Market Sizing in Vertical Software (Part 1)
A Guide to Vertical Hype Cycles & Picking Winners
Throughout the history of venture capital, two significant factors have determined the viability of a target market:
The cost of building and selling a product to constituent buyers
The demand–both ability and willingness–of those buyers to pay
While these two factors have evolved favorably over time for all B2B software, the impact on vertical SaaS has been profound. At Euclid, these shifts have led us to completely re-think the conventional wisdom around what makes for a venture-scale TAM.1
The TAMs They Are A-Changin'
The advent of more powerful programming languages, open APIs, and—most notably—cloud infrastructure have all contributed to a drastic reduction in the upfront expense required to achieve commercially ready code. This has made it viable for B2B software startups to target increasingly specialized user bases. For example, 40 years ago, when founders might spend several million dollars in CapEx upfront for physical IT infrastructure, investors reasonably expected startups to target vast markets to justify the risk. Today, where prototypes (if not full products) can be spun up for a four- or five-figure sum, it has become acceptable to start by targeting smaller markets.
The sometimes drastic but always steady increase in software budgets across industries has been an equally important factor. Before the dot-com reset, for example, building software exclusively for the construction industry was a likely non-starter. At the time, spending on technology–much less software–in that vertical was limited-to-nonexistent. As software “ate the world” in the intervening years, it captured an increasing share of corporate budgets. Even in the most laggard and low-margin industries, dollars are being cannibalized from headcount, services, and legacy IT to capitalize on the promises of emerging tech. That phenomenon has continued to evolve to a point where nearly any vertical with 10- or 11-figure aggregate revenue today can support a venture-scale software platform.
Behind these tailwinds, we believe a third critical factor has emerged, driving astute founders to “start small”: an increasing number of vertical winners demonstrate that the more tailored to a use case a product is, the greater its advantage in user experience, acquisition, retention, and speed of adoption. Put another way, vertical solutions can out-compete and capture market share from prior-generation horizontal or vertical solutions simply by being more specialized. This new generation of vertical startups can get a foot in the door with a hyper-focused, beachhead market, later expanding into the wider vertical to grow TAM. With often fewer serious competitors, the vertical upstart can achieve higher penetration rates versus horizontal peers, leveraging this dominance to cross-sell peripheral products and build a multi-revenue-stream platform over time.
We have already seen these software verticalization dynamics lead to breakout successes in the market. For example, Procore, Veeva, and Toast are well known public SaaS leaders in the construction, life sciences, and food service verticals, respectively. This cohort, however, is now ~20 years old.2 As we look into the future, we believe that most have underestimated the vertical phenomenon, both in terms of the viability of initial markets once thought “too small” and the lasting competitive edge that initial hyper-specialization can bring. While many VCs anchor their conception of a viable TAM by looking backwards, the wheels of software verticalization have continued to turn, creating a significant opportunity for contrarian early-stage investors. As the chart below demonstrates, vertical software and horizontal reached exit value parity for the first time in 2023.
Growing Vertical Share of B2B Software Exits
This is not to say that vertical disruptors will eventually replace all horizontal software. Some functions are simply similar enough across industries, making the vertical approach an unnecessary restriction on TAM and a drag on early product development. For example, paid advertising, cybersecurity, and finance are functions that often vary little across industries. In fact, knowledge workers often benefit from such tools being consistent as they move from job to job. The appeal of horizontal solutions in terms of TAM is also clear: if a startup is attacking a $10B software market from day one, investors don’t have to work to validate the potential path to revenue sufficient for a venture-scale outcome. Equally important, VCs can lean on their existing network of portfolio companies to quickly diligence products in familiar horizontal categories without deep, net-new market work. Finally, most investment professionals face organizational pressure to stick with what they know and what has worked in the past. “No one gets fired for buying IBM” as they say. This human element is precisely why we believe most of the venture ecosystem has underestimated the vertical opportunity and struggles to underwrite vertical markets properly today. TAM and market comprehension are the most common reasons for an investor to dismiss a vertically focused startup and, in our estimation, the least likely to be challenged.
Navigating Vertical Hype Cycles
Most software VCs tend to wade deep into a particular sector near the back half of what we call a “vertical hype cycle.” Venture-scale outcomes and high-profile financings drive an overabundance of capital into a specific vertical, driving up valuations, increasing competitiveness, diluting founder quality, and–most importantly–negatively impacting aggregate returns in that cohort. This phenomenon has been a feature of the venture capital ecosystem for decades. Historically, hype cycles have centered mostly around non-vertical themes. During our investing careers, we’ve seen the story play out in ad tech, direct-to-consumer brands, and consumer social, amongst others. Crypto is perhaps the most evident and well-covered recent hype cycle, as venture investment exploded in 2021 and 2022, only to decline by almost 70% in 2023.3 Other pandemic-era darling themes have seen similar fates, albeit on a smaller scale: funding for the creator economy and digital commerce declined over 60% in 2023.4
While vertical software investing was historically too under-the-radar to see many hype cycles, we are seeing the phenomenon creep into categories we have invested in for 10+ years. One striking recent example is in supply chain technology. In the early 2010’s, sub-sectors like freight were still considered tech-averse backwaters. Yet, as we saw with Transfix in 2014, forward-thinking bets in that vacuum were able to capture market share (and mindshare) extremely quickly. Supply chain has remained an active investment roadmap for us since, and given the scale of the constituent markets, we believe compelling opportunities remain. In the wake of early supply chain breakouts, however, segments of the category have since become overheated and noisy (see chart below). When COVID threw a wrench in global supply chains, the tide went out. While clouds are perhaps clearing with the likes of Samsara and Fortiv, the signal-to-noise ratio in supply chain software has just begun to recover.
Supply Chain Tech VC Funding
Many supply chain startups underwritten at the peak of the hype cycle ignored unit economics and business fundamentals. They pursued growth at all costs as cheap, abundant capital poured in, GPs late to the theme seeking their fund’s bet in the now-hot space. As we have seen in other hype cycles, in the wake of path-breaking founders picking off the best and biggest ideas, secondary and tertiary products abound, their only realistic outcome being a modest acquisition in the consolidation push that typically heralds the close of a hype cycle. The mid-2010s ad tech market was a perfect example of a late-stage cycle, seeing continued funding beyond the initial disruptive exchanges, DSPs, and SSPs, but producing few additional winners. We believe we have now entered the back portion of a hype cycle in certain areas of supply chain as late-stage fundamentals and liquidity fail to keep pace. Venture dollars into supply chain tech totaled $10.5B in 2023, down >80% from $61B in 2021, a 50% larger decline than the overall venture funding market.5 While traction is the ultimate arbiter, even great ideas and teams can fall victim to poor timing in a vertical hype cycle.
Hype for Beta, (Early) Conviction for Alpha
At Euclid, we believe that the return profile of investing during a vertical hype cycle will most often prove unattractive. As such, it is key to avoid waiting for external validation from the venture market to invest in a category. While we glean any and all learnings in the space, when it comes to underwriting, we focus solely on independently built, first-principles conviction. Tom Perkins said it well:
If there is no risk, you have already missed the boat.
This flavor of independent thinking has suited us well, yielding successful bets across foodservice (Postmates, 2012), real estate (HomeLight, 2013), supply chain (Transfix, 2014), construction (BuildingConnected, 2015), and more. And it remains a bedrock of Euclid’s strategy.
In this modern era of vertical software, that requires an entirely new set of heuristics. Not simply to understand which markets are or will be big enough, but also to understand stakeholder dynamics driving adoption, the ability to expand TAM over time, and the competitive and funding environment surrounding that vertical. In other words, we seek not just great markets, but great markets that our portfolio companies can capture and win early.
Our next post will cover Part II of Market Sizing—stay tuned to learn how we analyze and build conviction in a potential vertical market, and dive into an applied case study of one recent Euclid investment.
TAM = Total Addressable Market.
17-year average age to be exact
Khatri, Yogita (2023). Crypto VC Funding 2023. The Block.
Yurieff, Kaya (2024). Funding For Global Creator Economy Startups Plunged 58% In 2023. The Information.
Crunchbase (2024). Global Funding Report.
Pitchbook (2024). Supply Chain Tech Report.
Crunchbase source, above.