Invest Like the Best with Patrick O'Shaughnessy - Dave Yuan - A Primer on Vertical Market Software - [Invest Like the Best, EP.335]

Starting point is 00:00:02 Hello and welcome, everyone. I'm Patrick O'Shaughnessy, and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, stories, and strategies that will help you better invest both your time and your money. Invest like the best is part of the Colossus family of podcasts, and you can access all our podcasts, including edited transcripts, show notes, and other resources to keep learning at join colossus.com. Patrick O'Shaughnessy is the CEO and founding partner of Positive Sum and the CEO. of O'Shaughnessy asset management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of positive sum or O'Shaunacy asset management. This podcast is for informational purposes only and should not be relied upon as a basis

Starting point is 00:00:48 for investment decisions. Clients of positive sum or O'Shaunice asset management may maintain positions in the securities discussed in this podcast. My guest today is Dave Yuan. Dave is the founder of Tidmark Capital, which he started in 2000. 2021 after 15 years as a general partner at technology crossover ventures. Dave has been investing in vertical market software as long as anyone I know and he currently sits on the board of two VMS businesses, toast and carbon.

Starting point is 00:01:17 He is the perfect guest to deliver a primer on VMS, which is exactly what we do in this episode. Please enjoy my conversation with Dave Yon. So Dave, since we last talked, I spent so much time, really after reading so much of your thinking and work on the world of vertical market software, obviously there's now a lot of people that have thought about this, investigated VMS businesses, but I think you've been doing and thinking about this

Starting point is 00:01:41 as long as anybody. And I'm really excited to make this a masterclass at this kind of company building, this kind of investing. We'll stray beyond VMS alone, but you just have this wealth of knowledge that you very kindly have written up and shared with the world.

Starting point is 00:01:56 Maybe you can begin by telling us why this topic or this style of business is so interesting to you in the first place. I think part of this is 10, 15 years ago when we started investing in vertical software is very much a contrary in perspective. And so there's a little bit at me that wants to provide a different perspective in the world. As the world start to appreciate these businesses a bit more, I think what really has taken over is two things. One is the business models that you can create in some of these

Starting point is 00:02:26 verticals. And we'll obviously unpack that into a lot of detail. The first wave was really interesting how you go to multi-product, but then what we're starting to see is really businesses that span beyond a single part of the value chain. That's just super interesting to me. On a more personal level, you just see what these types of software companies can do for their clients. And so I remember during COVID, and I was on the board of toast, and we were going through some challenges as restaurants were effectively shutting down. And I went to our local downtown, and there's a local tacharia called Mama Coco, and it's an awesome story. The owner and the manager is taking recipes from his grandmother's recipe book.

Starting point is 00:03:08 It's a family business. They're out there building. And can't think they're really struggling. And a big part of what allowed them survive is extending it to online delivery. You see in good times and in bad times what software can do for these hunters. If you watch any commercial for a small business software or a vehicle software provider, it's always the owner on their cell phone on a beach. I think it's a nod to the fact that running these businesses is pretty damn hard and allowing these owners to get out of the

Starting point is 00:03:38 judgery and create some automation, create some space from their life, is this incredibly energizing value prop. And so a big part of why I continue to invest in vertical SaaS, when I continue to pull this part, part of it's an analytical exercise. Part of it's also, I just love what these products do for their customers. And I love the role that small business plays in America. It's kind of a stupidly simple question, but just define what VMS means to you, maybe along with like a basic taxonomy of the types of VMS, or are they all sort of of one flavor, just to level set on how you think about it so that we can then pick it apart. Let's start from the ground level and you can push me forward or pull me back as much as you

Starting point is 00:04:16 like. Vertical software versus horizontal software. So it's software built for a specific end industry. Now, that end industry can actually be a pretty wide expanse of characteristics. So I think most people conflate S&B and vertical software together because most of the time a merchant tends to be a local merchant, a restaurant, a hotel, a retailer. And I think that's generally true. But there also are larger verticals. So I was on the board of a CCC that sold to auto insurance companies. Those are some of the largest companies in the U.S.

Starting point is 00:04:47 And so there is a wide expanse of S&B to enterprise, but generally it's S&B. I think in general what we found in S&B vertical SaaS is there's just a wide expanse. usually one system that's more important than the others. And maybe there's two. Maybe there's one at the front office where revenue comes in and maybe there's one at the back office, which reconciles all the financials to pay bills and to file taxes. But generally, there's one system, people call it system record system gauge, and we call a control point because we want to capture this idea of data gravity. It stores the most important data of workflow gravity. It's what you do to get things done, is what you're engaged in with every day. And finally, account gravity, which is the simple,

Starting point is 00:05:26 stupid question or idea that if you have to turn off every system as you were to go out of business, what was the system you would turn off last? And that's sort of your account graphic. That's another indicator control point. This is the system that powers your business. In that way, if you own that and occupy that space, it gives you lots of opportunity to do more for your customer and expand your offering. That's what we tend to mean when we say vertical SaaS. And to your point, there's a wide range of actually end markets that might cover in a wide range of business smalls as well. If we were to imagine something ridiculously simple, like a barbershop or something like that,

Starting point is 00:06:05 how do you assessing a new opportunity think about where the control point might be? Like how variant are these control points? Or is it just two or three flavors and it's kind of always the same thing regardless of the industry? I think it's somewhere in between, which is actually if you spend time with merchants and the customers, you get to the answer pretty damn quickly. It's what's the most important system? What do you spend all your time in? What's the last thing you would turn off? Those types of questions can pull it forward quite easily. I think where the nuance comes is, look, most of these

Starting point is 00:06:37 businesses are not going through all the hard work to build a business to sell one product. And so as you think about the control point, you need to think about what's the next play, where do you take this foundation extended to? If we think about the very, of the markets themselves that could be addressed by one of these vertical market solutions. Walk us through what you think the variables are, maybe even like stack rank them. Okay, there's make up the number. There's a hundred different markets we could go after. How do we sort one through 100 in terms of what might be the most attractive place to go

Starting point is 00:07:09 build one of these businesses? There's probably 10 or 15 factors we look at in making an investment. Let me call out three. The three things that I think about with a vertical is you start with Tam. That's probably the obvious place, but if you're building a company sell into an end market like restaurants, there's various different versions of Tam, but think of it as like 800 to a million locations in the U.S. Well, that's a very different market structure than if you're selling into, let's say, laundromats. And so I do think that the size of the market really changes the company formation process.

Starting point is 00:07:45 It also changes how you think about your investment strategy. The second is competitive intensity. What does the vendor universe look like? And those two things tend to be correlated. And the big TAMs looks a little bit more like a horizontal market where there's a lot of both software vendors and a lot of cloud vendors. I think the third piece is what is the growth dynamic within the industry itself. So the growth dynamic is important for all types of investing, right?

Starting point is 00:08:11 The more change there is, the more growth, the bigger the TAM is over time, the more turnover. I think it's super important these industries because many of these merchants, they're not natural software buyers. And so once they find a product, they stick with it. And so if it's a very stable industry, there may be many locations, but the turnover is relatively infrequent. So you're at-bats are infrequent. So you don't really have that much of an opportunity to start taking share.

Starting point is 00:08:42 So you may have to take different approaches to winning. that control point. You should pull that apart. But the CEO of a public company of a software company selling into a very large vertical that you might expect to have lots of turnover, he described it a really clear way one time. He was like, look, Dave, only about 5% of this vertical reevalues their software every year. And so my job is to see every single sales cycle of that and win 75% of that. What that is is a very measured go-to-market strategy. This This is not your Salesforce did this masterfully over the years, which is building S curves of sales capacity.

Starting point is 00:09:21 This market that the CEO is describing is the opposite of that. Those three factors really tell you the type of company you want to build and therefore the investment strategy you want to pursue. If you had to add one more example from that list of 15 onto the three that you've laid out where the criteria is that it's like a very nuanced one or like a very subtle one, just to give us a flavor of the examples of what you might look for. What would you pick? I'll specifically go a little bit further out on the growth and risk curve, on the aspirational

Starting point is 00:09:50 curve, which is trust. And so if you think about the framework of vertical SaaS, you start out with a control point, you sell a number of products in and around that control point. Okay, that's great. The real home run is to go from one layer of the value chain. So let's say you sell into auto insurance. You do a great job there. You win the market.

Starting point is 00:10:08 You get to market leadership. Then the question is, can you extend through the value chain? And in this case, you go from the auto insurers to the auto buyer repair shops. The auto buyer repair shops tend to be service providers to the auto insurers, something like, I don't know, 70, 80, 90 percent of an auto buyer repair shop's revenue come from underwritten, insured consumers. Now, the reason why trust is so important there is if you want to go from auto insurance to auto buyer repair shops, you're now selling software to both sides of a transaction.

Starting point is 00:10:38 This industry has been around a long time. And there are various different phases of interactions between these two constituents that requires you as a service provider to create trust over long periods of time. It also requires there to be endemic rules of engagement, industry standards that you can also leverage to span that gap. So admittedly, this is the out there attribute. This is something that people get tickets in. I'm sure it's hard to underwrite, too. The difference in the outcome, if you get this right, and its potential high trust vendor is huge. It could be orders of magnitude difference in the outcome, so it's worth exploring.

Starting point is 00:11:16 I think that's right. I think maybe if you tone it down a little bit too, if you think about just within a merchant class, if you get to leadership, the more their trust amongst the merchants themselves, there's a lot of cooperation. There's a lot of collective benchmarking that you could create. So it's a really interesting concept. I've invested in some vertical market solutions before. And one of the things you learn pretty quickly is that on the marketing side,

Starting point is 00:11:37 it's interesting and different because you kind of know who. the buyers are. It's much less work to build your inventory of potential buyers. So you kind of know who to go after. So what do the most talented marketers, sellers do in VMS, given that the legibility of the client base or the prospect base is a lot easier than in like Slack or something that basically anyone in the world could use Slack? What have you seen the very best at marketing and selling and positioning VMS solutions do? I think that's a really astute point. I think this is less around discovery. It's more around account-based marketing. There's a lot more talented account-based marketers than I that can talk through the specific tactics. But let me share some concepts that

Starting point is 00:12:18 maybe I see at the board level. I think the first point is you really can't outstrip your leads. If there's 100,000 locations within the U.S., maybe there's call it 10,000 in Boston. 10,000 in Seattle, those numbers are probably wrong. But it takes only a couple SDRs calling that city in a year to really burn out their leads. So I think the first point is you've got to be really careful with traditional sales tactics as it relates to these much smaller verticals. I do think the advantage, and you need to take advantage of this, is the product market fit is quite a bit stronger, right? You're building a product for a specific type of customer. And so really leverage that as it relates to the value proposition, the product marking, how you introduce yourself

Starting point is 00:13:02 to customers. And then I think the other thing that's quite interesting, this isn't true of all verticals. And you asked about attributes earlier. This is another attribute that you can consider. But in some verticals, there's enough density locally that there actually is a flywheel effect. And so the best markers, I do believe, think about it much like an online marketplace, which is you go city by city. You go nail the tent pole accounts. There's a halo effect associated with it, and you start to see in your flywheel markets that actually things get easier. That's the opposite of horizontal SaaS. Horizontal SaaS is the deeper you get in penetration, the harder it gets because you have to step outside your ICP. You do have a local

Starting point is 00:13:46 network effect available to you in vertical SaaS. And the smartest marketers and the smartest go-to-market executives are taking advantage of that. On the product side specifically, like, why do any of these need to exist, especially with the proliferation of horizontal tools, You've laid out the players here that matter. There's the vendor, there's the merchant, there's the consumer of the actual thing that the merchant's providing. There's suppliers, employees, other stakeholders. Why can't you just cobble together a normal ERP, a normal CRM, a normal communications tool?

Starting point is 00:14:17 What is the reason that any of these products exist in the first place? What are the industry-specific nuances that make them rational businesses to create? The larger the customers are, the more the vertical versus horizontal equation changes. The smaller the customer is, the more likely they want immediate time to value, which favors vertical. There's also just an awareness aspect. If you're running a restaurant, if you're running a hotel, if you're running even 10 hotels, you probably don't run a broad RFP. You're looking for a tool that just works.

Starting point is 00:14:51 This solves every problem. Kill shot. Kill shot. And the nice part is, if you just think about software automation, even just small, increments of customization really do drive a ton of values. So every application is a database. It's a workflow and a UI. And so therefore, you probably could customize every single one of these horizontals. And maybe there's a template that you can overlay a horizontal tool. But it doesn't get at the heart of what delivers values to the merchant. And that's why you see many of the best

Starting point is 00:15:24 vertical SaaS entrepreneurs started out as customers. For instance, estimates and quotes in many markets is incredibly nuanced. If you're going to take a horizontal tool and try and create a estimate for bespoke for a certain end vertical, you're basically creating entire data taxonomy. Your workflows might be different. Your regulatory rules might be different. And so these small details actually have outsized impact in terms of the ease of use and the creation of value for these small merchants. Yeah, your point earlier too about who the buyer is, the owner of the business, just saying, look, I just need some of the solve this workflow problem versus a whole bunch of departments each buying their own.

Starting point is 00:16:03 You obviously is a huge difference, too. It brings back to the control points. And I love the way that you have laid out the various ways in which you can, I think you called them gravities earlier. You said workflow. You said data. You said account. Those are all units that make a lot of sense.

Starting point is 00:16:19 And I think you've called those control points 1.0. And then there's control points 2.0. What are those three ways of thinking about other ways to integrate into these? businesses in a way that everybody wins. We talked earlier about industry attributes, and one of the attributes was this general turnover or movement within an end market. And in many end markets, there is very low movement. So if you think about that, you have a small business owner who may have purchased

Starting point is 00:16:44 legacy software in the control point. And while that software's not modern or doesn't do everything that I want to do, it works and it's fully amortized. So they're unlikely a switch. So what are your choices? Your choices are either fight the fight and try and slog it out and slowly over time displace this legacy software, or you could do something like the language we use is integrate and surround, which is you integrate into the legacy software, but you provide surrounding

Starting point is 00:17:12 functionality that's disruptive. So a great example of this is the property management system in hotels. I think it was now 10 years ago, the dates might be a little bit off, but about 10 years ago, we were really excited to make a bit in property management. Property management is the control point for hotels. Hotels are incredibly important in the ecosystem of online travel, and hotels are really struggling with this idea of syndicating or listening to multiple OTAs while keeping their inventory and sync and not overbooking. And so we looked really hard at the property management system layer. The issue was that at the time, there were deep entrenched legacy players that would be really hard

Starting point is 00:17:52 to displace. And so what we chose to do is look one level up, the channel manager. The channel manager, and we happen to find this company called SiteMinder in Australia, essentially would integrate to every single PMS. They integrated to PMS is covering roughly 97% of the hotel global market, so integrated to all the PMSs and integrated into all the OTAs. And so what they've done, what they had done, and what they continue to do is surround the PMS, to the point where the channel manager and SiteMinder,

Starting point is 00:18:23 becomes essentially an integration layer into this legacy system, and enjoys a lot of the values that you might attribute to having the control points. This new generation of VMS players are thinking through how do we disrupt the existing control points? How do you think about the role that demand plays in this whole equation? And I think about this as like the Shopify question. Like Shopify has always said, we're a tool. You do product and marketing. We do everything else on the back end and we're not going to compete with you. We're not an aggregator of demand like Amazon. You're responsible for that and we'll do everything else. How do VMS companies tend to think about this where either they're the Shopify or they're the Amazon that also brings demand,

Starting point is 00:19:07 which is like a totally separate business model? How do you think about that comparison? This is the cutting edge, Patrick. Let me talk about a couple different perspectives and we'll try to integrate them. The first perspective, which I subscribe to, is particularly for small merchants, it's all about demand. Even if they're low margin merchants, even if they're not making high margins on that demand, it's in your mindset. Your job is to build a product or a service and bring customers in the door. Bringing customers in the door, it's such an emotional need. If you're an entrepreneur, like the biggest thing is, well, no one shows up. We've no one walks with that door. And so I think drive demand is incredibly strategic. And if there's an opportunity

Starting point is 00:19:46 to do so, I think VMS should look at that quite hard. I think the other things, going in a VMS's favor is that a lot of the aggregators of demand, like the online marketplaces, even Amazon, are viewed as predatory. I've done interviews for various different vertical online marketplaces. And almost to the person, the merchants really resent the marketplaces because they're taking 20% of a booking and oftentimes even higher than that and doing nothing. They feel like it's doing nothing. And so there's a really strong value proposition to your end merchant if you're able to provide demand. Now, the big issue, though, is really twofold. Number one, it's DNA. People build software perhaps don't have the same DNA to go aggregate traffic,

Starting point is 00:20:33 bid on keywords, create social media campaigns, whatever it is, whatever tactics required. The second piece is they lack density. So a marketplace really has pretty close to 100% of supply in a given geo. It's very rare when a VMS will have even close to that. that market share in a geo. So you need to think about those two obstacles, but there's a number of different ways that you can get pre darn close to creating demand or even creating demand and find your way around. I think that is the frontier. Are there attributes of the entrepreneurs that are building these companies that you think are distinctive from like the generic good software entrepreneur? Is there anything about building this kind of business that really

Starting point is 00:21:15 requires something different than the next Slack or whatever? I'll put a couple ideas. out there. I'm not sure if I fully believe them. I believe enough of them to put them out here. I think on the margin, there's been certainly counter examples of this, but I do think most of the best VMS entrepreneurs have really strong personal affinity or most likely real working experience in the operations of the merchants that they serve. The best VMS entrepreneurs, they live it and they breathe it. And obviously, that's true, horizontal entrepreneurs as well. But I think there's a higher premium on that. And as you think about some of these market dynamics, having credibility industry to get the 10-pull customers actually may be more valuable, all things being equal

Starting point is 00:22:01 than in the horizontal context. I think the second piece, and this is probably a bit more controversial, is vertical SaaS businesses are inherently multi-product businesses. They require focus like every other enterprise. They require an ability to win the control point. But you do need to start thinking about what's step two, step three, step four. And as an investor, I've had to train myself to back off the typical instinct of you can only do one thing well at a time. I think the best vertical SaaS entrepreneurs are thinking multi-product pretty darn early. So I think those are maybe the two distinctions. If we switch just for a moment, because your idea sparked the thought to the investor's perspective, obviously you've done

Starting point is 00:22:50 this very effectively invested in lots of the best BMS businesses across history personally. What do those that try to do this kind of investing and not do as well or fail? Get wrong, do you think? Back to our prior conversations, these markets are very, very different. The size of these markets are very different. The maturity of these markets are very different. The company's growth, where they are in the growth phase is very different. To pick some barbells, if you're an up-and-coming, if you're a disreliven, if you're just right,

Starting point is 00:23:20 in a very large tam. Well, you should be very, very aggressive at the point of at times being fairly sloppy with your eating economics. You should overfund it. You should go win. That's the phase you're in. Likewise, if you're in a big tam and you're the number one player by a small margin, you should make it a large margin. Double down. Raise a lot of expansion capital. Go big. Very similar to 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.

Starting point is 00:24:04 But the use of capital, and therefore the provider, the provider's mindset has to be very different. And so one of the things that we've really both, I've enjoyed and I think we as a firm has benefited from, is when I started investing, I did my first three years at a buyout firm in 2000, right in time to catch a bunch of falling knives. And then I went to a growth firm and learned the more secular high growth perspective. And I think these integration of 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

Starting point is 00:24:49 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. You already said it, like almost nobody even looks at new software every year. Talk about what drives good or great, I guess, for. 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

Starting point is 00:25:23 you, that's one of the things you just hear over and over again. You want like 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 like enormous. What drives that wedge or that difference in your experience? I would make a distinction between net retention. 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 metric people are citing our net of that. So that would make sense. But I think in all businesses, in all recurring businesses, there is this tradeoff

Starting point is 00:26:05 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. Now, 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's going to turn. 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

Starting point is 00:26:52 100%. So you have these nice cohorts that are growing in and of themselves, which is the goal of every recurring software investor. That 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 in gross retention. They could be more on the SMB side that gets lower the gross retention, but you make up for net retention. They could be lower. They could be solo.

Starting point is 00:27:35 practitioners. Shopify, many of their customers are actually solo endeavors. And if you look into it, if you look at zero, 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 these companies. What they do is they think about retention, not on a enterprise basis, but on individual basis. So if 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. So that's the one thing. The second thing, and this is what gets into the consumer side. This is why you asked me why I invest

Starting point is 00:28:17 here and I love being customers. I also love the confidence 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 tam 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. They'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 buy out to public. And you also have to have a little bit of

Starting point is 00:29:07 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? When I think of EMS, I think about a single like 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

Starting point is 00:29:45 existing operating system that I have to pay extra for? Like, 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 point of sale system and they have a payment's provider, man, 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 it, 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 in

Starting point is 00:30:28 because then you just get a lot of information of the financial health of your merchant as well as your consumer. That's the thought. And I do think because you typically are selling to an S&B 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.

Starting point is 00:30:58 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? You charge them two. Because 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.

Starting point is 00:31:22 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 charge it closer to four. Customers making a dollar because one plus one equals five. So they're getting $5 of value and paying four.

Starting point is 00:31:50 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 in the payment flow, payroll. What are the other big things you see over and over again as like ways to serve in this multi-product mindset, the merchant, that kind of 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. So taking in money is always good. It's a lifeblood of these merchants.

Starting point is 00:32:29 It's always great. And then once you get the flow in, you now have inside of the financial health of your merchants. So you could think about very low risk lending, some cashful lending. A part of Squares 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 so, and Square makes quite a bit money on that. And I think many vertical SaaS companies can do the same. I 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,

Starting point is 00:33:11 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. And 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.

Starting point is 00:33:42 You think about over time as you get back to this trust concept and getting. density within a single level of merchants, you may think about group buying. It may be a GPO, maybe 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 sort of incrementally move towards the consumer. You 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.

Starting point is 00:34:19 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 you've laid out. some of the key functions that like all of these merchants tend to have. And of course, you've got to make it bespoke to the industry, but that 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

Starting point is 00:34:59 with, what comes to mind? What is the creativity, the imagination, the art that you see and what seems to be a consensus more kind of mechanical, scientific approach? There's a guy in our network, a Tidemark fellow Lawrence Hester. He's started this company, Fair Harbor, is a bootstrap business that I think everybody chased and I chased hard for three or four years. So what it was was think about it as a booking platform, a website for tour and activity provider, 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 how do you get them to use your software? And so the creative thing that

Starting point is 00:35:44 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 torrent activity consumer, we go on a trip to Hawaii and look for a luau, is a transactional customer. They're probably not going to go to Hawaii again for quite some time or look for 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 six to seven percent 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.

Starting point is 00:36:23 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. He totally changed the business model just through pricing. The second thing is from a product standpoint is he would go these operators and say, hey, you really should think about redoing your website, using software to take bookings, so and so forth. And I'd be like, okay, well, I got to go around my business.

Starting point is 00:36:53 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 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. And then the final piece is he tied it in to a go-to-market model

Starting point is 00:37:17 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 provide 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

Starting point is 00:37:38 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 a booking that is very far from mechanical and was the winning strategy. And 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.

Starting point is 00:38:09 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? And I'm just going to leave it there. Like, 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 me four or five years ago, but I got to know more of the years. I won't name them because they haven't sold.

Starting point is 00:38:26 And at some point in time, we'll go chase them. But 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 how this existed because I'm not in that industry.

Starting point is 00:38:48 But they provided 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. They just did all in the software. But they were helped 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,

Starting point is 00:39:16 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 microversion of what Ariba's done over the years and other folks. So it's a cool little business.

Starting point is 00:39:43 Is the strategy you take away from there that you should always investigate what is the scarce thing? Like, what's the scarce supply in the ecosystem? And then really focus on serving that scarce supply in a unique way. Is that like 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.

Starting point is 00:40:10 You start out with the buyer, then you try and sell it to the supplier. Now, 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.

Starting point is 00:40:43 Another way of asking that one, I'll ask that one. Second is, was the right time to do this when Constellation started doing this. And 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.

Starting point is 00:41:23 So I think there's still quite a bit of opportunity. Now the big end markets, restaurants, things like that. Restaurants, construction, the trades, they have had software companies coming at them. But 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 Nakes 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 up.

Starting point is 00:41:58 So I think there's a lot of runway. But back to how we open 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. So if people are looking for a get rich fast approach, there's certain verticals that makes sense. If they want to build a business methodically over time, there's certainly other

Starting point is 00:42:22 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. And 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

Starting point is 00:43:12 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 indexed to this market. That being said, though, when I think there's a natural Edmund flow of these things and people will pull out as returns may not be as great as they anticipated or they get distracted by some other thing. I 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 its SMBs, which again, the line very

Starting point is 00:43:59 closely at vertical SaaS employee, close to half of the U.S. 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. So 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 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

Starting point is 00:44:37 align that to traditional frameworks. It's more about the P&L. So every P&L is your typical recurring P&L with an AAR bridge. But for 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 principle standpoint, back to your earlier question,

Starting point is 00:45:10 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 sub-slices because, first of all, there'll be competitive entry in sub-slices, and then also your value proposition is tied to how tight your product market fit is. So ICP is really important. The ARPOOP piece really is an experience-driven activity. It's kind of what you put in the bucket and what you don't is ultimately it 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 attached to payments.

Starting point is 00:45:51 You have great vertical software companies that have been in business for 10, 12 years, and they're attached rate is something like 20% to payments. And there's some operational nuances. There's some end market nuances as to whether you can get attached to 100%. And there in that difference can turn a what seems like a great deal into a pretty mediocre deal and vice versa. So I think that RAPU bill is very new. nuance. And so that's how I think about investing the space a little less on the exit

Starting point is 00:46:20 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. And 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.

Starting point is 00:46:51 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.

Starting point is 00:47:12 but people should take a look at CCC. So CCC is the business I described earlier that sells into the auto insurers. They move down to auto buyer repair. They're now billing 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 FOLio is doing is super interesting. They started obviously at the property management side and they've done a bunch of things on that to engage with tenants, but they're starting to move up the stack into equi holders and creditors. If you think about this idea of like single source of truth across layers of the value chain, that's a really powerful

Starting point is 00:47:57 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 One Stream, which is very similar in that regard. This is this concept of single search 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 is quite challenging, but also huge upside.

Starting point is 00:48:37 Spend time with MindBody and their acquisition of, I believe it's class pass. 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 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,

Starting point is 00:49:13 but I think has a lot of parallels and you could argue is as well as a zip recruiter. I 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 them all of them. I'll push just a 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,

Starting point is 00:49:50 there's no shortcut around it. You just got to write the big check, build the DNA and get after it. I 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, the content of record for understanding the different aspects of how these businesses work, how they grow, the nuance that drive success.

Starting point is 00:50:17 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 some. I 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

Starting point is 00:50:54 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. And I really am grateful to my family like it's more than just going and achieving. And then the first two years at Time Mark 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 this. 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

Starting point is 00:51:41 the best. It's a lovely place to end. Dave, thank you so much for your time. Yeah, likewise. Fun conversation, Patrick. If you enjoy this episode, check out join colossus.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 and episodes to the big ideas, quotations, and more, as well as share the best content we find on the internet every week.

Invest Like the Best with Patrick O'Shaughnessy - Dave Yuan - A Primer on Vertical Market Software - [Invest Like the Best, EP.335]

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