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

My guest today is Dave Yuan. Dave is the Founder and Partner of Tidemark Capital, which he started in 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 Karbon. 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 Yuan. The Vertical SaaS Knowledge Project - Tidemark Capital Founders Podcast Founders Episode 136 - Estee Lauder Founders Episode 288 - Ralph Lauren For the full show notes, transcript, and links to mentioned content, check out the episode page here. ----- This episode is brought to you by Tegus, the modern research platform for leading investors. Stretch your research budget with flexible expert calls you can trust. At a fraction of the cost of traditional expert networks, Tegus customers pay only what an expert charges – with zero markups and no confusing call credits – netting an average 70% savings. Don’t want to conduct a full hour call? Tegus offers the ability to schedule 30-minutes, an offer you won’t find anywhere else. And they don’t stop there. With white-glove custom sourcing for every project and robust compliance measures, including a dedicated 50+ analyst team that vets every call transcript, Tegus ensures your privacy and protection. As the industry innovator for qualitative insights, Tegus helps you find the right experts you need at a quality and speed that can’t be matched. For a limited time, as a listener, you can trial Tegus for free by visiting tegus.co/patrick. ----- Invest Like the Best is a property of Colossus, LLC. For more episodes of Invest Like the Best, visit joincolossus.com/episodes. Past guests include Tobi Lutke, Kevin Systrom, Mike Krieger, John Collison, Kat Cole, Marc Andreessen, Matthew Ball, Bill Gurley, Anu Hariharan, Ben Thompson, and many more. Follow us on Twitter: @patrick_oshag | @JoinColossus Show Notes (00:02:57) - (First question) - Vertical Market Software (VMS) offers unique business models and customer benefits (00:04:02) - Industry-specific software serving SMBs with tailored functionality (00:06:53) - Assess market based on TAM, competition, and growth dynamics (00:10:00) - Trust as a nuanced factor in evaluating market opportunities (00:11:59) - Leverage account-based marketing and local network effects for VMS solutions (00:14:22) - Vertical solutions offer tailored value and quick results for specific industries (00:16:21) - Disrupting legacy control points through integration and surrounding functionality (00:19:07) - Building demand is crucial for small merchants (00:21:31) - VMS entrepreneurs need operational experience and multi-product mindset (00:23:13) - Investors need to adapt to the specific growth stage and market dynamics (00:25:22) - Gross retention is driven by control points, individual-based retention, and distribution (00:29:43) - Multi-product vertical SaaS: Integrated solutions for efficiency and value (00:32:33) - Diverse offerings to serve merchants' needs in a multi-product approach (00:34:07) - FareHarbor's unique strategy led to success in the tour industry (00:38:43) - LA-based company revolutionized commercial casting with a free software tool (00:40:03) - Opportunities remain in VMS, with greenfield areas and specific markets (00:45:12) - Key valuation considerations for VMS businesses (00:47:27) - Time horizon is crucial for investing in VMS businesses (00:48:04) - Businesses worth studying in this category (00:51:12) - The kindest thing anyone has ever done for him

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Patrick O'Shaughnessy?

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• 0:35Patrick O'Shaughnessy?

  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 joincolossus.com.

• 1:00Speaker 01

  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'Shaughnessy Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Positive Sum or O'Shaughnessy Asset Management may maintain positions in the securities discussed in this podcast.

• 1:32Patrick O'Shaughnessy?

  My guest today is Dave Yuan. Dave is the founder of Tidemark Capital, which he started in 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. 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 Yuan.

• 1:59Patrick O'Shaughnessy?

  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 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. Maybe you could begin by telling us why this topic or this style of business is so interesting to you in the first place.

• 2:35Speaker 02

  I think part of this is 10, 15 years ago, when we started investing in vertical software is very much a contrarian perspective. And so there's a little bit in me that wants to provide a different perspective in the world. As the world starts 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 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

• 3:16Speaker 02

  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 taqueria called Mama Coco, and it's an awesome story. The owner and the manager is taking recipes from his grandmother's recipe book. It's a family business. They're out there building. And candidly, they're really struggling. And a big part of what allowed them to survive is extending it to online delivery. You see in good times and in bad times what software can do for these owners. If you watch any commercial for a small business software or vertical software provider, it's always the owner.

• 4:01Speaker 02

  On their cellphone 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 judgery and create some automation, create some space for their life is this incredibly energizing value prop. And so a big part of why I continue to invest in vertical SaaS, why I continue to pull this apart, part of it's a 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.

• 4:31Patrick O'Shaughnessy?

  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 a level set on how you think about it so that we can then pick it apart.

• 4:44Speaker 02

  Let's start from the ground level and you can push me forward or pull me back as much as you 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 will conflate SMB and vertical software together because most of the time a end 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 US. And so there is a wide expanse of SMB to enterprise, but generally it's SMB. I think in general,

• 5:25Speaker 02

  what we found in SMB vertical SaaS is there's 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 engagement. We call it 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 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 gravity. That's another indicator control point.

• 6:11Speaker 02

  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 that might cover and a wide range of business malls as well.

• 6:32Patrick O'Shaughnessy?

  If we were to imagine something ridiculously simple, like a barber shop or something like that, 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?

• 6:50Speaker 02

  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 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?

• 7:22Patrick O'Shaughnessy?

  If we think about the variance of the markets themselves that could be addressed by one of these vertical market solutions, walk us through like what you think the variables are, maybe even like stack rank them. Okay, there's make up the number, there's 100 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 build one of these businesses?

• 7:43Speaker 02

  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 US. 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. 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.

• 8:28Speaker 02

  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? 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 your at-bats are infrequent.

• 9:09Speaker 02

  So you don't really have that much of an opportunity to start taking share. So you may have to take different approaches to winning that control point. And 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 in a really clear way one time. He was like, look, Dave, only about 5% of this vertical reevals their software every year. And so my job is to see every single sales cycle of that 5% and win 75% of that. What that is, is a very measured go-to-market strategy. This is not your Salesforce did this masterfully over the years, which is building S-curves of sales capacity.

• 9:54Speaker 02

  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.

• 10:04Patrick O'Shaughnessy?

  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?

• 10:17Speaker 02

  I'll specifically go a little bit further out on the growth and risk curve, on the aspirational 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. 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% of an auto buyer repair shop's revenue come from underwritten insured consumers.

• 11:01Speaker 02

  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. 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.

• 11:38Patrick O'Shaughnessy?

  I'm sure it's hard to underwrite, too. The difference in the outcome, if you get this right and it's potential high trust vendor, is huge. Could be orders of magnitude difference in the outcome, so it's worth exploring.

• 11:48Speaker 02

  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, there are trust amongst the merchants themselves. There's a lot of cooperation. There's a lot of collective benchmarking that you can create. So it's a really interesting concept.

• 12:03Patrick O'Shaughnessy?

  I've invested in some vertical market solutions before, and one of the things you learn pretty quickly is that on the marketing side, 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 Slack or something? Basically, anyone in the world could use Slack. What have you seen the very best at marketing and selling and positioning VMS solutions do?

• 12:39Speaker 02

  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 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 US, maybe there's, call it 10,000 in Boston, 10,000 in Seattle. Those numbers are probably wrong, but it takes only a couple of 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.

• 13:20Speaker 02

  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 marketing, how you introduce yourselves 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.

• 14:03Speaker 02

  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 network effect available to you in vertical SaaS. And the smartest marketers and the smartest go-to-market executives are taking advantage of that.

• 14:27Patrick O'Shaughnessy?

  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? 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?

• 14:58Speaker 02

  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.

• 15:24Patrick O'Shaughnessy?

  To solve every problem. Kill shot.

• 15:26Speaker 02

  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 value. 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 vertical SaaS entrepreneurs start out as customers. For instance, estimates and quotes in many markets is incredibly nuanced. If you're to take a horizontal tool and try and create a estimate for bespoke for a certain end vertical,

• 16:10Speaker 02

  you're basically creating an 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.

• 16:26Patrick O'Shaughnessy?

  Yeah, your point earlier too about who the buyer is, the owner of the business, just saying, look, I just need some to solve this workflow problem versus a whole bunch of departments each buying their own, you know, 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. 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?

• 17:02Speaker 02

  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 legacy software in the control point. And while that software is not modern or doesn't do everything that they want to do, it works and it's fully amortized. So they're unlikely to 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 you use is integrate and surround, which is you integrate into the legacy software, but you provide

• 17:44Speaker 02

  surrounding 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 bet 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 listing to multiple OTAs while keeping their inventory in sync and not overbooking. And so we looked really hard at the property management system layer. The issue was that at the time, there are deep entrenched legacy players that would be really hard to displace.

• 18:26Speaker 02

  And so what we chose to do is look one level up, the channel manager. The channel manager, and we happened 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 site minder becomes essentially 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?

• 19:11Patrick O'Shaughnessy?

  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 backend 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, which is like a totally separate business model? How do you think about that comparison?

• 19:44Speaker 02

  This is the cutting edge, Patrick. Let me talk about a couple of different perspectives and then 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 whether no one shows up, whether no one walks through that door. And so I think drive demand is incredibly strategic. And if there's an opportunity to do so, I think VMS should look at that quite hard. I think the other thing going in a VMS's favor is that a lot of the aggregators of

• 20:28Speaker 02

  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, bid on keywords, create social media campaigns, whatever it is, whatever tactics are required. The second piece is they lack density.

• 21:13Speaker 02

  So a marketplace really has pretty close to 100% of supply in a given geo.

• 21:20Speaker 02

  It's very rare when a VMS will have even close to 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 pretty darned close to creating demand or even creating demand and find your way around. I think that is the frontier.

• 21:35Patrick O'Shaughnessy?

  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 requires something different than the next Slack or whatever?

• 21:52Speaker 02

  I'll put a couple of 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 of 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 ten pole customers actually may be more valuable, all things being equal than in a horizontal context.

• 22:37Speaker 02

  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.

• 23:17Patrick O'Shaughnessy?

  If we switch just for a moment, because your idea sparked the thought to the investor's perspective. Obviously, you've done this very effectively, invested in lots of the best VMS 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?

• 23:37Speaker 02

  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 disruptor in a very large TAM. Well, you should be very, very aggressive at the point of at times being fairly sloppy with your 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

• 24:21Speaker 02

  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 and A, but the use of capital and therefore the provider, the project 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 bio 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 the two really helps us look at these various different

• 25:05Speaker 02

  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.

• 25:26Patrick O'Shaughnessy?

  One of the things that you hear over and over when you talk to VMS businesses and also VMS 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, 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. Like, 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

• 26:10Patrick O'Shaughnessy?

  drives that wedge or that difference in your experience?

• 26:14Speaker 02

  I 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 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

• 26:59Speaker 02

  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 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. That is how we think about it. I do think there is this really interesting

• 27:39Speaker 02

  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 nineties in gross retention. They could be more in the SMB side that gets lower the gross retention, but you make up for net retention. They could be lower, they could be solo practitioners. Shopify, many of their customers are actually solo endeavors. And if you look into it, if you look at Xero, a big chunk of that market is FD of one. By definition, you're going to have relatively low retention rates there.

• 28:23Speaker 02

  And so what do you do there? And I think the really interesting part of that segment is a couple of 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. So 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 the end customers. I also love the confluence of function and skillset. 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.

• 29:05Speaker 02

  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 SMB 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 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.

• 29:47Patrick O'Shaughnessy?

  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 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? Like, what does multi-product defined to you mean?

• 30:25Speaker 02

  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 payments rider. 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 created language that we started to borrow and maybe even steal, is this idea of better together. One plus one equals five. They just work better together, reconciliation's better. And in this particular example, we've written an essay around the benefits of integrated payments, and because then you just get a lot of information on the financial health of your merchant as well as your consumer. That's the thought.

• 31:08Speaker 02

  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? Because presumably, the nice part about multiproduct for the vendor, for the SaaS company is there's very little incremental sales cost.

• 31:53Speaker 02

  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 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, but you're also four Xing your ARPU, obviously. It's a really nuanced question, but that's what makes this fun.

• 32:28Patrick O'Shaughnessy?

  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 like ways to serve in this multiproduct mindset, the merchant, that kind of always work if you earn that trust?

• 32:46Speaker 02

  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 the 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 merchant. So you could think about very low risk lending, some cash flow lending. A part of Square's P and 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 of money on that. And I think many vertical SaaS companies can do the same.

• 33:30Speaker 02

  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, 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 you, those are natural extensions. If you go towards the supplier side, then you think about things like procurement,

• 34:11Speaker 02

  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, 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. And in very rare circumstances,

• 34:54Speaker 02

  you'll actually start to see some vertical SaaS companies being able to create something that equates like a consumer marketplace.

• 35:02Patrick O'Shaughnessy?

  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 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 in what seems to be a consensus, more kind of mechanical, scientific approach?

• 35:42Speaker 02

  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. So 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.

• 36:04Speaker 02

  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 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 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 fee. So he would charge, I think, some percentage, I want to say it's 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.

• 36:49Speaker 02

  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. He 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 on and so forth." And be like, "Okay, well, I gotta 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

• 37:33Speaker 02

  of dollars on these tour activities where everybody else is trying to sell software at thirty 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. And then the final piece is he tied it in to 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.

• 38:18Speaker 02

  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. 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 that might be a good example.

• 38:38Patrick O'Shaughnessy?

  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 gonna leave it there. Like, that one was so interesting.

• 38:50Speaker 02

  There's this business in LA, and I'm gonna 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. 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 provided a tool for these casting directors. I didn't know this existed because I'm not in that industry, 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

• 39:32Speaker 02

  take hours and hours of time. They just did all in software. But they were held 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 backend, they just built this LinkedIn where all the actors, for a very small amount of money, would upload their content and their prayers. 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 Arriba's done over the years and other folks. So it's a cool little business.

• 40:16Patrick O'Shaughnessy?

  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?

• 40:31Speaker 02

  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. 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?

• 40:58Patrick O'Shaughnessy?

  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. 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?

• 41:41Speaker 02

  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, the big end markets-

• 42:01Patrick O'Shaughnessy?

  Restaurants, things like that.

• 42:03Speaker 02

  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 NEX 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 who's 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

• 42:48Speaker 02

  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, the sort of quick instinct. And, and I think you're starting to see some particularly

• 43:29Speaker 02

  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. I do think while maybe the painting this end market all

• 44:10Speaker 02

  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. It's SMBs, which again align very closely 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, and a lot of that will come through automation. So I think it's just a great place to invest.

• 44:45Patrick O'Shaughnessy?

  On 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?

• 45:06Speaker 02

  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 and L. So every P and L is your typical recurring P and L with an ARR bridge. But 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. Cause 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.

• 45:49Speaker 02

  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 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 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. 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.

• 46:31Speaker 02

  And there's some operational nuances. There's some end market nuances as to whether. You can get the attached to 100% and that 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 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.

• 46:55Patrick O'Shaughnessy?

  Is there anything that we haven't talked about surrounding this discipline of investing in company building that you think is really important?

• 47:02Speaker 02

  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 their 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 and L. Some of these P and L's 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.

• 47:32Patrick O'Shaughnessy?

  What investors or companies should people interested in this category study most carefully? You're not allowed to say Constellation Software.

• 47:39Speaker 02

  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. So CCC is the business I described earlier that sells into the auto insurers. They moved down to Autobuy 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 Folio is doing is super interesting. They started obviously at the property management side and they've done a bunch of things on the to engage with tenants, but they're starting to move up the stack

• 48:20Speaker 02

  into equity 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 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 is 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

• 49:04Speaker 02

  extension, which I think captures a lot of imagination and is quite challenging, but also huge upside. Spend time with MindBody and their acquisition of, I believe it's 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. Cause 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,

• 49:45Speaker 02

  but I think has a lot of parallels and you could argue is as well as ZipRecruiter. 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 ZipRecruiter 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 gotta write the big check, build the DNA and get after it.

• 50:29Speaker 02

  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.

• 50:35Patrick O'Shaughnessy?

  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. 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?

• 51:07Speaker 02

  Yeah, so I'm a long-term listener. You were gonna 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. And 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

• 51:52Speaker 02

  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

• 52:09Patrick O'Shaughnessy?

  Simple but beautiful.

• 52:10Speaker 02

  Simple, maybe not novel, the truth.

• 52:12Patrick O'Shaughnessy?

  The simple things are always the best. It's a lovely place to end. Dave, thank you so much for your time.

• 52:17Speaker 02

  Yeah, likewise. Fun conversation, Patrick.

• 52:18Patrick O'Shaughnessy?

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