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Vertical Operating Systems and Embedded Fintech
Why We’re Excited About the Intersection of Vertical Software and Financial Products catering to specific SMB industry niches
Software-as-a-service (SaaS) is a revered business model by investors. And for good reason - well over 50% of exits over the past decade have been software companies (NVCA). The majority of those companies have been enterprise SaaS businesses, selling to large corporates with big technology budgets, customer bases, and data assets to manage. These large enterprise SaaS companies are often horizontal in nature - industry agnostic customer focus, aiming to own a singular function offering a myriad of use cases like financial operations, procurement, workforce collaboration, CRM, and ERP.
Vertical software, where we’ll focus our efforts in this post, refers to software companies selling to small and medium businesses who employ roughly 50% of the US workforce. Furthermore, vertical software is laser focused on a specific industry, building an operating system catered to the needs of that industry. In the same way iOS is the lifeblood of most of our phones, an operating system for SMBs is the non-negotiable set of data, standards, and workflows that fuel SMBs operations in a particular industry.
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One good example is Procore, a $9B vertical software platform for the construction industry. It serves general contractors across preconstruction, projection management, workforce management, financial operations, and analytics. The company has built a single platform for their customer base, expanding its product suite through new product development (insurance, payments, bidding) and M&A (Levelset and Labor Chart)
Source: Procore Investor Day
Historically, vertical software has been deemed less attractive markets for a few reasons, including smaller addressable markets, challenging sales efficiency, and greater churn. Small businesses have been viewed as less attractive customers due to average contract values (smaller), sales inertia (higher), and retention challenges (closer to consumer subscription churn than enterprise).
Despite the preconceptions, there are a number of examples over the past two decades of vertical software businesses who have successfully built a platform that becomes the industry standard for a given vertical. Many of these companies are lauded by private equity firms like Vista, Thoma Bravo, and Silver Lake who have invested heavily in the category. There are also a number of publicly traded and late stage private vertical software companies who have overcome initial hurdles of smaller perceived market size to build durable franchises. Guidewire in P&C insurance, ServiceTitan in field services, and Veeva in life sciences are a few examples.
“I would like to think that Guidewire along with a few other super examples, like Veeva, have proven that if you solve a deep enough problem, and those very deep problems tend to be industry specific and you do it in a sufficiently general fashion to capture enough market space, you actually can create an interesting and independent software company.” - Marcus Ryu, Co-Founder of Guidewire Software
In short, the success of companies like Shopify in commerce, Toast in restaurants, Procore in construction, and AppFolio in real estate have demonstrated the limitations in those arguments. Here we’ll highlight why we believe that conventional wisdom is short sighted and the role fintech will play in scaling durable vertical software business.
Opportunity for TAM Expansion
Since vertical software is purpose-built for clear industry niches, it condenses the size of the potential market at face value. That said, the most successful vertical software companies have been able to substitute a smaller initial market for greater market share through network effects as well as TAM expansion through product expansion. The most attractive markets are often those characterized by highly manual workflows, deskless industries, and a fragmented long-tail of market participants.
Source: Bowery Capital
A robust vertical SaaS product is ultimately an operating system for the merchants who run their businesses on that platform.
Whether it’s managing bookings for creatives, overseeing projects for contractors, or scheduling appointments for a salon, the platform should aim to be the lifeblood through which a business operates. The attach points run the gamut from customer acquisition, customer relationship management, inventory, payments, and financial management.
As vertical software platforms earn the right to serve as the system of record for merchants, they can then deepen their customer relationship while increasing monetization through incremental product innovation. Perhaps the most impactful way to do that is through fintech.
Vertical SaaS + Fintech
Traditional monetization for vertical software comes from subscription-based, recurring revenue streams paid by customers. As highlighted above, the ability and willingness to pay from SMBs, particularly those who are operating in less technology-oriented industries, is invariably constrained relative to large enterprise buyers. As a result, the revenue opportunity purely from software is less abundant. However, a core tenet of the vertical software playbook is a multi-product orientation. One of the most valuable ways to become multi-product is through incremental fintech and transactional revenue streams.
Historically, that has meant payments. Vertical software businesses like Toast (54%) and Shopify (46%) each derive significant portions of revenue from payments and fintech.
This isn’t a new phenomenon. Software private equity firms commonly look to monetize payment volume through payment facilitation (payfac). PayPal invented the ‘merchant aggregation’ model over 20 years, which preceded the modern payfac model that many of these software platforms rely on today to monetize payment flows - that can mean an additional 2-5% take rate on $100M of GMV (source: Barclays).
Looking forward, vertical software platforms will (and already do, in many cases) incorporate lending, invoice factoring, spend management, insurance, and payroll into their product suites. By adding in fintech offerings, selling vertical software to SMBs can become a profitable and sustainable business of its own. Fintech products provide additional revenue streams, as well as customer acquisition engines, retention catalysts, and more expansive value propositions for customers. In the process, this helps to reinforce the operating system role the vertical software platform seeks to serve for its customers.
One example of an embedded financial platform is Authentic, a turnkey insurance platform that allows vertical software companies and franchises to launch captive insurance programs for their customers to offer tailored, affordable SMB insurance coverage. In the process, Authentic’s software partners generate revenue through commissions on new policies while also retaining the majority of the underwriting profit from those policies. Authentic is an Upper90 portfolio company.
Leveraging vertical software platforms with captive customer relationships and proprietary transactional, financial, and product-level datasets presents unique opportunities to create and distribute financial products to existing customers. A few unique characteristics of vertical software that get us most excited about the fintech applications include:
Gauging Intent: platform, usage, and transaction-level data can inform customer intent for financial products to simplify the customer experience and engagement
Pre-Approvals: platform-level data provides better insight into customer quality and underwriting
CAC Advantage: demonstrably lower customer acquisition costs because you already own the customer relationship through software, often a daunting challenge for standalone fintech
Revenue Diversification: subscription and transactional monetization allows for a diversified revenue mix
Customer Lock-in: building a one-stop shop for end customers where each incremental product reinforces the value of the platform, driving greater stickiness and net dollar retention
Think of a restaurant running their business on Toast. If they have constraints on their existing cash flow for the month, but need to place a big order for new inventory, Toast has the financial, transaction, and POS data to know that the restaurant would likely benefit from a merchant cash advance offered through the software platform via Toast Capital. Toast Capital has originated over $1B in loans since inception in 2018 and the vast majority of borrowers are repeat customers.
Another example is Cents, a vertical software platform that helps laundromats grow, manage, and optimize their business. Cents launched Cents Capital to offer loans to laundromat operators running their businesses on Cents’ core platform. Through a combination of SBA and commercial loans, Cents provides another tool for their customers in the form of access to capital to finance the opening of new locations, purchasing of equipment, or renovating an existing location.
Source: Redpoint Ventures
As a hybrid fund, Upper90 provides credit facilities to fintech, software, supply chain, and marketplace businesses. We work with founders to identify stable parts of a company where credit can be utilized earlier to finance growth more efficiently. As an early capital partner, our product is less dilutive capital for founders to fund those more predictable parts of their business with asset-backed credit alongside equity for alignment.
In the case of vertical software, funding activities like new financial products and strategic acquisitions is often better suited for credit than equity.
Our mission is to partner with exceptional founders to create a more efficient balance sheet. We’re particularly excited about two types of businesses within vertical software:
Core vertical software platforms building the next operating system tailored to an industry that aims to accelerate acquisition, boost monetization, and deepen engagement through financial products like lending, cards, factoring, and payments (like Upper90 portfolio companies Outgo, Octane, and Toolbox).
Enabling infrastructure that helps larger vertical software platforms embed financial products to offer to their existing customers (like Upper90 portfolio companies CapitalOS and Authentic). Financing activities like lending, factoring, insurance and earned wage access are key areas of focus for Upper90 credit facilities.
If you’re a building a software business thinking about the intersection of vertical software and financial services, we’d love to meet you. Feel free to reach out to Conor@upper90.io.
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