How COVID is Changing the SaaS/Vertical Software Landscape for M&A
Deal multiples and valuations in the tech field have entered 2021 at - or near - record heights. Software-as-a-Service – particularly in the vertical software space – is no exception. The question is what is driving interest – and if valuations will remain at the current levels.
Vertical software companies (VSC) often operate differently from the much-famed technology unicorns with billion-dollar valuations. Instead of burning through cash in the pursuit of rapid growth, many vertical software companies prefer slower, incremental growth.
VSCs have many good reasons for favouring what could be described as slow and steady, or ‘the tortoise-approach,’ to growth. However, a move towards cloud-based solutions and Software-as-a-Service (SaaS)-centred subscription-based business models has led to increased tempo, including when it comes to M&A acquisitions. To a large degree, the vertical software space has increasingly become the vertical SaaS space.
For clients, the move provides benefits like lower CAPEX investment requirements and eased access to constantly updated software solutions. Simultaneously, both clients and VSCs reap rewards in the form of recurring, predictable cash flows and easily scalable business solutions.
Within the technology space, including vertical software, the developments have contributed to high valuations – and new opportunities for M&A on both the buy- and sell-side. Grasping the opportunities requires companies to be well prepared for the inherent challenges in and around the vertical software and SaaS space.
The Vertical Approach
Vertical software companies focus on managing and meeting many – or even all – companies’ software needs within a given industry space. Their acute industry insight enables them to meet said companies and organisations’ needs.
Across industries, COVID-19 has increased digital transformation speed, often accompanied by a realisation that standardised, out-of-the-box solutions from major software providers will not suffice. As a result, vertical software is seeing increased customer interest.
However, said customers’ preferences are evolving. For example, in relation to delivery and billing, preferring Software-as-a-Service (SaaS) subscription-based payment structures, and increased demand for upgraded technological solutions and platforms, such as cloud and Fintech. These trends have grown as COVID creates economic uncertainty. Companies are more comfortable with rolling costs of subscription-based solution models, even if the life-time costs might be higher.
Drivers of M&A In Vertical Software
Increased demand and changing customer needs have meant that vertical software companies are focused on adding new solutions to their portfolios. Inorganic company or conglomerate growth through M&A is often the fastest way to add new solutions and capabilities. Strategic investors, such as private equity (PE), also show an increased interest in tech acquisitions, including in VSC and SaaS.
As a result, M&A activity in the SaaS-VSC space is high and showing strong deal metrics. SaaS M&A reached 425 deals during Q4 2020, equal to a 13% YoY increase. Median EV/TTM Revenue also rose to 5.7x – the highest quarterly average in five years.
Approached correctly, target companies stand to gain advantages by being acquired by a vertical software company. Becoming part of a VSC tends to equal access to many new potential customers and opens cross-selling opportunities with relatively little loss of autonomy. These factors mean that many technology companies, especially in the small to mid-market segment, are – or should be – considering VSCs as an alternative to raising growth capital through VC or PE funding or an IPO to continue their growth trajectory.
On the buy-side, vertical software companies’ M&A drivers include the previously mentioned switch towards cloud and SaaS-based business models. Acquiring companies with complementary solution offerings that meet changing customer demands or enhance IT infrastructure are industry-wide priorities. Furthermore, VSCs looking to expand operations often acquire companies in new regions and countries. Frequently, country-specific intricate regulatory frameworks govern industry verticals. In such cases, M&A can be the fastest, most efficient way of securing access to customer groups and segments without risking compliance issues.
BDO Market Analysis Shows Growth
BDO analysis indicates that the market has a lot of confidence in software companies. A confidence that encompasses vertical SaaS companies’ ability to continue to grow their businesses.
Our data analysis of end year figures from 2018, 2019, and 2020 points to several conclusions:
- Total sales trading multiples have increased: Indicating that market confidence in the industry’s growth potential is high.
- Rapidly growing expectations: Median and Average EBITDA multiple was stable 2018 and 2019 but skyrocketed in 2020. This could be an indication that markets view the impact of COVID as something that increases the future potential.
- The median EV/Sales trading multiple went from 4.1 to 5.1 and EV/EBITDA from 11.8 to 15.5: Both indicate that investors expect to see increased growth in the space. Said slightly differently, it indicates that the average company is valued higher, against what is likely a similar cash flow situation.
Also supporting our conclusions is that enterprise value has shot up during the period. Median enterprise value has more than doubled and the average enterprise value has increased by almost 50%. Contact us to hear more about our proprietary M&A research and findings.
M&A Metrics, Deal Structures, and Ecosystem Differ
When considering targets, vertical software companies’ core M&A metrics partially overlap those of other types of investors, such as historical earnings and potential growth through bolt-on acquisitions. We explore common M&A metrics for the technology space in our PE – software company guide and a recent article about important M&A metrics for software companies.
Some metrics are more specific to the vertical software and SaaS companies, such as the opportunities for cross-selling solutions and management structures conducive to functioning within a larger organisational hierarchy.
When considering M&A in the vertical and SaaS space, it is crucial to know how said metrics differ depending on the industry vertical. For example, customer metrics, such as customer satisfaction level and churn rates, may be particularly important for patient-focused healthcare VSCs with SMB clients. Here, end-consumer data analytics and due diligence will play a particularly strong role throughout the M&A process. In comparison, an VSC servicing enterprises in the manufacturing industry will have a different focus, business structure (for example, longer selling cycles) and the associated metrics. The differences may extend to deal structure, including potential earn-out targets and similar clauses.
Metrics and deal structures are connected to the core characteristics of the Vertical SaaS sector, including:
- Winner takes all: Since Vertical SaaS is particular to a specific industry, companies can secure large parts of the market. As a result, the industry often sees ‘winner takes all’ scenarios in specific countries or regions.
- Better cross-selling and upselling opportunities: Upsells and cross-sells are core to Vertical SaaS. For example, if you provide an ERP system to a given industry, it supports cross-selling and upselling solutions such as marketing software and advanced finance functions.
- Lower CAC: Since target audiences tend to be highly homogenous, marketing initiatives can better reach across your potential customer base.
Increased Competition From Big Tech
Traditionally, vertical software has preferred an M&A strategy that could be coined as ‘buy bits and buy low’. Many vertical software companies have focused on acquiring small and medium-sized enterprises (SMEs), scale-ups and start-ups with complementary solutions and technology.
Larger, multi-national vertical software companies have occasionally paid significant sums for companies - most often when buying direct competitors or to enter a new space with regional and national laws, regulations, business culture, etc. In such cases, the larger companies generally employ a ‘buy and leave’ M&A strategy by acquiring the smaller company or companies and then leave them to continue running their businesses almost unchanged.
Due to altered business conditions, including increased competition from big tech companies, we are seeing increased competition for targets, which are driving valuations up. If your technology company is in the mid to small market cap space, vertical companies may be particularly interested at present due to extra pressure from outside.
A core reason is innovation. Companies whose business model relies on meeting the exact needs of specific industries risk limiting themselves to meeting those needs. Other companies, either bigger or willing to think outside of the box, are often in a better position to innovate faster and more disruptively.
Simultaneously, big, faster-moving – and very deep-pocketed - tech companies are, to some degree, making their solutions more and more modular. The goal is to make it possible for customers to mix and match, optimising their software solutions. In other words, to take the horizontal solutions and easily adapt them to fit vertical, industry-specific needs. In this move, big tech holds the advantage of scale, thereby being price competitive while simultaneously having the economic clout that can minimise risks when developing new solutions.
Vertical SaaS Sector to Remain Hot
However, getting the deep vertical insight that VSCs have often does not fit with big techs businesses’ priorities. To maintain that advantage – and meet some of the increased competition and new customer demands – we see increased M&A interest from VSCs.
Further increasing activity is the surge in smaller, distressed high-quality targets due to the economic consequences of COVID. Scaling a small business against the larger SaaS players is very difficult and consumes many resources, which contributes to wanting to be acquired. If you are a smaller company in the space looking to stay independent, revisiting growth strategies and goals may be advisable. Staying specialized and gradually achieve scalability may be the option to remain competitive – especially in the short run.
To summarise, we see vertical SaaS as the emerging standard for the VSC industry. Vertical SaaS companies are excellently positioned to capitalise on increased customer demand – especially in sectors with strict legislation, unusual production cycles and other specific or niche requirements. Industry-tailored solutions that are in full compliance with the rules and regulations in any given space are among the unique selling points. This is particularly useful for companies in the low to mid-market space that may struggle to gauge compliance and risk issues associated with integrating new software solutions or adapt standard solutions from major software vendors to their specific needs.
The opportunities lead to heightened competition – increasingly also from big tech companies. Therefore, the need to innovate quickly and add new solutions at speed is leading to increased M&A activity with a focus on complimentary small to mid-sized software providers.
All the above will likely not change in the near to medium future, and we expect the space to continue showing increased M&A activity.