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Vertical Software: A Founders Guide to Success

By, Bessemer Ventures Partners 2017.

In the past decade, the market for vertical SaaS has nearly tripled to support numerous $1B+ public companies and a new wave of cloud players that's kept Bessemer busy. This is a handbook for future founders looking to build enduring, successful companies, straight from the best practices of our vertical software portfolio with 25+ investments.

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Vertical Software: A Founders Guide to Success

  2. 2. A VERTICAL SOFTWARE FRAMEWORK FOR FUTURE FOUNDERS public companies and a new wave of cloud players that’s kept our firm busy. In the past decade, the market for vertical software businesses has nearly tripled to support numerous $1B+ investments across education, real estate, construction, healthcare and more. To date, Bessemer has built one of the largest vertical software portfolios in the venture business with 25+ This presentation is intended to share our continued enthusiasm for the vertical opportunity and to walk future founders through the keys to building a successful, enduring vertical software business.
  3. 3. WHY BUILD VERTICAL SOFTWARE? The prize is big and getting bigger1 We believe the opportunity to build vertical software is greater now than it’s ever been before. Here are the three drivers that make this a unique time for vertical software founders: Winner take most dynamics2 Attractive exit opportunities3
  4. 4. WHY BUILD VERTICAL SOFTWARE? THE PRIZE IS BIG & GETTING BIGGER PRIZE IS BIG AND GETTING BIGGER1 | GENERATIONAL TRANSITION Companies in all industries are being led by a new generation of leaders that grew up with software. These execs view software as a source of competitive advantage and are making software "table stakes" in their industries. Vertical software companies have emerged as some of the most valuable IPOs in recent years. Companies like Athenahealth and Guidewire have eclipsed household names like Zendesk and Hubspot, commanding valuations above $5B. The aggregate vertical software market has tripled in market cap in the past 6 years, growing from ~$50B to $150B1. We expect this growth to continue thanks to a few factors: CLOUD & MOBILE Cloud and mobile have made software more useful than ever before. Software can now be used in the field through smartphones, in a collaborative environment on the web, in concert with other API- based services, and in a way that doesn’t require a dedicated IT support staff. This has dramatically increased the customers that can be served by industry software and the value that software can create. 2010 3x ~$150B Market Cap ~$30B in cumulative revenue ~$50B Market Cap ~$13B in cumulative revenue 2016 Source: Morgan Stanley
  5. 5. WHY BUILD VERTICAL SOFTWARE? WINNER TAKE MOST DYNAMICS WINNER TAKE MOST DYNAMICS2 | EASIER TO PULL AWAY FROM THE PACK Vertical leaders enjoy less competition. They sell into markets with buyers who have homogenous needs. These buyers are often risk averse want to buy from the market leader. Fewer competitors and reference buying drive winner-take-most dynamics, making it easier for a vertical leader to pull away from the pack. Vertical markets are often smaller than horizontal markets. But vertical leaders enjoy winner-take-most dynamics that allow for capturing massive market share. Veeva, for example, has successfully grabbed 60% of the life sciences CRM market, compared to 20% for Salesforce in the general CRM market. GREATER CAPITAL EFFICIENCY These forces also conspire to make vertical software companies much more capital efficient. In our analysis of public companies, we've found that vertical software businesses need about 45% less cash to get to IPO than their horizontal peers. Veeva is the prime example, having raised only $7M prior to going public. Time to Market Share Industry Market Share 20% in general CRM in 19 years 60% in pharma CRM in 8 years Vertical Horizontal $63M $141M Average capital required before IPO 44% less
  6. 6. WHY BUILD VERTICAL SOFTWARE? ATTRACTIVE EXIT OPPORTUNITIES ATTRACTIVE EXIT OPPORTUNITIES3 | PUBLIC MARKETS Public markets are no longer penalizing vertical software. It seems that the historic concerns about market size have been offset by a growing awareness of the winner-take-most dynamics we discussed in the prior slide. High growth vertical companies are now trading at similar multiples as their horizontal peers: Conventional wisdom used to say that vertical software companies were hard to exit at attractive valuations because of market size concerns. Over the past few years, this has changed dramatically thanks to a few trends: PRIVATE EQUITY Private equity has shown a big appetite for vertical software. The success of Vista, Thoma Bravo, Silver Lake and other software-focused PE firms has generated a massive inflow of LP capital into technology PE over the past few years. These buyers love vertical software businesses because they exhibit many of the features they're looking for in acquisition targets (like high defensibility, limited competition, strong customer retention, and potential for high profit margins). Recent vertical PE-led and strategic M&A multiples have been robust:13.7% 4.4x 14.9% 4.6x Revenue Growth EV/Revenue Vertical SaaS Mean1 Horizontal SaaS Mean STRATEGICS While interest remains unpredictable on the strategic side, we’ve seen some large strategic acquisitions in recent years such as Cox’s $4B acquisition of Dealertrack, Verizon’s $2.4B acquisition of Fleetmatics, Salesforce’s $2.8B acquisition of Demandware, and numerous vertical acquisitions from Oracle (Moat, Textura, Opower, Logfire, etc.) $1.6B $2.7B $5.8B $1.5B $1.1B 7.1x N/A 5.0x N/A 3.0x Acquired Company Acquirer Acquisition Value LTM Rev Exit Multiple CVent Veraforte Solera Vista Equity Bain Capital Vista Equity Ministry Brands Insight Partners DelTek ThomaBravo
  7. 7. HOW TO BUILD A SUCCESSFUL VERTICAL SOFTWARE BUSINESS? Choose your market wisely1We’ve been fortunate to work with many successful vertical software companies in our history. Here are some lessons we’ve gleaned from their success. Execute flawlessly2 Build multiple acts3
  8. 8. HOW TO BUILD SUCCESSFULLY? CHOOSE YOUR MARKET WISELY The spoils in vertical software go to the leader. We recommend choosing a market where you have domain expertise, a large market opportunity, and a path to market leadership. DOMAIN EXPERTISE Many founders behind the best vertical software businesses spent years in an industry before deciding to build software to change that industry. While not a requirement, we believe that domain expertise is one of the unfair competitive advantages that give vertical software founders a leg up. With many teams coming from industry backgrounds, we often see companies breaking the “Silicon Valley” mold and starting businesses outside traditional tech hubs in the US, as evidenced by the $1B+ vertical software companies outside of Silicon Valley shown here. Burlington, MA Waltham, MA Lake Bluffs, IL Charleston, SC Lake Success, NY Carpenteria, CA Ottawa, Canada San Luis Obispo, CA Verona, WI Richardson, TX Salt Lake City, UT Plano, TX Watertown, MA 1 |CHOOSE YOUR MARKET WISELY New York, NY Toronto, CA
  9. 9. CHOOSE YOUR MARKET WISELY1 | A BIG ENOUGH MARKET If your goal is to build a company worth $1B+, we believe you need to see a clear path to $200M+ of ARR. One of the most common reasons we struggle to invest in a thriving vertical software investment is because the total addressable market (TAM) is too small. The best way to think about TAM is a bottoms up analysis where you multiply a realistic annual average contract value (ACV) by the number of customers in your target market. The RealPage market sizing analysis shown here is a good example. RealPage charges customers on a per unit basis ($54 per year per unit on average). The company estimates there to be 46M units in the market, representing a TAM of $11B in ARR. If you’re looking to attract venture capital in today’s market, build a credible case for a $100M+ ARR business with 20% market share. If you can’t, self- funding can be an attractive way to maximize value by alleviating the pressure to play for the billion dollar outcome. Source: RealPage Q1 2017 investor presentation HOW TO BUILD SUCCESSFULLY? CHOOSE YOUR MARKET WISELY (continued)
  10. 10. CHOOSE YOUR MARKET WISELY1 | A PATH TO MARKET LEADERSHIP Winner-take-all dynamics are only helpful after you’ve achieved market leadership. These dynamics can make it particularly difficult to win market share where there are incumbents. The key is to find a path to market leadership. Here are some strategies we've seen from recent success stories: HOW TO BUILD SUCCESSFULLY? CHOOSE YOUR MARKET WISELY (continued) Re-platforming to the cloud. In markets still dominated by legacy, on-premise players, there remains several opportunities to re-platform to the cloud. Demandware made a killing going after e-commerce incumbents like IBM, SAP, and Oracle, delivering a cloud experience that these incumbents could not match. After a successful IPO in 2016, it was acquired last year by Salesforce for $2.8B. Mobile-first software for non-desk workers. By taking advantage of mobility, you can attack markets that have never had access to software. As an example, Procore used mobile devices to deliver software to construction workers in the field, attacking a $1T+ industry that had historically been underserved by technology. Focusing on SMBs. Cloud delivery and web-driven high-velocity sales have made software less expensive to sell and far cheaper to implement. As a result, companies like Shopify can price their products to target a new class of SMB customers who historically couldn’t afford software. These SMB markets can be deceptively large. Shopify has grown to $400M of ARR by catering to this customer base. Delivering Integrated Payments. It used to be that software companies sold software and payments companies delivered payment processing. Now, vertical software companies can deliver a better experience for their customers and capture more revenue by processing payments for their customers. In 2016, payment processing made up ~40% of MINDBODY’s total revenue. Vertical AI. While tech giants like Google, Facebook and Amazon lead the competitive race to build platform-level and general AI, industry- specific data sets and tasks are outside their crosshairs. New vertical software companies can use AI to build defensible data moats that enables them to grow faster and do more than incumbent competitors. Startups like Merlon Intelligence are using NLP, machine learning and other new methods to build risk management and compliance solutions for financial services companies.
  11. 11. EXECUTE FLAWLESSLY2 | CUSTOMER LED PRODUCT DEVELOPMENT Everything starts with product and engineering. Without a best-in-class product, you can never build an industry-defining software business. The most successful product and engineering organizations in our portfolio share a few qualities: The software world has gotten so competitive that growth companies need to execute flawlessly across all dimensions. We’ve seen a few functional areas separate the best from the pack: HOW TO BUILD SUCCESSFULLY? EXECUTE FLAWESSLY (1) Obsessive focus on hiring and retaining the best talent Not only is a top performer 10x-100x more valuable than a mediocre hire, the mediocre hires often function as a drag on output and morale. This is particularly acute in the product and engineering functions. (2) Highly agile squad model with decentralized decision making Rather than building a monolithic organization where product decisions are made top down, we’ve found that our top performing teams rely on a cross-functional squad model where individual squads are empowered to make product decisions. This usually involves a product manager, a designer / UX specialist, and a team of 5-10 engineers. Spotify has excellent resources on this topic. (3) Customer-driven product management Many companies pay lip service to customer-led development, but for the best, it is core to their culture. Here are some tactics we see from our best product teams: • Focus on understanding customer needs. Rather than just asking for feature requests, these teams instead focus on understanding customers’ root problems and finding solutions to those problems. • Full squad engagement with customers. The entire squad engages with customers, not just the product manager. This provides much deeper insights into customer needs and humanizes the customer’s problems for the engineering team. • Rich, clickable prototypes. Watching users interact drives enormous product insights and it ends up being a lot cheaper to make changes at the UX stage than after you push code. • Continuous feedback from customers every step of the way. The best teams view product development as an iterative process, with ongoing discovery calls, demos, on-site visits, conversations with sales reps, feedback from customer support, etc.
  12. 12. Marketing Qualified Leads Meetings Orders EXECUTE FLAWLESSLY2 | Source - BVP proprietary data, Jeff Epstein & John Golub “Marketing, Sales and Service Best Practices for Cloud-based Businesses” - a 2013 survey of 100 U.S.-based, enterprise-focused SaaS businesses with an average ACV of $26k SCALABLE SALES & MARKETING After you’ve built a great product, the biggest challenge you will face is scaling a sales and marketing engine. There’s been a lot of written around the key B2B marketing disciplines, all of which are important to master, including: • Ops/analytics (measuring what works, brand sentiment, A/B tests, etc.) • Content marketing / webinars (driving leads and brand affinity through great content) • Paid marketing (SEM, display, direct mail, affiliate, etc.) • Field marketing (local events, trade shows, world-class user conferences) • Communications (telling your story for both customers and hires) • Outbound calling (generating leads through an army of BDRs) On the sales front, sales strategy is really a function of average contract value. Software companies selling to SMBs with a lower average contract value will rely more heavily on marketing to drive inbound leads to feed a high-velocity inside sales team (although we’ve seen some companies like MINDBODY make outbound work even at a low ACV). Those selling to the enterprise with a higher ACV will rely more heavily on BDRs and an account-based marketing engine to feed leads to a hybrid inside/field sales force. See the chart on the left for helpful benchmarks we gathered from an internal poll of BVP’s enterprise sales teams. HOW TO BUILD SUCCESSFULLY? EXECUTE FLAWESSLY (continued) Marketing Ops Sales Development Reps (SDRs) # of meetings scheduled for AEs New Business Account Executives (AEs) Customer Success Managers (CSM) 3 SDRs per 10 AEs Most by geo’s (70%), but also by vertical & account Base: $40- 60K Variable: $11-$50K net new $ARR or new $MRR ~ Most often by geography (70%), or vertical (30%) Base: $48- $105K Variable: $48-$102K net new ARR from renewals, upsells, customer NPS 1 CSM per $2M ARR or 2 CSMs per 10 AEs Most by accounts (57%), otherwise by geo/vertical Base: $40- $100K Variable: $0- $60K PERFORMANCE METRIC? STAFFING? HOW DO YOU ORGANIZE? COMPENSATION RANGE?
  13. 13. 2 | METRICS & IMPLEMENTATION As you scale your business, you need to instrument and benchmark your performance to make sure each function is on track. After surveying our portfolio of vertical software businesses as well as public comps, we’ve outlined what we believe to be ‘good’, ‘better’ and ‘best’ industry standards across growth, retention, CAC payback and gross margin: Note that we’ve seen many cloud companies calculate CAC payback incorrectly. Bessemer’s method is: There is always a trade-off between growth and cash burn. We’ve found that an Efficiency Score (defined as % year-over-year ARR growth - % FCF margin) is a good way to think through those trade-offs. As seen in the chart below, best-in-class software companies follow an Efficiency Score progression of 70 - 50 – 30 from expansion to post-IPO. Source - Internal BVP benchmarking from 10+ years of anonymized data. HOW TO BUILD SUCCESSFULLY? EXECUTE FLAWESSLY (continued) EXECUTE FLAWLESSLY GOOD BETTER BEST 30-70% <85% minimal 18-24 months <65% 70-100% 85-95% 100-120% 12-18 months 65-80% 100%+ 95%+ 120%+ <12 months 80%+ <1x 1x >1x Annual Net Retention 1 Year Forward Growth CAC Payback Upsell Retention Cash Flow (New ARR/Mo. Burn) Gross Margin CAC Payback [ Total Sales & Marketing Costs Last Qtr ] [ New CMRR Added Last Qtr ] * [ % Gross Margin ] = %CARRGrowth+%FCFMargin 0% 100% 50% = 70% = 50% = 30% Expansion Stage ($30-60M ARR) Pre-IPO Stage ($60-100M ARR) Public ($100M+ ARR)This framework applies to vertical SaaS companies who are >$3mm ARR (annual recurring revenue) and who sell an average ACV (annual contract value) of greater than $10k
  14. 14. 3 | Vertical software founders capitalize on their market leadership to pursue “multiple acts” after they get to meaningful scale with their core product. We’ve seen a few examples worth highlighting: HOW TO BUILD SUCCESSFULLY? PURSUE MULTIPLE ACTS PURSUE MULTIPLE ACTS Cross-selling new products. Cross selling is the idea of selling new software into your existing customer base. A company that we has done well in this regard is Veeva. Veeva has been able to successfully cross-sell new products such as their content product, Vault, which now generates more revenue than its core CRM product. Payments. Integrated payments is a new area of value creation in vertical software. In the past 5 years, companies like Vantiv have launched enabling technologies that make it easier for software companies to drive payments. For example, Ministry Brands has quietly built a $1B+ company selling a combination of software and payment processing for the church market. Marketplaces. OpenTable started off as a reservation management solution which built an impressive footprint in the restaurant industry. Once it had enough access to supply, it was able to flip a switch and become a consumer-facing reservation marketplace which ultimately became more valuable than its core software business. Mindbody is following a similar path in health & beauty. Mergers & acquisitions. Acquiring companies can help drive cross-selling opportunities, unlock cost synergies, and diversify the revenue of the overall company. Companies such as Jack Henry, Constellation Software, Tyler Technologies, RealPage, and Fiserv have been able to sustain growth and market dominance over time via the acquisition of small companies. International Expansion. Going international is difficult, but it can be a scalable way to continue revenue and user growth. Demandware has been able to grow a large percentage of revenue through their joint venture in Japan and their expansion into Europe, Australia, and China.
  15. 15. We’ve laid out a broad market map below which shows the relative industry size with both vertical incumbents (typically on-prem solutions) and newer cloud competitors. With the tailwinds we’ve outlined in this report, we believe any one of these verticals is ripe for innovation. OPPORTUNITIES FOR THE NEXT VERTICAL SOFTWARE WINNERS U.S. GDP (in Trillions), excluding services Real Estate Government Commerce Manufacturing Finance Health Telecom & Media Construction & Engineering Hospitality Education Transportation $0.2T$0.2T $0.7T$0.7T$0.8T $1.3T$1.3T $2.0T $2.2T $2.3T $2.4T Vertical Incumbent Cloud Competitors Source: Morgan Stanley, JPMorgan
  16. 16. BVP’S VERTICAL SOFTWARE PORTFOLIO Bessemer has a long history of investing in vertical software founders across a variety of verticals. We look forward to future growth in the space and invite future founders to reach out and share their vision. 25+ investments across different verticals, with founders and teams all around the world REAL ESTATE HOSPITALITY FINANCIAL SERVICES HEALTHCARE LOCAL BUSINESS CONSTRUCTION RETAIL & COMMERCE WELLNESS & FITNESS AUTOMOTIVE RESTAURANTS AGRICULTURE LEGAL SERVICES EDUCATION
  17. 17. For more information, contact the authors: Brian Feinstein – and Ben Mathews –