Picking Your Market: Vertical TAM & Concentration

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Let’s say you have read the VSKP and are convinced—you want to build a vertical SaaS company. The next logical question is what market you should pick. The ideal SMB vertical should be:

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• Gigantic: Big markets have the universal quality of being full of money. For a Vertical SaaS Vendor (VSV), you should define your market not just by total size, but by number of locations, initial ARPU, and expansion ARPU. Ideally you can do this by either expanding and extending. 
• Highly fragmented market: It is challenging to build a business in a market where SMBs are fighting over the leftovers of large enterprises. A VSV should target a market with lots of small and midsize merchants. 
• Highly fragmented value chain: You want to be selling to fragmented buyers and buying from fragmented sellers. Having this up and down the value chain is important for two reasons: One, it makes a marketplace possible, and two, it often means a better profit pool from payments. Many small payments are generally much more profitable than fewer large payments. 

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To kickstart this analysis for you, we set out to study which industries are both big and dominated by SMBs. (We will save fragmentation up and down the value chain for another day.) The government's business census (released in 2020, from 2017) provided the requisite data.

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In the chart below, I mapped industries at the 4-digit NAICS level. (There is a perpetual argument around which level of classification is best, but we used the 4-digit for today’s exercise.) Here's how to read the chart:

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• Each circle represents one 4-digit NAICS code.
• A circle's size is proportional to the sales of the industry.
• The x-axis represents the number of companies in each 4-digit NAICS industry.
• On the y-axis you see the market share of all but the top 50 companies. So for industries up near 90% on the y-axis, the top 50 companies represent only 10% of the market (highly fragmented). Conversely, in industries near 10% on the y-axis, the top 50 companies represent nearly 90% of the revenue.

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In the upper right of the diagram, you see fragmented verticals with many SMBs. This is Vertical SMB SaaS Heaven. For example, the restaurant industry is off the chart way to the right with 500,000+ restaurants. There is a reason this sector is home to so many VSV success stories like Toast, Olo, DoorDash, and UberEats.

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In the upper left are the fragmented industries that have fewer companies—these verticals are SMB or mid-market opportunities. The lower left of the chart is the land of the giants. In these verticals, you are an enterprise solution, or your company will fail.

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Vertical SMB SaaS Heaven

Let's take a closer look at the highly fragmented, large SMB markets. In the chart below, the axes are the same, but I'm making a few changes:

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• only including those industries where the top 50 companies have less than 20% market share
• expanding the x-axis to include restaurants
• adding color-coding to denote related verticals (so now we have four variables in two dimensions. I think we are at the max!)

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In this chart, you can see restaurants and bars in blue. The red circles are the various types of healthcare practitioners who operate outside of large hospital networks. Green circles represent the trades related to the entire life cycle of a building, from construction to maintenance. In purple are auto dealers.

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Implications

None of this may immediately surprise you. After all, we know that there are no small airlines! But it’s still interesting to see the actual numbers. For instance, both florists and personal care services (barbers, nail salons, etc) are fragmented industries—but the latter are 10x the size of the former.

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One could imagine a young, time-rich analyst (we are neither) comparing the size of vertical SMB SaaS businesses created in each vertical relative to the market opportunities presented here. This analysis would help you determine where there is potential growth left in an existing market, or how big the opportunity is for a new player in a new vertical. 

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The point of these exercises is to help know which market to pick, but importantly, they are all views looking towards the past. Startups are building for the future, so make sure you know how you expect your market to grow (and why). If you’d like the complete data set for your fundraising deck or just to check our work, fill out this request form.  

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