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December 05, 2011

Go Vertical

Start ups are great barometers for the future.  Those of us who spend our time immersed in the world of young companies are priviledged to get a glimpse of what's coming around the corner by meeting with entrepreneurs who are trying to bring the future forward.

In that context, I enjoyed USV's Christina Cacioppo's blog post, What Comes Next, where she summarized a few trends that are coming out of some of the start up incubators.  I have also seen the componentization of software and the shift to independent work agents, the latter of which has interesting policy implications for a jobs-obsessed policymakers.

Yet, in my own work with various incubators, I am often struck by the lack of vertical focus.  Perhaps it is because incubators are full of young entreprenurs who have less domain knowledge and therefore are not as well-positioned to transform existing industries.  But if you believe software is eating the world, vertical industry by vertical industry, business process by business process, then we should start seeing more entrepreneurs pursuing vertically-centric strategies.  When I heard about this weekend's $3.4 billion acquisition by SAP of HR software company SuccessFactors (which barely got any coverage from the tech press), I was further struck by the opportunity.

Many mature, massive industries are ripe for innovation.  Here are a few obvious ones where we at Flybridge have been spending time:

  • Education.  The education industry is a massive one, growing quickly and full of outdated models.  Online learning, peer-to-peer learning and the redirection of student expenditures are all areas that we find interesting.  Companies like Open English, SimpleTuition and Skillshare are all gaining significant traction in this vertical and taking novel approaches that get around traditional gate-keepers.
  • Health care.  If the multi-trillion dollar health care industry isn't the perfect area for innovation, I don't know what is.  Whether it's in areas like cost containment, process automation or point of care diagnostics, there appear to be plenty of openings for entrepreneurs.  We see companies like Patient Keeper, T2 Biosystems and Athena Health leading the way in this vertical - avoiding FDA risk by simply delivering software or diagnostic devices that makes the entire system more efficient.
  • Financial Services.  With the financial markets upheavel, there are massive dislocations going on in the financial services industry.  Subprime lending has disappeared.  Payments are going digital and mobile.  And banks are under increasing pressure to stay focused on their core businesses.  As a result, companies that either focus on providing services where banks used to tred (ZestCash, GreenDot) or are working with banks to help enhance their revenue opportunities or efficiencies (Cartera Commerce, Convoke Systems) are finding significant growth. 

I could name others - advertising, manufacturing, insurance and human services - where we are seeing old hands coming to the "transformation table" as well as the young bucks, who are also asking "why not?"

The impact of horizontal technological advancements - such as cloud computing, big data, broadband penetration, smart phone penetration - takes time to be felt broadly in business.  Hopefully some of these start ups will make a dent in core business processes and therefore the all important metrics around productivity, which we need desperately as a country.  And hopefully we'll see more start-ups realizing that going vertical can be very rewarding.

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Jeff,

I greatly enjoyed this post, I think you make a great point. However, I would argue that a vertical business model may not be in the best interest of the incubators. As you know, the model of an incubator is to sort through hundreds of applications and accept companies into your program based solely on their idea, market, and interviews with the entrepreneur. While most bets are made based on how passionate and knowledgeable the entrepreneur is, and much less based on the idea they are pursuing, it is important to note that a horizontal type business model such as cloud computing or big data is less risky than a startup pursuing a vertical type model. An incubator is still a fund, and must take risk into account. Once they have a pool of extraordinary entrepreneurs, they must further weed out the candidates based on the markets they are pursuing. It is in their best interest to pick models that have the greatest success rate and whose assumptions have already been validated and paths have been cleared.

While a startup looking to go vertical has an amazing potential for reward, I don't believe they are the best candidate for an incubator since the assumptions their model is making and path they are taking has yet to be proven and involves much more risk. This is one of the major faults I have seen with incubators and has led to very crowded markets in certain sectors. I think going forward, it will be increasingly rewarding to find the companies that are going vertical at an early stage and nurture them individually using the specific industry expertise of your/any vc fund that an incubator doesn't usually have.

The assumption I'm making here is that maybe many startups that wish to pursue a vertical model aren't being accepted into incubators at a very high rate compared to horizontal type businesses. Whether or not this is true, I have no idea. Have you seen anything that has suggested this type of assumption/what are your thoughts?

-Zach Ringer

I agree that there are huge opportunities to disrupt these industries, but in many verticals it's very difficult for a startup to control a solution from end-to-end. Inevitably, almost any startup in a "legacy" vertical will have to integrate with a part of the value chain that operates at anything but startup speed. One of the biggest challenges that startups face in driving this disruption is figuring out where they need to partner and leverage existing infrastructure vs. where they can build and innovate. (And to prove this out before running out of cash.)

The companies in education you mentioned do a great job of creating their own marketplaces, but that's much more difficult to do in health care and financial services where there is so much inertia for the status quo that a startup can't entirely change the game and will often focus on doing something incrementally better within the existing ecosystem rather than reinventing it.

To drive meaningful disruption, the early stage capital needs are a lot higher in some of these verticals and lean startup/customer development type approaches aren't as directly feasible. With a higher initial "buy-in" required to prove out their model, this can be a barrier (especially to first time entrepreneurs) in getting the funding necessary to seed a company with sufficient runway. e.g. the BankSimple team has now raised $13MM and is still in early beta testing.

- Derek

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Great point, Derek.  Penetrating legacy verticals is very hard with a cold start (a la BankSimple).  If the management team has no experience in the vertical, it’s a challenge to find that source of the “unfair advantage”. 

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Interesting perspective, Zach.  Why do you think a vertical play is “less risky” than a horizontal one?  I don’t know whether vertically-focused start-ups are not being accepted by incubators or if the application pool is skewed, but I am observing that the end result is tilted more towards horizontal than I would typically expect. 

I would argue that a vertical approach is more focused and therefore less risky than a sweeping, horizontal one. But I can see that the appeal of revolutionizing the entire world rather than just a single one might be more attractive for entrepreneurs and the incubators that invest in them.

Hello Jeff,

First of all.

I'm a big fan of your book which I read and is one of the main reasons I've decided to launch my consulting practice to help VC backed portfolios develop sales viable revenue, build sustainable business models., etc.)

I so agree with your diagnosis with the lack of Vertical climbing (great visual)today within the start-up universe. However, I have just spent 8 months working with a VC backed (solid revenues)Healthcare Company (claims management service/technlogy) and on account of learning the true nature of this market there may be some solid, practical reasons why start-ups or any sane individual would shy away from innovation here.

Take Healthcare, especially U.S. Healthcare, and trying to introduce anything into the Health Insurance Providers where most of the dollars are)
For example,Large U.S. payers (think Blue Cross, Cigna and Aetna's of the world) are getting a premium every year that goes up 4-6% for healthcare deliverable and (you can argue quality of that deliverable) the need for change is not going to be driven by what I would argue is a rather non-competitve environment. These are monopolies of a sort (whole blog post on my site coming up on that theme and how hard it is to reach buyers and what that process is) and the only game in town for many covered (health plan) enrollee...so the business drivers, competitive landscape is much different. Which results in a very old school (they move as buyers like politburo 5 year plans or vestiges of that kind) mentalities and general inertia to change/inovation..I"ll buy when BBSBC of Minnesota buys a CRM system for 2.5 million but in the meantime...!

Also, the technology they all use for claims managment processing of forms is "standardized" with ICD9 (for example) is almost impossible to innovate with..they all travel the same crummy highway with no tolls and no revenues to fix the six foot deep pot holes...if your new car (tech inovation/process/services) is going to be purchased then it's going have to travle down this highway where the average speed limit is 10 mph..! So a start-up company has to know what they are up against in order to bring something new to market..these are some reasons I believe, (for they can see the corpses of those and the burned out hulks that have tried to run the what remains of the crumbling pavement)individuals/start-ups have perhaps shied from!

Oops I've gone on quite a spree here but you can see and perhaps feel my pain of having had to learn this lesson these last months(and why I may serve as a good guide away from the ruinious ruts)

Which by the way is what my company www.oneillprod.com is going to be focused on which is in guiding startups to the portions of the highway that have been modernized or at leat willing to fill in the holes....in healthcare.
Thanks jeff for this article...for it really got me thinking!

Sincerely,

Sean

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Thanks, Sean. You are right about the role of gate keepers and lack of competitive incentives making health care innovation very tricky for entrepreneurs.

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