-use software, its database of consumers and their locations, and its integration with fleets of vehicles in real time. Airbnb applies the same logic to house-sharing. Several others attack healthcare or groceries. Why couldn’t the next (and current wave) of vertical software businesses do the same?

The knock on most vertical software businesses has been total addressable market (TAM).  Conventional wisdom suggests that the TAM for a vertically-oriented business must be smaller than that of a horizontal business since you are fundamentally selling to fewer people.  But that’s not thinking outside the box.  Because vertically-oriented businesses can go deeper into their target vertical than horizontal ones can, they end up not just picking up a lightweight business process and automating it, but rather solving much deeper and more significant problems for their target industries. This enables them to command significantly higher prices (which increases the TAM).

More profoundly, the addressable market for the best vertically-oriented businesses is not just the size of the current software market in that industry, it can be the size of the industry as a whole!  Just as Uber’s TAM is not just how much consumers previously spent on taxis, it may be the size of the transportation industry as a whole.  And when we look at those numbers, the TAM for vertical software-as-a-service is very, very large. Consider B-to-B businesses that serve industries like food distribution, for instance.  Sysco alone does $45 billion in revenue.

Attacking large B-to-B markets with software has the potential to create companies that are larger than Salesforce is today. In fact, the set of public SaaS companies that serve vertical markets have only scratched the surface of the possible. We are not far from a world when technology is not a subset of the economy; it is the economy.

Image from Vertical by vonderauvisuals licensed under CC by 2.0

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