Vertical Markets: A Trillion-Dollar Opportunity

According to a Gartner, vertical-specific software is by far the largest category of the software market posting $100B in sales in 2013 and accounting for 28% of the market. The second biggest category, operating systems, holds only 8% of the market, ahead of database management systems, ERP, middleware and security.

$100B is a surprisingly large number given that customers in many vertical markets are notorious laggards when it comes to adopting technology. Most still rely on paper-based, manual processes and the majority of the $100B software spend is on legacy technology.

Going forward, we believe the total opportunity in vertical markets is far larger than Gartner’s $100B. Replacing manual processes is perhaps an order of magnitude bigger… 10 x $100B is literally a trillion-dollar opportunity!

Consumers Lead the Way (Again)

Inspired by ease-of-use of sites such as Amazon.com and eBay, Salesforce.com kicked off the SaaS industry, and consumers have led the way in other markets ever since. With the proliferation of mobile and cloud technologies, software will penetrate industries that were previously impervious to change.

Consumer Internet companies such as Priceline, Uber, Airbnb, Expedia and Zillow are transforming their vertical markets (travel, hospitality and real estate) and are already valued at $150B.

Software in Disguise

As software eats the world, more and more vertical markets will be transformed. However, the next-generation technology companies may not sell software at all. For example, companies such as Google and Facebook view themselves as software companies but do not make money selling software.

Many next-generation B2B companies that transform their industries may not be software companies in the traditional sense. Instead, they may provide a service, a product or complete solutions such as BPO (business process outsourcing) or DIFM (do-it-for-me) services.

For example, Athena Health ($5B market cap) offers healthcare providers a combination of software and business services that range from eligibility verification to insurance claims submission. The company has been described as an “an excellent illustration of SaaS-enabled BPO.”

Straying even further from software sales, Vesta, whose software helps detect credit card fraud in transactions, decided to sell a fraud loss indemnification solution to its telco customers. Vesta grew for the next 10 years, guaranteeing billions of dollars in transactions for carriers on its way to achieving Inc. Magazine Hall-of-Fame status by making it on the Inc. 500 list five years in a row.

Beyond Silicon Valley

Great vertical market software companies get created wherever there is deep domain expertise. Out of the top 32 publicly traded vertical software/solutions companies valued at more than $1B, only four (12.5%) are based in Silicon Valley. The other 28 companies representing 94% of the market capitalization are headquartered in cities such as Bedford, Charleston, Chicago, Landover, Oleathe and Plano.

Two vertical software companies, valued at more than $11B apiece and virtually unknown in Silicon Valley circles are Verisk Analytics, based in Jersey City, and Constellation Software, based in Toronto.

As we’ve gotten more serious about finding vertically focused companies, we’ve had to travel. During 2014, more than 90% of Altos Ventures’ capital deployed in new investments funded companies based outside of California.

Bootstrapped and Capital Efficient

Another strong pattern we’ve seen in vertical software startups is that the vast majority are bootstrapped and extremely capital efficient. There may be several reasons for this. First, vertical software companies may not require the latest technological breakthroughs. However, they do need deep domain expertise.

The founders of vertical companies tend to have years of experience and frustrations with the problems facing their respective industries. They also know their industries’ key players, many of whom are unknown in Silicon Valley circles. For example, in the construction industry, key players include general contractors, sub-contractors, lenders, suppliers, building and land owners and countless local regulators. In the medical industry, there are totally different sets of players such as patients, doctors, providers, insurance companies and government agencies.

With the proliferation of cloud, mobile and open source software which has dramatically lowered the costs of starting software companies, entrepreneurs who know their markets have the advantage. Those targeting specific verticals can use their knowledge to build targeted solutions without much (if any) VC funding.

The second reason vertically focused companies are more capital efficient is that most are NOT based in Silicon Valley where venture funding is plentiful and the cost of living seems to be getting more expensive every day. While Silicon Valley companies are setting new fundraising records, the rest of the world continues to bootstrap.

The third reason vertical companies are capital efficient is that they tend to spend less on R&D and Sales and Marketing. The savings from R&D comes from a narrow focus which enables vertical companies to deliver a better product at lower cost (often a 2x savings). That said, the biggest savings comes from lower Sales and Marketing costs.

In a study conducted by JEGI, the typical median Sales and Marketing spend was 51% of revenue for a sample of eight public horizontal SaaS companies, compared to 20% of revenue for eight public vertical software companies. It is not uncommon to see vertical software companies achieve rapid growth while spending far less on Sales and Marketing due to highly targeted messaging campaigns. Vertical companies also tend to benefit from word-of-mouth marketing, as news spreads in industries with long, established relationships.

Market Share vs. Penetration

“Time is the friend of the wonderful company, the enemy of the mediocre.”

-Warren Buffett

People can mix up concepts of market share and market penetration. There is a distinction. Market share refers to a company’s share of an existing market, such as the $100B vertical-specific software market. Market penetration refers to the relatively small penetration of the total potential market that has not yet adopted the technology.

When we look to invest in companies, we want to see high growth and market share with low market penetration. Companies that achieve very high market share can exhibit winner-take-all, monopoly-like economics. Companies with low market penetration have long-term growth potential.

One of the key characteristics of the 32 public vertical companies we identified was that most achieved dominant positions in their markets over a long time (average age was 20+ years). Although these companies have high profitability due to high relative market share, many companies still had low market penetration due to the nature of their industries.

The ideal combination is a company with fast growth, high market share and low market penetration. For example, OpenTable dominates the restaurant reservations market. However, after 14 years of rapid growth, the company has less than 15% penetration of restaurant seats in North America.

Another example of a company with high market share and low market penetration is Woowa Brothers, a mobile service for restaurant delivery orders in South Korea. The company has more than 50% market share, poised to become the dominant player in its industry. Yet its market penetration is still only 10% after reaching $1B in transaction volume in record time. The company will have many years of growth ahead, even after surpassing $100M in net revenue while growing 100% this year.

Spectacular Returns

The combination of large markets, extreme capital efficiency and growth potential has resulted in some spectacular returns for investors in vertical software companies. The highest-profile example in the VC industry is Veeva ($3.6B market cap), which raised only $7M in VC funding prior to its IPO.

In the public markets, any investor could have made 10x returns in the last five years by investing in Tyler Technologies ($4.1B market cap) and Ellie Mae ($1.9B market cap). Tyler provides “information management solutions and services for the public sector” and Ellie Mae provides “software solutions and services for the residential mortgage industry.”

Going forward, we expect vertical software/solution companies to provide some of the best risk-adjusted returns for entrepreneurs and investors due to a combination of low cash burn and the potential for spectacular return on capital.

Disclosure: Altos is an investor in Vesta and Woowa Brothers.