An Era for Vertical Software

Why Vertical Software is poised to win over the next decade

Venture Capital in 2024

The last 18 months have been sobering for much of the venture capital ecosystem. The percentage of VC firms actively investing declined by 38% in 2023, per Pitchbook. This drop in deal activity reflects GPs intentionally decelerating investment pace as they shift back to traditional fund cycles while doing their best to avoid going to market in a historically challenging fundraising environment. 

However, investment mentalities adopted in the peak cycle of 2019-2022 remain entrenched in our industry. Newer funds and certain aggressive established managers have raised capital on early-stage fund models unsustainable in any other historical period save 1998-2001. Amongst the things starting to look irrational to us: complete reliance on “decacorn” outcomes, reserves models that aim to “buy up” substantially from sub-5% entry ownership in their hottest deals, mass incubation strategies, bets that one sector will generate sufficient venture-scale exits across every economic cycle, and generalist seed funds without substantial brand power.

2024 will represent a turning point, perhaps even a new era for venture capital. While the fog feels like it’s lifting, the path forward isn’t yet clear. One includes a soft landing for the US economy and the continuing recovery of software multiples, with ZIRP-era behaviors continuing around hot themes. Another sees a recessionary period in which VC capital inflows remain stagnant and startup funding the year dips below $100B. Either way, a more measured VC market in 2024 is a certainty. For many GPs, that will come with a rude awakening as their strategy becomes more difficult to execute or their thesis of choice is negatively impacted by tightening markets. 

An Era for Vertical Software

We see this reversion of the venture ecosystem to its mean as a strong tailwind for Euclid–not only because of our experience and high-conviction fund model but also because of our thesis. As a category, Vertical SaaS is uniquely well suited to thrive in volatile market conditions and produce fund-returning outcomes. Procore, Mindbody, GuideWire, FleetCor, and BlackLine, for example, were all founded within a year of the Dot Com crash and went on to successful IPOs. Even older vertical software companies have shown tremendous resilience, from Yardi and RealPage, to AthenaHealth and Medidata (all founded in the 80’s and 90’s).

The sections below aim to answer the question: why is vertical software different? Our answer discusses the factors driving the natural market resilience we see in vertical software as a category–resilience that will help them thrive in 2024 and beyond. It also serves as a summary of the unique considerations that go into building a category-leading vSaaS business–our understanding of which is central to our focus on backing the best founders in our thesis. 

The Discipline of Vertical Software

1. Teams

The best founding teams for an industry-specific SaaS solution understand stakeholder workflows first-hand–not only their day-to-day but also what it takes to drive lasting behavior change. This experience can come from working at a vertical software startup or from direct industry operating experience. Especially in the latter case, they are more likely to locate near industry hubs, which are less frequently coastal (e.g., a software business selling into hospital systems is more likely to be based in Nashville). At the earliest stages, this means different geographies, networks, and parameters that must be baked into sourcing strategy to ensure you’re seeing the best.

Hiring outside the management team is often a very different exercise for vertical startups. Let’s take the example of salespeople. Sometimes, the product use cases and terminology are general enough to poach best-in-breed reps from other SaaS companies. However, the best vertical SaaS salespeople often have a background in the industry. For example, many of Toast’s best account executives are former chefs or food distribution reps. In the case of our portfolio company, MachineryPartner, a baseline understanding of construction equipment is a huge bonus when interfacing with OEMs and construction companies. 

Team profile isn’t necessarily a contributor to vertical SaaS resilience. It does, however, speak to why the pipeline of strong founders solving vertical problems is so consistent–it is inherently less correlated with tech downturns and Silicon Valley trends.

2. Market Opportunity

In many ways, the market opportunities vertical SaaS businesses stand to capture are why we have such conviction in Euclid’s thesis. Today, roughly half of the sub-sectors composing GDP are without category-specific software. Equally important, most preseed GPs are unused to underwriting such markets. Investors rarely have personal experience in these sectors (think SaaS for auto shops, medical coders, or food distributors). As many verticals are greenfield from a tech perspective, they don’t rhyme with past big VC wins in a way that trips investor pattern-matching.

Many of the most interesting vertical opportunities arise in markets that, at first blush, most GPs would dismiss as too small, difficult, or idiosyncratic. We have heuristics we use internally to evaluate new markets and remain unbiased to preconceived notions. While ridesharing is the obvious example of a market widely dismissed (until Uber proved skeptics extremely wrong), we see this as a consistent pattern in vertical SaaS, from ACV Auctions and ServiceTitan, to Procore and Toast.

In a tighter venture market, funds tend to stick closer to their knitting. At the risk of getting dinged for straying outside core competencies, investment committees are even more likely to prematurely dismiss compelling vertical opportunities. While a clear advantage for Euclid at first check, we find this aversion–and the capital scarcity it can lead to–evaporates with tangible product-market fit and revenue traction.

3. Market Size

TAM is also one of the biggest potential points of failure for GPs investing in the space. At Euclid, we invest solely in underserved markets large enough to support $1B+ enterprise-value businesses at scale. Neither is always simple to identify. 

What is an underserved market? Ideally, one lacking in existing software options. But spaces with dominant, legacy market-share leaders can also be interesting if there is a compelling reason to believe unseating them is possible. Aging incumbents, high levels of PE consolidation, and rock-bottom NPS are positive indicators. We are most compelled by technology-driven advantages that would be hard for legacy leaders to replicate. Scope is also critical here: you can rarely rip-and-replace full-stack solutions. The selection of a beachhead where we can get early adopters quickly and set the stage for product expansion beyond that initial wedge is paramount.

What is a sufficient TAM? This is a difficult question in vertical SaaS because the best startups grow their addressable markets significantly over time. The many vectors of potential growth are a strength of the category. We evaluate opportunities to expand horizontally via product offerings, vertically into adjacent sub-verticals, and through value-chain extension. While a $500m exit could safely return Euclid’s fund, we like to see a potential path to a $15B TAM / $100m ARR–our beachhead SAM, however, could be as low as 10% of those figures. Last, it’s important to note that–even holding size constant–not all markets are created equal. In a diligence process, we spend substantial time evaluating the delicate balance between market fragmentation (critical, at least on one of supply and demand) and ACVs at scale (SMB markets can be CAC-intensive and churn-heavy).

More focused initial market sizes can be a healthy insulating factor for vertical SaaS companies, contributing to early resilience. Focused beachheads mean fewer startup competitors and less attention from more diversified market leaders until significant momentum is established and TAM expansion begins. 

4. Go to Market

One consistent feature we look for in potential vSaaS category-winners is an efficient and scalable go-to-market model. At Euclid’s investment stage, relationships with industry stakeholders are crucial in identifying early adopters and high-value referenceable customers–another motivation for our high emphasis on founding team makeup. Beyond early adopters, successful vSaaS startups foster inherent growth advantages to capture vertical mindshare (and hence market share) efficiently. 

Vertical SaaS presents a unique value proposition to its customers: software designed from the ground up for your specific industry and job. Often, customers can access best-in-class software integrated into their workflows for the first time, solving high-value pain points–not some shoehorned horizontal tech. This serves two important functions: (1) specialized software is easier to sell to the specific subset of users it was designed for, and (2) it fosters incredible loyalty among customers of the product. In the former case, competition and industry-specific product-market fit enable more efficient marketing and sales. In the latter example, intra-industry loyalty unlocks referrals, word of mouth, and an industry mindshare “moat.”

Such organic growth models are sometimes endemic to the market, creating strong network effects and non-linear growth for the vSaaS startup. For example, BuildingConnected (a prior Euclid GP portfolio company) built software enabling general contractors to bid out project work to subcontractors. The nature of the workflow was inherently collaborative. General contractors bid out work on BuildingConnected, and subcontractors would join the network to receive work. Recognizing the usefulness of the software, subcontractors migrated over to using BuildingConnected for all their project work, even with general contractors off-platform. Over time, it became the industry standard as more general contractors and subcontractors joined to collaborate during the pre-construction phase. Such examples of stakeholder network effects are common within vSaaS and can accelerate early growth and deepen industry lock-in. 

In aggregate, once a vSaaS startup reaches strong product-market fit within an industry, these characteristics combine to produce highly efficient go-to-market models. We share some of these numbers in the Capital Efficiency section below, illustrating how this contributes also to resilience. Vertical go-to-market strategies also naturally foster deep business development relationships and integrations within a category. In horizontal applications, the breadth of the ecosystem is often a hindrance to successful business development and partnership. Within vertical markets, however, vSaaS startups can focus on a smaller network of high-value partnerships to accelerate growth. It also enables deeper integrations into customer workflows, increasing both revenue and product opportunities. 

5. Product Expansion

One of the foremost strengths of vSaaS is its stickiness, both in terms of traditional retention rates and the higher switching costs inherent to successful vertical platforms. This enables them to build additional products onto that platform, capture peripheral industry stakeholders, and expand their revenue opportunity. As mentioned in earlier sections, this is why wedge products are such critical aspects of Euclid’s underwriting–they are the “point of control” (to borrow a term from the team at Tidemark) that enables a path to vertical dominance. The strongest points of control revolve around increasing revenue by opening up new markets, speeding up sales cycles, or improving end-customer experience. Depending on the vertical, however, hair-on-fire issues may center around procurement or workforce management. While many speak to the “operating system” or “system of record” opportunity, we find the faster and more successful path is often with a wedge product vs a holistic platform.

Perhaps the trickiest aspect of product expansion to underwrite–but certainly the most commonly cited by founders–is the ability to tack on peripheral sub-sectors. Some startups can successfully capture seemingly distant new verticals with minimal product work (e.g., Mindbody from yoga studios to gyms and spas). Others struggle to expand into outwardly analogous segments (e.g., ServiceTitan from HVAC to lawn care). This is why we find there is no substitute for diligence in evaluating product expansion opportunities—the more important to the story it is, the more industry and market reference calls we bake into our process.

When a strong “point of control” is captured by a vertical software business, it creates a natural moat. Customer switching costs are high because it’s embedded within how they run business (hopefully improving their bottom line), fueling superior retention rates vs. the SaaS average. Non-tech workforces are costly to retrain and vertical workflows are harder to replicate. At scale, the startup can leverage its access to first-party data to improve its products and launch new offerings more quickly. This product moat may be the biggest driver of resilience–properly entrenched vSaaS are simply “less discretionary” than consumer or horizontal B2B platforms.

Note: We briefly mention vertical data moats above. Euclid believes vertical SaaS businesses–as owners of key proprietary training data–will own some of AI's most powerful, value-generating B2B applications of the next decade. We will expand on this in an upcoming post. 

7. Capital Efficiency

On average, vertical SaaS startups are more capital-efficient than their horizontal peers. Data supports this finding in two ways. First, vSaaS players tend to spend less on sales & marketing per dollar of ARR, both public companies and in earlier stages (especially up to $30m ARR, where the gap narrows a bit, likely as market and product expansion accelerates). A study by Tomasz Tunguz found that vSaaS businesses have a sales & marketing efficiency advantage of around 50%. A study from RCCF purely focused on ARR generated per dollar had similar findings:

The median ratio for [vSaaS] was 287%, as compared to 168% for the horizontally-focused SaaS companies. Further, 75% of the vertical providers achieved greater than 100%, [versus 59% for horizontals].

Second, we see consistent examples of vertical startups achieving venture-scale outcomes with less-than-average private capital paid in. The classic example is Veeva Systems, raising just $7m before its $4.4B IPO in 2013 (only six years after its founding). Though Veeva was an outlier in many ways, we see this as a consistent pattern across both IPOs and M&A. TripleSeat, Moat, Instructure, LevelSet, Apptio, and Plangrid are all examples of vSaaS startups in the last decade that achieved $500m+ exits with prior amounts raised of <10% of EV.

As we’ll demonstrate in a later post, vertical software businesses also have more optionality in exit opportunities. In addition to traditional software acquirers, vertical technology is inherently relevant to non-tech strategics within their space. There is also an extremely robust market for sponsor-driven acquisitions in vertical spaces–perhaps due to their relevance to rollup or tuck-in strategies–with firms like Vista Equity near-exclusively on the category.

None of this guarantees that a breakout vertical SaaS business will not raise as much as a horizontal peer on its way to success. On average, however, a dollar invested into the category will yield more ARR, higher enterprise value, and, over the long run, greater VC DPI. The ability to exit earlier, to a broader range of buyers, is compelling for early-stage investors like Euclid. While we underwrite every company to have IPO potential, some of the highest IRRs (and certainly the lion’s share of exit volume) come from pre-emptive M&A.

Capital efficiency, of course, is another major contributor to vertical SaaS businesses’ ability to weather volatile market conditions. We welcome a world in which growth-stage capital is more selective, to the extent it incentivizes lean management, minimizes unnecessary dilution, and accelerates the path to exit.

8. Founder Needs

In our first section, we touched upon the differentiated backgrounds of strong vertical software founders. It follows that these founders also require differentiated support from their VCs. This insight solidified our conviction in Euclid’s right to win with the best founders in our space. They need a different type of fund: one that recognizes vSaaS for the specialized discipline that it is. 

Top vertical software entrepreneurs don’t need industry experience, customer introductions, generic advice, or support services from a VC. They need a lead-quality partner that understands vertical software excellence: the roadmap for leveraging a unique industry insight to build a category-winning software company. Generalists lack the depth and sector specialists lack the breadth. We built Euclid with this unmet need in mind, combining our long, successful track records of backing and supporting vSaaS across industries (breadth), with Vertex, our proprietary network of proven vSaaS entrepreneurs who bring tactical operational guidance and mentorship (depth). 

In supporting our portfolio, the immediate goals are simple: reach product-market fit, accelerate early growth, and attract tier-one downstream capital. The foundations we help build, however, reach far beyond the Series A. Our model is predicated on creating the ideal conditions for long-term success: winning a category and building a multi-billion-dollar company. Leading vSaaS founders partner with Euclid because we help them win not just the battles, but also the war. 

Euclid is the first-check VC for vertical software. Partnering with domain-expert founders, we lead & co-lead inception-stage and pre-seed rounds. Together, we’re accelerating an inevitable future in which every industry is powered by purpose-built SaaS. Learn more here.

Sources

• Anders, Guo (2023). 2023 Growth & Efficiency: The Vertical SaaS Companion Guide. ICONIQ.

• Bhasin (2023). Flavors of SaaS: 1H 2023 Update. Allied Advisors.

• Feinstein, Rea (2022). 10 lessons from a decade of vertical software investing. Bessemer Venture Partners.

• Fractal Team (2022). Vertical SaaS Isn’t Discretionary. Fractal Software.

• Heimann, Rathi (2017). River Cities SaaS Operating Metrics & Valuation Benchmarking Study. River Cities Capital Funds.

• Khan (2023). Vertical SaaS Decoded. CRV Insights.

• Ramaswami, Guilfoyle, Wu (2023). The New Era of Vertical SaaS. Madrona Venture Partners.

• Temkin (2023). 38% of VCs disappeared from dealmaking in 2023. PitchBook.

• Tunguz (2015). Do Vertical SaaS Companies Benefit from Higher Sales Efficiency? Tomasz Tunguz Blog.

• Tunguz (2015). Vertical SaaS Startups Require Different Go To Market than Horizontal SaaS Companies. Tomasz Tunguz Blog.

• Yuan (2024). The Vertical Software Knowledge Project. Tidemark Capital.