In the next fifteen hundred words or so I am going to make a case that investing in niche, founder-owned, vertical software businesses is the place to be (all the cool kids are doing it). Gone are the days of broad-based, horizontal, one-size-fits all software solutions. Focus is now the dominant trend for products and it’s the key investing trend I’ve been pursuing for several years. Just like great football teams make hay in the red zone, vertical software businesses do as well. It’s all about finishing off those last 20 yards or that last 20% of the solution. Getting deep in a vertical, understanding problems and then solving them over longer periods of time and development I believe makes for a highly attractive, differentiated and defensible product. If you build that product, a very attractive business model / strategy can emerge.
I’ve spent the last eight years working with midsized technology companies as a private equity investor. I’m part of the tech investing team along with the other guys here at the FunCast so a big part of my job is trying to figure out where to look for attractive investments. As part of this effort, I spend an inordinate amount of time thinking about software businesses so I am happy to share some thoughts with you here on why I focus where I do – on businesses solving problems for specific verticals using technology.
In this piece, I will theorize and explain why this is my strategy versus chasing more horizontal solutions, which despite having growth rates similar to vertical solutions, I find to be more expensive to invest in and have lower-margins! I will start by establishing five points to lay the groundwork for my thesis and then go deep into some data to bring home my point. Here we go.
My Five Claims
- Focus = Profit: operating as the premiere, value-added product or solution for a specific vertical or customer type affords higher pricing power and it should also enable an organization more visibility of customers, competitors and market trends to help get a better bang for your buck for expenses such as sales and marketing. Further, vertical-based solutions have the potential to be more entrenched and thus stickier, meaning customer retention rates should be higher (leading to higher profits). I also find a niche market can bring with it less competition (or at a minimum, more clearly defined and better behaving competition) and therefore, higher profit margins.
- Focus = Execution: with a deep understanding of customers and the ins and outs of a competitive marketplace, you can better prioritize activities and resources and execute sales activities more effectively. Legendary Green Bay Packers coach Vince Lombardi won championships by executing the “Packers Sweep” (a very simple, straightforward football play of the time) to perfection, doing it better than anyone else – vertical solutions endeavor to do the same.
- Focus = Awareness: focused solutions allow higher market share and organic awareness potential (i.e. word of mouth lead generation). Knowing your space cold also allows you to create relevant content that can make your company a go-to partner for customers, not only for products and services, but for expertise.
- Focus = Control: through the elimination of options (not trying to be everything to everybody) you can more efficiently out-strategize and out-execute competition. Oftentimes we find that the last 20 yards (the “red zone”) of a product’s development or strategy are the most difficult when dealing with verticals (often built up over many years of iterative development, tailored to the specific vertical) making it more entrenched and, thus, more sticky with customers.
- Focus = Risk Mitigation: if you own your space and know your customers, you will better avoid surprises. You are more aware of market trends affecting your customer, you are acutely aware of competitive offerings, and you can exert more influence over your vertical (assuming you can execute). Having such deep insights, you can even better react to events and trends that are out of your control, further mitigating downside.
Now, I’m going to go ahead and geek-out here for a bit (bear with me) and take a stroll into some data to back up my thesis. The following tables include two composite groups of publicly traded stocks along with Salesforce.com as another point of comparison.
Some key findings:
Vertical-Focused Software Companies Have Higher Margins
As can be seen below, the average last twelve month “LTM” EBITDA margin for vertical software businesses is much higher than the set of horizontal software businesses. Why?
It turns out that gross margin percentages in vertical software businesses are relatively similar to horizontal software businesses. However, the most pronounced difference between the two categories is go-to-market expense, defined here as sales and marketing expense (“S&M Expense”). As you can clearly see, vertical software businesses on average spend much less on a percentage of sales basis than horizontal software businesses. In these comparable groups, horizontals spend nearly 2x the amount as verticals (38.6% of sales versus 21.9%)!
I was startled by this when I ran the numbers and it raised follow-up thoughts and questions for me. Clearly, the vertical software businesses here are spending less money on sales and marketing. This plays right into three of my core premises (#1 – Focus = Margin, #2 – Focus = Execution, and #3 – Focus = Awareness).
However, I want to know why. There is a much larger market out there if you’re not focused on a vertical, so the land-grab potential is enormous! Why not have a broader solution and spend more? That should lead to much higher growth rates, right?
Growth Rates Aren’t Dictated by Market Size
As can be seen below, growth rates between these two categories are actually pretty similar!
Growth rates are practically the same despite EBITDA margins that are much greater in vertical software businesses (primarily due to spending half as much on sales and marketing)!
Further, if you grant me #4 – Focus = Control and #5 – Focus = Risk Mitigation, then on a risk-adjusted value basis, the vertical-focused software space seems much more attractive and valuable right?
You Can Buy Vertical Software Businesses Cheaper Than Horizontal Software Businesses
When you look at the comparable groups, vertical software businesses trade at a discount to horizontal software businesses. I also like to invest in businesses with strong cash flows which allow a business to self-fund growth, avoid dilution in equity raises and create equity value by building up cash on the balance sheet. Again, if you grant me #4 – Focus = Control and #5 – Focus = Risk Mitigation, in my opinion, these are much more attractively valued investments for similar growth results!
There is clearly a premium put on the horizontal software businesses, likely due to market size. However, as a private equity investor, I would opt to pay less for a vertical software business, dominate a market and have a chance of selling to one of these horizontal software businesses and be paid at their much higher multiple, achieving multiple expansion. The holy grail of private equity is combining strong growth and profitability with multiple expansion – buying vertical software businesses at least gives you a shot of selling into the larger horizontals. The horizontal software businesses here trade 35% higher on an Enterprise Value / Sales basis and nearly 75% higher on an Enterprise Value / EBITDA basis!
Some Final Thoughts If You’re Still Not Convinced
These fact patterns are why I invest in vertical software businesses. I spend all day looking for founders who have solved a problem with technology in a vertical they are well-versed, building differentiated solutions that can gain significance in a vertical market. Some of you may be saying the market for opportunities for companies such as these must be pretty thin right?
I am of the mind that software is eating the world. Traditional business models are being turned on their heads by entrepreneurs taking the old and making it new. We have a portfolio full of companies where founders took novel technological approaches to build better mousetraps in existing markets. These are markets filled with competitors but ripe for innovation and these companies have been able to take market share from their peers. These markets also have compelling long-term trends that provide the ecosystem for innovative players to prosper and it’s my job to identify these players in these kinds of markets. I would say that in every business, there is a tech-enabled opportunity. According to the Inc. Magazine August 28, 2012 article put out by Karl Stark and Bill Stewart(1), in a survey put out to the CEO’s of the Inc. 500 list, 77% of respondents indicated they founded their businesses using their personal savings. These are entrepreneurs building businesses, solving problems with their own capital and sweat equity, interested in the long play. Whoever in each vertical is solving problems with tech, I want to partner with.
Now, how does that look in a lower-middle market private equity portfolio? A sneak peek is below for some of my firm’s most recent tech-enabled services investments (aggregated for confidentiality).
As can be seen, employing this vertical technology strategy, we have been able to buy niche companies achieving impressive growth rates (on par with the category) at incredibly high margins (over 2x the EBITDA margin of even the vertical software group) for significant discounts to public comparable companies (at the time of purchase, we paid more than a 50% discount to the category on an EBITDA basis). In short, we are business builders looking to partner with entrepreneurs who are building truly differentiated products and services that have the opportunity to dominate their vertical markets.
Feel free to reach out with thoughts or input and follow me on Twitter @D_RyanMilligan