Before the New Year, a compression among publicly traded SaaS stocks pitted nervous Wall Streeters against eye-rolling Silicon Valley-ites. It appeared that Wall Street, having inflated every company with the words “remote work” or “cloud” on their website, got spooked and share prices plummeted.
On January 2, 2022, Bloomberg published a collection of jargony viewpoints from financial institutions about their expectations for 2022. They described valuations as “stretched,” “excessive,” “rich,” “elevated,” “high,” “lofty,” and “cause for concern.” JPMorgan opined that “Increasing interest rates and marginally tighter monetary policy should be a headwind for high-multiple markets such as the Nasdaq.”
I trained as a lawyer—not an economist, but that sounds like a turbulent year ahead for B2B SaaS companies. However, markets might treat horizontal and vertical SaaS differently.
Horizontal SaaS companies serve more industries than they can fit on a single drop-down menu. They do a few things many types of organizations need and earn high-multiple valuations based on a massive, total addressable market (TAM). Meanwhile, vertical SaaS companies sell comprehensive, cross-functional technology to one industry. Although their TAMs are smaller, their valuations might be more resilient if valuations have in fact peaked. Several reasons stand out:
THE PSYCHOLOGY OF VERTICAL BUYERS
When I first took Filevine to a legal conference in 2015, a lawyer approached me to tell me that it was illegal; you can’t sell cloud software to lawyers!
Put yourself in their skeptical shoes. People don’t sit around wishing they had better software—not in verticals like medicine, accounting, or law, which often sell an expert’s time. No one wants to lose billable hours or patient slots to software updates, retraining, and developing new workflows unless those can move the dial financially. The vertical SaaS shopper is someone who doesn’t want to need your software.
Imagine if I came to your house and said, “I want to sell you a new set of copper pipes. Once we’re done, you’ll have the best pipes in town and won’t need new ones for 20 years. We’ll just need to tear down and rebuild some walls, so you can’t use the bathrooms or kitchens for a few weeks.”
You’d turn me down, unless your pipes were old, leaking, and causing damage. That’s the situation vertical SaaS often sells into: industries that are profitable despite some leaking pipes. Once vertical SaaS customers buy, they are arguably the stickiest and most loyal customer base in tech. That’s good news for vertical SaaS valuations.
THE TRANSPARENCY OF A VERTICAL TAM
The best thing about vertical SaaS is that founders know exactly how many potential customers there are. You can, for example, pull a list of dental clinics in every American city. That means investors also know your TAM, which is a counterintuitive advantage.
For comparison, horizontal SaaS companies speak to a massive but harder-to-define TAM. Thus, there is extreme pressure to show constant, accelerating growth. Their sales teams often maximize customer acquisition—through, say, discounting—without worrying about margins. They need customer growth to validate their TAM, and by extension, their high-multiple valuations. When valuations peak or growth slows, the horizontal SaaS companies have a long way to fall.
If you make dental software and there’s 197,000 clinics in the U.S., that’s your U.S. TAM. You can raise rates occasionally, but not too quickly. If you want a higher average selling price (ASP), you must continuously launch services and products that either increase the value of the base subscription, your prix fixe menu or can be sold a la carte, in addition.
Rapid growth doesn’t validate or invalidate a vertical SaaS company. Investors won’t demand a pivot if you don’t have one million new users by tomorrow. Because they understand your TAM better, they are less likely to have inflated your valuation in the first place.
INDISPENSABILITY
In horizontal SaaS, founders tend to build systems that are interesting but not mission-critical. There are exceptions to that observation—like Salesforce and other systems of record—but most horizontal SaaS is dispensable or easily changeable. Vertical SaaS founders tend to be domain experts who hire or partner with technologists. They build systems that are usually indispensable and therefore less vulnerable to chaotic markets.
Given their limited TAM and long sales cycles, vertical SaaS companies must capture a significant portion of a client’s technology budget. A point solution won’t do that. Rather, the vertical players must package cross-functional systems you see offered by generalists—like document management, project management, timekeeping, etc.—in ways that only an industry insider would know to do it. The platform has to be better than a Frankenstein equivalent made of integrated, horizontal SaaS.
The domain expert usually overbuilds this system with fail-proofing measures and backups that seem extreme to outsiders. But when legal platforms fall short, careers, reputations and a lot of money are on the line. When medical records software fails, care providers might make incorrect—and even fatal—treatment decisions.
When markets get shaky, businesses can jettison some of their horizontal SaaS—but the vertical SaaS stays because the customer regards it as part of their day-to-day, and doesn’t want to work without it. Besides, who wants to replace the pipes twice?
SCALE MIGHT BITE
Because the public markets are heavy on horizontal SaaS and light on vertical, we’re getting a skewed view of whether Wall Street prefers one to the other. While vertical software platforms might have difficult buyers and smaller TAMs, those constraints often produce indispensable platforms that are sticky and resilient. These qualities might make vertical SaaS less vulnerable when Wall Street decides that valuations have in fact peaked. Industry leaders find out soon enough.
Ryan Anderson is the founder & CEO of Filevine, a project management, collaboration and legal case management tool for lawyers.