Vertical SaaS Exiting Q3
or why vSaaS companies look highly competent to take on all sorts of macroeconomic conditions
A Programming Update:
You may have noticed this newsletter has not exactly been weekly as of late!
The short answer is that I’ve recently welcomed our first kid and time has been a bit of a scarce resource.
But back to (mostly) weekly from here on out. What’s more, I’m pretty excited to be moving towards a more eclectic mix throughout the next year.
In short, my goal for the next year is to 1) analyze different vSaaS companies and industries, 2) dive deep into building out robust product and GTM motions within vSaaS companies, 3) map out guides for implementing the best vSaaS softwares into SMBs.
Numbers 1 and 2 are pretty self-explanatory, so let me speak to number 3 a bit. One of my hunches is that given the number of SMBs that will be changing hands over the next decade and how little tech is currently implemented by the average small business, there’s a big opportunity to increase operational efficiencies, marketing ROI, and more by implementing the cream of the crop vSaaS solutions in a business upon acquisition.
Or to quote an earlier piece:
Over the next decade, we will enter the great Generational Handoff. Business owners in stodgy industries will begin to retire and seek to sell their life’s work. A major problem is that the processes and insights that led to a healthy business are often not fully legible…
Great vSaaS products will fix this problem. By unlocking central workflows, unleashing second order insights, and rendering businesses more fully legible, the next generation of entrepreneurs can acquire small businesses and carry their services into another era.
But more on this to come.
Bearish or Bullish?
There’s a lot of negative sentiment these days around B2B software as a category. Most of it is tied to the interest rates, but that’s not the whole story. Tons of companies have just run at losses pursuing growth at all cost strategies with not a ton of discipline in the fundamentals.
And so within the public markets, you’ve had a general rotation away from B2B SaaS, multiple compressions, and a new think-piece every day from a VC about how there’s tons of zombie startups wandering around.
But while there’s been a general reckoning with all of SaaS, remarkably, vertical SaaS companies look… pretty good? I think the financial metrics agree even despite the multiple compression that every SaaS company has undergone.
I mean sure if your entry point into these companies was at the top, then it can’t look great. But if your perspective is on the long term value of vertical SaaS companies from here on out, it looks really promising. And I think what the macroeconomic conditions have allowed us to do is to look at how and why vertical SaaS businesses are set up to endure and thrive in every sort of business cycle.
So that brings us to today’s newsletter. Plenty of people can do raw balance sheet analysis. I’d prefer to spend time thinking about how various parts of the vertical SaaS thesis correspond to different macroeconomic cycles.
So first, some thoughts on what explains why these companies look really good on the fundamentals exiting Q3, and then a quick look at what public vSaaS companies are excited about.
To sum up the big trends within the macro environment that I think these companies are beginning to display, vertical SaaS companies are:
Cyclical with their industries (especially on the transactional side)
Acyclical with the rest of B2B SaaS
Countercyclical through Financing
Cyclical with Verticals, Acyclical with Horizontal SaaS businesses
One of the things I have been thinking about recently is the fidelity between vertical SaaS platforms and the sectors they serve.
And especially as the new wave of vertical SaaS platforms start to delve more into transactional revenue stemming from payments, financing, and more, I think this becomes a really fascinating dimension to watch. This may be an obvious insight that I am somewhat late to the party on. But I think Q3 is perhaps the first time where we can start to see how vertical platforms correlate more directly with their industries.
Post-Covid, and especially in vertical platforms with a fintech component, vertical SaaS platforms are becoming thematic for their industry. They function as useful indexes on the transactional volume flowing into a sector. Bullish on restaurants going into the new year? Well then Toast looks like a significant bet on that thesis. Bearish on mortgage originators through 2024? The sentiment around Blend pretty directly mirrors this.
So especially around transactional volume happening on platform, you start to see a cyclical component of company earnings tied to the industry performance.
Depending upon the industry and the individual vSaaS, I think you can view this cyclical dependence around transactional revenue as net negative or positive. Transactional revenue is always sort of like that. It’s great in good times and lousy to depend upon as a company in bad times.
But I think in the vast majority of vSaaS cases and especially as valuations have normalized, it’s appropriate to view this transactional volume as upside for the company rather than downside risk.
It’s a boon in great macroeconomic conditions in the industry and not destructive to business value in bad ones.
The reason is two-fold. First, no vertical SaaS platform with a fintech component has come even close to bringing the majority of industry transactions on their platform. And so even if there is a slowdown in industry-wide transactions, the important metric is whether these companies are expanding their industry utilization for payments at a rate faster than the slowdown.
And second, while payments will often make up a significant portion of revenue, we aren’t dealing with mere payments facilitators.
Every single vertical platform has built out mission critical software and continually is expanding the number of workflows facilitated. And this subscription revenue as far as I can tell is not best thought of as purely cyclical with an industry or cyclical with B2B SaaS buying as a whole. Given the mission critical nature, you actually see a greater desire to operate efficiently in recessionary conditions and consolidate systems where possible. In other words, it’s mostly acyclical both with their industry and with the broader B2B software market.
In a lot of these companies, you aren’t seeing huge slowdowns in the same way that many software businesses are experiencing.Sure sales cycles or customer acquisition costs may increase but a) the software isn’t getting replaced unless the underlying customer goes out of business and b) these industries are looking for new ways to wholesale digitize and increase efficiency. There's only one crop of companies focused on this and it's the focus of the newsletter.
And so, vertical SaaS companies are continuing to grow the number of customers on platform and don’t experience churn, even when their industry experiences a slowdown.
So yes, they have a cyclical element tied to their industry in transactional revenue and on the software side, especially in the sales cycle. But they also have a way of resisting some of the fears that are popping up throughout the rest of the software industry. In fact, vertical SaaS companies more often than not will benefit from a crunch on IT budgets.
Horizontal SaaS and vSaaS
And so I think what you will also see is that vertical SaaS platforms over the next 18 months will strengthen their value propositions vis a vis other B2B SaaS platforms and start to move acyclically from horizontal SaaS.
Every horizontal SaaS platform is grappling with the recessionary headwinds that are beginning to display.
For instance, here’s a blurb from Hubspot’s earnings call:
The macro environment has become incrementally more challenging. We see two clear trends in this environment based on our customer and prospect conversations. On one hand, deals are taking longer to close. There are more decision-makers involved, more approval layers and budgets are tighter…
On the other hand, HubSpot is emerging as a platform of choice to help customers get through these uncertain times. Our customers need more leads, better conversions and better customer experience. But they need to do it all with less. Our value proposition of easy-to-buy, easy-to-use and easy to build, resonates even more now as customers are looking to consolidate their tech stack.
If I could boil down my suspicion into one sentence: If the buying criteria for small to medium sized businesses becomes “do more with less,” do they choose horizontal solutions to manage different flows or do they choose a vSaaS platform capable of managing the whole gamut of workflows in a highly contextualized way?
This doesn't mean that Hubspot or horizontal B2B SaaS more broadly is doomed. It just means that when Hubspot is having trouble or B2B SaaS as a category looks shaky, it very well may be the case that vertical SaaS companies aren't experiencing the same sorts of headwinds.
The very buying criteria displayed in the SMB segment is the buying criteria that vSaaS companies win deals on.
So yes, I am sure every software company will experience longer deal times, but one crop can make a claim on winning the deals against head to head competition.
This sort of workflow aggregation and industry fidelity will mean in the long term that although vertical SaaS companies will always have dependence upon their specific industry trends, broader software market reckonings won’t be as eventful in vSaaS land over the long term.
In other words, I don’t think you should index how vertical SaaS companies will perform off of other B2B SaaS offerings. Their cycles may actually benefit from the trends.
In this way, my hunch is that if an extended tech recession happens, vertical SaaS platforms will look far better as a group in contrast to the rest of the horizontal tech and fintech industry.
So one way to think about vSaaS in the current macroeconomic conditions is that their industry fidelity allows them to be resilient to all sorts of non-industry specific conditions and in some cases to benefit when efficiency becomes primary.
I think this yields a pretty fascinating portrait of vSaaS as a business category that can endure all sorts of macroeconomic weirdness so long as the platforms maintain capital efficiency and discipline.
Or in other words, they exemplify all the reasons why 20 odd years ago, Mark Leonard arrived at his conclusion that vertical market software companies were the cream of the crop from an investment standpoint. But you can read more on that here.
Alright so that’s a lot of “cycles,” here’s one more before some commentary on individual companies.
Does diversifying into financing and lending yield an interesting countercyclical revenue stream for vertical SaaS platforms?
We often think about financing as a vehicle for growth or an opportunity for leverage. And it is. Especially in great economic environments. But the flip side of financing, (especially for SMBs during downturns) is that they allow companies to solve cash flow constraints at opportune times.
The most powerful intervention performed during the Covid years was the SMB loans program to ensure that the SMB sector was able to make payroll. Sure, it operated more as a grant program than a traditional lending operation, but the point is the same: injecting capital into businesses to solve cash flow issues is one of the most critical opportunities.
In other words, when cash flows get constrained, SMBs face two options: close the doors or find financing. And when you have a massive edge in underwriting risk given access to central business performance data, you end up with a program that a) keeps your customers in business during downturns, b) generates profits upon the financing agreements during bad industry cycles, and c) ensures SMBs are able to pay rent.
To state the obvious, if your financing portfolio goes underwater during the downturns, none of this matters. So sophistication and capital market management is table-stakes for a successful operation. But if done correctly, this gives vertical SaaS companies a way to maintain a countercyclical profit line in downturns and protect the rest of business through churn reduction.
Alright so that about sums up vertical SaaS within the current market cycle.
The rest of this is going to be a mix of commentary and highlights from public companies. This of course isn’t exhaustive and it’s much more centered around the companies that are more indicative of the newer wave of vertical SaaS companies.
I’m going to focus on three: Toast, Shopify, and Procore. Toast’s summary is a bit longer than the others, mainly to demonstrate this sort of cyclical heuristic.
Toast continues to absolutely crush the restaurant space. A couple things stand out:
One of the funny things about Toast’s increase in payments volume is that they readily admit that some of this is attributable to inflation in menu prices. If the price of a meal goes up, and the payment happens through your system, your numbers start to look really good even if the number of transactions on platform stagnates. Toast in Q3 is demonstrating higher transaction volumes but it’s pretty clear that a lot of the payments volume increase is tied to price inflation.
Or in other words, a lot of their transactional performance is tied to cyclical factors in the restaurant industry.
The integration of XtraChef
Toast has been making strides to manage more workflows around the back office of a restaurant and made the move to buy XtraChef last year.
Perhaps the most interesting things about this is the way this allows Toast to gain far more insight into data that allows them to surface useful analytics to their customers. This sort of data is really valuable but it’s the sort of data that has been historically locked in invoices. So by automating invoice ingestion, you end up with the second-order insights that customers are willing to pay money for due to the dramatic savings.
Our customers can access the price tracker directly from our newly designed xtraCHEF dashboard to stay on top of fluctuating ingredient prices and costs. Restaurants like Plaza Pizza are watching price fluctuations week to week and in response to these insights have engaged in negotiations with food distributors. Plaza Pizza was able to successfully reduce food costs by nearly 10%
Toast is continuing to invest in SaaS offerings that compound the gains of their platform, automate workflows that cause real business headaches, and allow them to increase their ARPU.
Toast is perhaps one of the early success stories of integrated financing programs for vertical platforms.
Boasting 17m in gross profits on the quarter, Toast is continuing to double down. Some of the data on this is really interesting: 70% of the 2021 cohort has taken out a second loan.
Ergo it follows that at least 70% of the customers survived one of the toughest years for restaurants out there. I don’t want to overindex on this data but it does seem to me that “willingness to take a financing arrangement during 2021” is one of the better indicators for “might be prone to churning due to shutting doors” or at the very least “won’t expand platform usage due to growth constraints.” So not only is Toast getting a fantastic and profitable business line, but it at minimum also defended 70% of customers using financing against churning due to cash flow problems.
So Toast functions as a great example of how financing allows vSaaS companies to maintain countercyclical and profitable revenue defense.
Shopify is probably worth a bit more of a deep dive at some point. They’re a pretty weird one to categorize as a vertical SaaS company for all sorts of reasons, but I think more and more they are becoming a true vSaaS for merchants.
More than most other companies on here (and partly because I don’t think they have been traditionally thought of as a platform), they have been extremely vulnerable to a sky-high multiple and the other systemic factors that led most internet companies to way overindex on the Covid boom in ecommerce and digital services.
But Shopify has done a pretty bang up job of rightsizing the company and continues to boast greater penetration of Shop Pay utilization.Post-Q3, Shopify's claim on becoming a vertical SaaS platform for merchants continues to grow, especially as they have continued to invest in crossing the gap between DTC and retail.
And the current business is still incredible even in the midst of all the shakeups that have happened.
Shop POS is perhaps the biggest wedge that Shopify has to become this sort of omnichannel platform. The narrative makes a lot of sense: If you as a merchant own both storefronts and have a significant ecommerce presence, why would you want your sales and inventory data bifurcated between multiple platforms? You don't. And so by connecting the dots between these two, Shopify strengthens the case for large enterprise merchants to use their platform as a source of truth for the entire operation.
So one way to read Shopify’s journey thus far is that they are slowly orienting away from primarily being cyclical with ecommerce to becoming far more cyclical with merchants as a whole.
If Shopify is able to fully orient towards this sort of omnichannel platform, a lot of other product offerings start to open up. Perhaps take the infrastructure from the Deliverr acquisition and also productize a solution for wholesale fulfillment to large retailers?
Second, even with the fraught situation facing ecommerce players post-Covid and iOS 14 ad changes, Shopify Capital has continued to grow, reaching around 4B in financing agreements since 2016 (with about 2B in the past year). No idea on the profitability. I’ll be generous and assume it’s going pretty well given the ramp up.
I’ll leave aside Shopify Plus for the sake of length, but suffice to say, since Shopify is so critical to ecommerce players, you aren’t seeing churn off the subscription. Quite the opposite, especially as larger enterprises like Glossier come on the Shopify platform.
Lastly, Procore is a fun one. To date they haven’t launched many financial products. That’s changing but the Procore story this quarter is that they have continued to see pretty strong sales cycles in their core product. All of this comes back to some of the macro trends being seen in construction as detailed by Tooey:
And we have seen that there is just a broad secular demand for construction globally. And by the way, we always mention this, but even in the economic downturns, there's a lot of stimulus that comes into the market. Right now, we have the $1.2 trillion infrastructure bill in the U.S. amongst the chips bill too. So where one sector kind of wanes, the other one expands. But what we're seeing is that the pie is growing, and it's growing across all facets of construction.
So the construction sector is holding up, and since Procore ties their pricing to volume flowing into contractors, my hunch is that the platform is increasing revenue amongst existing customers at the same time that they they continue to digitize more customers in the industry.
The other aspect of the Procore story is that they are beginning to experiment with all sorts of additional financial products including materials financing and Procore Pay.
These are sort of a black box right now in terms of information, but I think you can broadly sense Procore’s ability to start to exhibit some of the other macroeconomic qualities around vSaaS.
Perhaps the largest takeaway for all these platforms and for vSaaS companies writ large is that they are still nowhere near to their end state or terminal valuation. They still have massive opportunities to digitize large swaths of their chosen industries. So apart from these thoughts on the sustainability of these businesses in different market cycles, you also have huge growth opportunities ahead to do what these companies do best: digitize large swaths of industries with world-class software.
It’s perhaps trite in the face of so many headwinds in the tech sector to exempt vertical SaaS businesses from pain ahead. But at the same time, where else can you allocate capital, talent, and product vision with payoffs that hold up in all sorts of macro conditions, not just in zero percent interest rate climates?
I’m not sure, and it’s why I’m eager to see what the next 10 years in vertical SaaS looks like.
Happy building and investing.
One more thing:
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Blend and anyone dealing with bank products is probably the exception here.
I’ll be the first to admit that this feels far more speculative to me and somewhat less dependent on Q3 guidance.
In fact, one of the ways you could imagine Hubspot rectifying this is to white-label their CRM for vertical SaaS companies to develop on top of. There’s such a massive opportunity for vSaaS companies to develop robust CRMs for their sellers this and strengthen their value proposition immensely. De facto, a company like Nickel is selling into companies that employ sales reps. Connect the fintech layer with the CRM layer and instantly, utility to material sellers goes up.
Veeva is sort of going towards this and is making more and more tailored CRMs for different customer bases; a MedTech CRM being the prime example.
Churn rate reduction is accretive!
The more complex the operation, the more this data matters. And so it also offers a fantastic way to get into larger enterprises.
I wouldn’t be surprised if it increased platform usage amongst the cohort as well.
One of the quirks here is that there’s a ton of different pay-facs that process online sales. So simply by increasing utilization of Shop Pay, (up to 54% this quarter), you end up increasing transactional volume even apart from increased ecommerce sales as a whole. As far as I can tell, that’s the story here.
This doesn’t only apply to enterprise merchants. SMBs are using this too. There’s a local leather goods shop that has fully converted to Shop POS for their retail footprint.