Dave Yuan - A Primer on Vertical Market Software - [Invest Like the Best, EP.335]

25:04Double down, raise a lot of expansion capital, go big, very similar to a horizontal strategy. On the flip side, if you're in a more modest category and you've gotten to category leadership and barring some sloppiness from the capital markets, you kind of have this thing pretty well understood. Well, you probably shouldn't raise a big primary round. If there are other reasons to raise capital, you should maybe diversify through secondary liquidity. Maybe it's M &A. But the use of capital and therefore the provider's mindset has to be very different. And so one of the things that we've really both enjoyed and I think we as a firm has benefited from is when I started investing, I did my first three years at a bio firm in 2000, right in time to catch a bunch of falling knives.

25:48And then I went to a growth firm and learned the more secular, high growth perspective. And I think these integration of the two really helps us look at these various different markets and these various different companies at really quite different stages of growth and maturity. So I think to do this right, to invest in this end market right, there are certain commonalities in terms of company formation and thematic pieces, but your mindset has to be really different depending on the end market and the company you're backing. One of the things that you hear over and over when you talk to BMS businesses and also at BMS investors is the critical importance of gross retention of really, really high sticky, sticky customers.

26:33You already said it, like almost nobody even looks at new software every year. Talk about what drives good or great, I guess, versus good gross retention in these businesses. What is it that makes the stickiest versions of these things? When I was doing my original listening tour on this, which included a conversation with you, that's one of the things you just hear over and over again. You want 98%, 99 % logo retention, which is unbelievably high, in order for these things to really become great businesses. And the difference between 99 % and 94 % is enormous. What drives that wedge or that difference in your experience?

27:08I would make a distinction between net retention and gross retention. Net retention factors in the expansion that you get from existing customers. because if you are selling to small businesses, it is unlikely that you'll get into the mid-90s. There's natural attrition. And maybe the metrics people are citing are net of that. So that would make sense. But I think in all businesses, in all recurring businesses, there is this trade-off between TAM and cost of distribution with net retention. In more limited TAM scenarios, you really do want net retention higher than 100%. So your gross retention plus any expansion that you get from the existing customers, it just totally changes the economics of the business.

27:50Now, the question is how you get there. So I do think the nice part about this control point framework is it correlates very highly to gross retention. The more gravity you have, the less likely the customer is going to churn. And then if you think through this methodical framework of how you cross attach a second, third, fourth product, you can go from gross retentions. And typically, depending on the segment you're selling into, they are lower than 90%, but you start increasing the expansion, that gets you well over 100%. So you have these nice cohorts that are growing in and of themselves, which is the goal of every recurring software investor.

28:26That is how we think about it. I do think there is this really interesting periphery area. You sort of break vertical SaaS down to its basic levels, you are selling to SMBs. And that is like an intersection between consumer and enterprise, right? Just almost like by definition. And so you look at these companies and the end customers can be in that spectrum. So they could be more close to the enterprise side where you get to your point, mid-90s and gross retention. They could be more on the SMB side that gets lower than gross retention, but you make up for net retention. They could be lower. They could be solo practitioners.

29:03Shopify, many of their customers are actually solo endeavors. And if you look at Intuit, if you look at Xero, a big chunk of that market is FDE of one. By definition, you're going to have relatively low retention rates there. And so what do you do there? And I think the really interesting part of that segment is a couple things. One is the best companies, and we have some fellows from some of these companies. what they do is they think about retention, not on a enterprise basis, but on individual basis. So Joe starts a lemonade stand, it doesn't work out, and he starts a taco stand. Well, as long as you keep Joe, that's pretty good retention.

29:39So that's one thing. The second thing, and this is what gets into the consumer side, and this is why you asked me why I invest here and I love being customers. I also love the confluence of function and skill set. This gets more to the consumer side, which is, hey, if you have, let's say, 60 % retention, 65 % retention, in an enterprise market, that's really tough. There's a massive leaky bucket. But if you're in a big town and you have really broad and cheap distribution, let's say you're pretty good at linear TV, which is many of what these S &B products have done. Well, that's okay because you're more like a consumer business and any consumer business would die for 60 % retention.

30:20They're more like 20%. So it's really this spectrum. I do think to be a great vertical SaaS investor, you have to think from perhaps expansion stage to buyout to public. And you also have to have a little bit of enterprise software DNA, a little consumer DNA, a little fintech DNA, and then obviously a lot of time in this core category. If you think about the products and the multi-product mindset of the entrepreneur, which like you said, runs a little bit counter to the normal advice, I guess, in all entrepreneurship, which is that you're supposed to do one thing and do it extremely well. What does multi-product mean?

30:55When I think of EMS, I think about a single operating system. If I'm a barber, it's where I book and bill and do all the stuff that I need to do to run my business. So what does multi-product really mean? Is it a new button that I double click on my desktop to open a second piece of software? Is it new features inside the existing operating system that I have to pay extra for? What does multi-product defined to you mean? Let me try and pull apart each of the pieces. You can push me where you want. Take Toast. Most of these restaurants have a point of sale system and they have a payments provider.

31:28Man, it'd be a heck of a lot easier if there was just all in one. You take payment into your point of sale. There's no reconciliation. It's easy. And so the way Chris, the CEO of Toast, describes, and I think he's very creative language that we've started to borrow and maybe even steal, is this idea of better together. One plus one equals five. They just work better together, reconciliation is better. And in this particular example, we've written an essay around the benefits of integrated payments because then you just get a lot of information on the financial health of your merchant as well as your consumer.

32:02That's the thought. And I do think because you typically are selling to an SMB where they don't want a ton of vendors, they just want stuff to work, you are able to move to what you're describing, which is an operating system for this merchant. And the more you can add, the better. And again, it tends to group in front office and back office, but generally the more you add, the better. Now, I think what you're also pulling on is this idea of monetization. So if one plus one equals five in that early example, what do you charge them? Do you charge them four? Do you charge them one and a half? Do you charge them two?

32:41Because presumably the nice part about multi-product for the vendor, for the SaaS company is there's very little in incremental sales costs. That's not fully true, but it's generally true. And so therein also is a really interesting TAM question. If you're in a big TAM, you probably charge to the lower end because you're adding value and you're just creating this great compounding flywheel. And if the customers are bigger, maybe, then you know you're going to cross all sorts of other products over time. If it's a smaller TAM, then maybe you'd charge it closer to four. Customer's making a dollar because one plus one equals five.

33:14So they're getting$5 of value and paying four, but you're also forexing your ARPU, obviously. It's a really nuanced question, but that's what makes us fun. What are the other big, chunky... You talked about payments, getting into payment flow, payroll. What are the other big things you see over and over again as ways to serve in this multi-product mindset, the merchant that always work if you're in that trust? I do think in the front offices, payments in certain circumstances where it's not a single transaction, it might be engagement over time for a service provider, various different things like the whole billing idea.

33:51So taking in money is always good. It's a lifeblood of these merchants. It's always great. And then once you get the flow in, you now have insight of the financial health of your merchants. So you could think about very low risk lending, some cash flow lending. A part of Square's P &L, for example, is instant deposit, which is getting money rather than waiting three days for the money to show up in your account, getting it instantly. And that's just time. There's very little risk associated with that. And Square makes quite a bit of money on that. And I think many vertical SaaS companies can do the same.

34:24I do think there's a step function in terms of effort as well as opportunity where you do think about what are the constituents around you. There's your customers, there's your employees, there's your suppliers. If you go to the employee side, that usually can be a little bit more linear because these employees work for you and they engage with your systems anyways. Then you start thinking about things like employee scheduling and payroll. And this idea that if you think about your control point and data gravity, it's the data about your most important assets. Well, one of your most important assets are your customers and your employees and your suppliers.

34:58And so those are natural extensions. If you go towards the supplier side, then you think about things like procurement, you think about actually payment flows to them. You think about over time, as you get back this trust concept and getting density within a single level of merchants, you may think about group buying. It may be a GPO, it may be other formats of that. The consumer side, as we talked about earlier, that's the holy grail. That's where there's a lot of money and that's where there's a lot of joy and energy for your merchants. There's ways to incrementally move towards the consumer.

35:31You start out with things like CRM, you think things like loyalty, you think about how to increase the conversion rate, things like consumer lending, those types of things, you can move into creating demand either directly. And in very rare circumstances, you'll actually start to see some vertical SaaS companies being able to create something that equates like a consumer marketplace. I've talked to some investors that think the right approach here is pretty mechanical. There's more science than art in this style of software building and investing than would typically be the case because there's just a lot of overlap between...

36:11You've laid out some of the key functions that all of these merchants tend to have. And of course, you got to make it bespoke to the industry, but there's a lot of science to it. So I'm curious about the art. When you think about the most creative case studies or entrepreneurs that you've engaged with, what comes to mind? What is the creativity, the imagination, the art that you see and what seems to be a consensus, more mechanical scientific approach? There's a guy in our network, a Tidemark fellow, Lawrence Hester. He started this company, Fair Harbor. It's a bootstrap business that I think everybody chased, and I chased hard for three or four years.

36:47So what it was, was think about it as a booking platform, a website for tour and activity providers. So helicopter operator, luau provider, fairly straightforward. As you think about building a business, all the tough things that we talked about earlier come to mind. How do you track these people down? How do you get them to buy software? How do you get them to use your software? And so the creative thing that Lawrence did is some combination of pricing strategy, product strategy, and go to market. So the first thing he did, he realized is that a touring activity consumer, we go on a trip to Hawaii and look for a luau, is a transactional customer.

37:25They're probably not gonna go to Hawaii again for quite some time or look for a luau. So what does that mean? You can charge them a buy-side feed. So he would charge, I think, some percentage. I want to say it's 6 % to 7 % of the fee, and it's just tucked in at the end. That's a lot of money compared on these high ticket sizes if you're taking a helicopter tour, for example. So as a result, he was making money on the buy side fee. He would charge the tour operator payments, but they were paying for payment services anyways. And he would also price match and really take the price quite low. So that's one piece.

38:00He totally changed the business model just through pricing. The second thing is from a product standpoint is he would go to these operators and say, hey, you really should think about redoing your website, using software to take bookings, so and so forth. And be like, okay, well, I got to go around my business. We'll talk later. It's like, actually, we've done it for you. By changing the economics, he was making tens of thousands and sometimes hundreds of thousands of dollars on these tour activities where everybody else was trying to sell software at 30 bucks a month. And so what he could do is he could build a team to go build the product for the customer as part of the sales cycle.

38:40And then the final piece is he tied it into a go-to-market model where he'd pay these young salespeople, these folks right out of college, and realizing the annuity value of these businesses and the increased monetization, he'd write a compensation plan that provided very little base, but half the first year's booking. And so you had these sales reps. There's a great story of a sales rep that slept in a van and drove, I think it was around Hawaii, and wouldn't come back until he booked every single tour operator in that geo. That combination of three factors built a significant business that he ended up selling to booking that is very far from mechanical and was the winning strategy.

39:24And there's other providers in the space that have tried to match it, but there really hasn't been something as successful. So that might be a good example. That is an amazing example, like replete with lessons. Because that one is so good, I have to ask, what's the next one? What's the next great case study that comes to mind? I'm just going to leave it there. That one is so interesting. There's this business in LA. And I'm going to get this a little wrong because I talked to him maybe four or five years ago, but I got to know him over the years. I won't name them because they haven't sold. And at some point in time, we'll go chase them.

39:55But what they did is they went after probably the most manual market that you can imagine, which is the commercial casting market. It's literally finding people to show up and act for a commercial. And so where do you think the power is in that? It's in the casting. So what they did was they provide a tool for these casting directors. I didn't know this existed because I'm not in that industry. But they provide a tool for this casting director to go through hundreds, thousands of resumes and various different auditions in a very clean way and create a portfolio very easily. This used to take hours and hours of time.

40:28They just did all of the software. But they were able to basically offer that for very little, or I think it was actually free. And so they got all the casting directors. And so on the back end, they just built this LinkedIn where all the actors for a very small amount of money would upload their content and their parameters. And so what a great business. You're taking a lot of the sweat labor out of the ecosystem. You're able to monetize the fat end of the market, which is all these actors looking for commercial gigs by providing this pretty simple tool at the top of the stack. And so it's sort of a very micro version of what Ariba has done over the years and other folks.

41:08So it's a cool little business. Is the strategy you take away from there that you should always investigate? What is the scarce thing? What's the scarce supply in the ecosystem? And then really focus on serving that scarce supply in a unique way. Is that a pretty repeatable strategy? I think that's right. I think when you start thinking about extending through the value chain is our language, but you go sell from one customer to the customer's customers or the other constituents, the easiest, most linear way is by following the money. You start out with the buyer, then you try and sell to the supplier.

41:40Now, to your point, fragmentation matters a lot. And so if there's only two suppliers and many buyers, well, you start with the suppliers first. It is very similar to an online marketplace mentality, which is what's the hard side? What's the scarcity? So I have two maturity questions, both relevant for investors in this space. The first is like how saturated and penetrated just the raw opportunities are for entrepreneurs to go after. And then the second is how mature and priced in is the idea of VMS for investors? Another way of asking that one, I'll ask that one. And second is, was the right time to do this when Constellation started doing this?

42:15And now it's, everyone knows about it and it's fine. And like the attractiveness of VMS is inversely related to how much people know about Constellation or something like that. Let's start with the entrepreneurial side. How saturated red versus blue ocean do you think in general building a VMS business is today relative to the past? I think it's certainly more saturated in the past, but man, there's so much Greenfield in my opinion. greenfield that was either underserved or not served at all by software or underserved through desktop productivity software that was sold in the 90s. So I think there's still quite a bit of opportunity now that big end markets, restaurants, things like that, restaurants, construction, the trades, they have had software companies coming at them.

43:02But nonetheless, even in the big verticals, there's a lot of sub problems that need to be solved. And so I think there's still a lot of runway. One quick plug is what we did was we ran all the NAICS codes and we looked at every single vertical by location and fragmentation to help entrepreneurs pick their spot. So if people reach out to us, we'll send them. So I think there's a lot of runway, but back to how we opened the conversation, just like an entrepreneur or just like an investor is investing their capital, an entrepreneur also needs to be pretty thoughtful how they invest their time and invest it accordingly to the market attributes.

43:39So if people are looking for a get rich fast approach, there are certain verticals that make sense. If they want to build a business methodically over time, there's certainly other verticals where that's required. So I think you just need to be smart about what market you go after. Fairly obvious comment, but I think people still get that wrong. As an investor, I think it's largely the same, which is, I think, painting this set of companies where there is commonality, but very different end market attributes, the same is really dangerous. And I do think investors tend to go for the TLDR and go for the sort of quick instinct.

44:21And I think you're starting to see some particularly expansion stage investors sort of paint everything the same. I don't think returns will be great with that approach. I do think you have to be a bit more nuanced and you have to go from expansion stage to private equity, to public, to various different modalities to match the modalities of the end markets that you're investing in. I think there's some truth to that. I think you're starting to see people maybe over-index to this market. That being said, though, when I think there's a natural ebb and flow of these things and people will pull out as the returns may not be as great as they anticipated, or they get distracted by some other thing.

44:59I do think while maybe the painting this end market all with the same brush may lead on the margin to some companies getting overvalued, some companies will very much still be undervalued with what we're seeing as it relates to the multi-product orientation and also the ability to extend up and down the value chain. And I think it's just a really productive area to invest in. And it's SMBs, which, again, align very closely with vertical SaaS employee, close to half of the US. These are big problems that need to be solved. They have a lot of work to do and a lot of that will come through automation.

45:35So I think it's just a great place to invest. Have you alighted upon methods of valuation or variables that go into how you think about the multiple that should be placed on a business like this that's different than the normal software metrics that everyone cites for valuing every software company, growth rate and ARR? and rule of 40 and all these kinds of things. Are there VMS specific valuation considerations that you think are smart or important? Yes. It's less around what the exit multiples are, because I think you can align that to traditional frameworks. It's more about the P &L. So every P &L is your typical recurring P &L with an ARR bridge.

46:13But for VMS, I think the important look is locations by ARPU. The nuance there where I think you can take it like any investment framework, you can do a 10-minute review. You can do a 10-month review. And I think the nuances that you pick up with a 10-month is on the location build, segments really, really matter. Because if you think about from a first principles standpoint, back to your earlier question, a horizontal business looks at the universe as everything in. A vertical business is taking a slice. Well, even within vertical, you need to think about subslices because first of all, there'll competitive entry in subslices.

46:50And then also your value proposition is tied to how tight your product market fit is. So ICP is really important. The ARPU piece really is an experience-driven activity. It's kind of what you put in the bucket and what you don't is ultimately what drives to what you do. Right now, the conventional wisdom is if you own the merchant, well, you should get all the payments and then you should get all the payroll and all the other things. Well, the reality is there are a lot of nuances as it relates to attach to payments. You have great vertical software companies that have been in business for 10, 12 years, and their attach rate is something like 20 % to payments.

47:25And there's some operational nuances. There's some end market nuances as to whether you can get the attached to 100%. And there in that difference can turn what seems like a great deal into a pretty mediocre deal and vice versa. So I think that ARPU build is very nuanced. And so that's how I think about investing in space, a little less on the exit multiple side, which of course is super important too. Is there anything that we haven't talked about surrounding this discipline of investing in company building that you think is really important? I do think time horizon matters a lot because most of these markets just by the nature do tend to turn over a little bit slower than a horizontal market just by the personas and then also the organizational structures.

48:10And so I do think the best investors in this space need to have a very long time horizon because otherwise you'll be more driven by multiple than P &L. Some of these P &Ls do take a while to build out. Some of the best VMS businesses have been going at it for 30 years. So I think time horizon really matters. What investors or companies should people interested in this category study most carefully? You're not allowed to say Constellation Software. I'll point out the ones that are less obvious. I'm no longer on the board. I'm no longer formally affiliated with the company. but people should take a look at CCC.

48:42So CCC is the business I described earlier that sells into the auto insurers. They moved down to auto buyer repair. They're now building an online parts marketplace. That is, to me, super interesting. I think that's the strongest expression of extending through the value chain. I think maybe two others that are a little less covered. This isn't a comment on their valuations by any means or an investor recommendation. What Affolio is doing is super interesting. They started obviously at the property management side and they've done a bunch of things to engage with tenants, but they're starting to move up the stack into equity holders and creditors.

49:17If you think about this idea of single source of truth across layers of the value chain, that's a really powerful concept. There's trust issues, as we described earlier, but ultimately the unit of measure on all these things is really the property financial performance. And so there are various different slices that want to see different views of that. We invested in a horizontal business called OneStream, which is very similar in that regard. This concept of single source of truth, I think, is applicable across both vertical and horizontal. I think the other one that are really interesting case studies, and the reason why they're interesting is just the different approaches to the consumer extension, which I think captures a lot of imagination and is quite challenging, but also huge upside.

50:04Spend time with MindBody and their acquisition of, I believe it was ClassPass. I think that's super interesting how that came together. I spent some time with the team and there's some really interesting nuances that affect monetization and affect the success of that type of approach. Because I think from an industrial logic standpoint, of course, you take an operating system software company that has decent market share, you add a marketplace and it all works. And so just unpacking that experience, I think is super interesting. I think the final one, which is probably less known as a vertical software player, but I think has a lot of parallels and you could argue is as well as a zip recruiter.

50:44I wrote an essay on this, but I think just the high level is you go from a job distribution tool. So I have a job spec that I want to push to multiple job boards rather than posting to all of them. I'll push just to zip recruiter to essentially creating their own pool of candidates. through very clever tactics. And then they ultimately went all in and spent a lot of money to build a consumer brand. And just seeing those phases of development are super interesting. Ultimately, I think what it suggests is if you really want to build a consumer brand, there's no shortcut around it. You just got to write the big check, build the DNA and get after it.

51:23I think there are probably ways to make it easier, but it's just a really instructive case study. So those are the three that come to mind. Dave, I think if anyone out there wants to understand and study this space that you've created your own system of record, if you will, sort of content of record for understanding the different aspects of how these businesses work, how they grow, the nuance that drives success. I've so enjoyed talking to you and also reading all the things that you very generously put out there. And I love the spirit of sharing this very openly and freely. I just think it's so positive, Sam.

51:53I love it. I ask everyone that I talk to the same traditional closing question. What is the kindest thing that anyone's ever done for you? Yeah. So I'm a long-term listener. You were going to ask this question. And I think most people might think, all right, what's the most authentic and what's the most novel answer? And hopefully you combine the two. And the authentic answer is maybe not that novel. And it's one I'll go with here is it really is my family and the team around me. And I know that's not a specific answer, but if you want to be a great investor, and I aspire to be that, if you want to go start a firm, If you want to go do anything, you break a lot of glass and you push really hard.

52:31And I really am grateful to my family. Like it's more than just going and achieving. And then the first two years at Tidemark were pretty intense. We raised in 2021. We were fortunate to say no a lot in 2021, but it's really hard. We're trying to make a name for ourselves. And that discipline was painful. And now as we build the business in probably one of the most turbulent times, I'm really grateful to the team to stick with it and keep driving and keep put one foot in front of the other and building this team. So simple, but beautiful. Simple, maybe not novel, the truth. The simple things are always the best.

53:08It's a lovely place to end. Dave, thank you so much for your time. Yeah, likewise. Fun conversation, Patrick. If you enjoyed this episode, check out joincolossus.com. There you'll find every episode of this podcast complete with transcripts, show notes, and resources to keep learning. You can also sign up for our newsletter, Colossus Weekly, where we condense episodes to the big ideas, quotations, and more, as well as share the best content we find on the internet every week.

53:54Thank you.