Each archetype calls for a distinct investing approach geared to various horizontal and vertical categories of software. Once investors understand the investing dynamics throughout a category, they can construct their deal sourcing, investment themes, and strategy around the corresponding approach. The archetypes are grounded in patterns of growth, which can be identified using data available through G2 and other public sources. Our discussion will look more closely at the software categories and factors of growth.

A Push for Order in the Business Application Landscape

Because categorizing software types can be challenging, we created a basic classification of horizontal and vertical categories. Suitable for use in nearly every industry, horizontal applications are used for functions across the business, such as SalesTech, Enterprise Resource Planning (ERP), or human resources technology (HR Tech) solutions. Vertical applications are meant for specific needs or use cases within particular industries, like insurance claim processing software (InsureTech) or electronic health record (EHR)/Healthcare Information Technologies (HCIT) software.¹ 1 We made the decision to exclude horizontal infrastructure, cybersecurity, consumer tech, and Web 3.0 from this analysis to manage scope, but we hope to tackle those categories in future publications. Notes: 1 We made the decision to exclude horizontal infrastructure, cybersecurity, consumer tech, and Web 3.0 from this analysis to manage scope, but we hope to tackle those categories in future publications.

This horizontal-vertical arrangement provides a starting point to break down vendors and solutions into even more refined groupings that enable assessments of key growth factors. We put horizontal and vertical business applications into smaller categories using G2’s software taxonomy, which is framed on a highly granular software segmentation. For example, in the horizontal HR Tech category, G2 includes smaller categories like software for talent management, benefits administration, or HR analytics. (See Exhibit 2.)

To show where software vendors that could be attractive candidates for private equity backing are gathered in significant numbers—in other words, to estimate the number of potential, addressable investment targets—we started with roughly 13,300 software companies, based on data from Pitchbook and CB Insights. We then further reduced the number of targets in the overall market by looking at business model and funding status. The resulting estimated “universe” of targets is loaded heavily toward prominent software areas like Healthcare and HR Tech. (See Exhibit 3.)

Opportunity does not end there, with clusters of promise throughout the technology space. Verticals that offer plenty of targets are health care and financial services; customers in these spaces have extensive technology needs, and the two areas make up a large share of the overall economy. With this universe of targets in view, investors can then look for noteworthy adoption behaviors and trends throughout each category.

Look at Headcount Growth for Signs of Promise

Growth in the software world is varied and inconsistent. A single category of enterprise B2B offerings will show more than one growth profile. For example, analytics software—fitting the Pockets of Opportunity growth archetype—consists of both business intelligence and data analytics tools, which experience moderate growth, and machine learning and data science products showing faster and more extensive growth.

Growth and adoption of software can also be the result of several different underlying dynamics. Customer IT budgets can change throughout a sector. In the public sector, increased funding may fuel market growth as agencies spend more on government technology (GovTech). Customers are apt to adopt solutions that directly increase business revenue, such as marketing technology (MarTech) or donation platforms in the nonprofit sector. New ways of working often create immediate need for enabling technology, such as workplace management systems. Investors are left questioning if these catalysts are driving meaningful, long-term growth or shorter bursts of adoption.

While company revenue would be an obvious indicator of sustained or slowing market growth, public access to information around a small private company’s revenue is unlikely. However, PE teams can anticipate customer adoption of a software type if the relevant vendors show hiring activity or expanded headcount in two key staffing areas: sales and marketing and engineering.

Assessing Headcount Growth

First, for a set of publicly traded software companies, we found a correlation between aggregate sales headcount growth across a category and potential revenue growth. To scale this analysis, we then leveraged alternative data on sales headcount to apply it to a sample of firms in our G2 dataset.

Sales headcount is not the only metric of growth. Investors can augment this view by monitoring changes in engineering headcount. An increase in design, programming, and related personnel may mean that companies in a category plan to develop new products or features in response to market demand.

We found that certain categories, such as GRC and Supply Chain—which match the Pinpoint Play archetype of smaller numbers of targets and clear growth patterns—feature high headcount growth in both sales and engineering. This data indicates the categories are building new innovative products through engineering hires and driving top-line expansion through sales roles. (See Exhibit 4.)

Investors should be alert for various conditions when scrutinizing headcount growth. For example, firms should confirm the type of funding evident throughout a sector, as software vendors with early-stage venture capital backing often focus heavily on product development. These companies will not recruit more outbound sales staff until leaders are convinced that the product fits a clearly defined market. Only then will vendors scale their sales teams to cover the market; for example, many GRC software providers are still ramping sales teams well after a wave of product development moved forward. Investors should also remember that after a market has run through an initial spike of adoption, vendors with sufficient sales staff in place to acquire new customers will curtail sales headcount growth—even if revenue continues to increase. Sales and product headcount become more stable as a category matures and adoption stabilizes.

Analysts must also recognize that the degree of headcount expansion will depend on the vendor’s implementation strategy. Some software types are easier for customers to implement and require less vendor support for deployment and training, limiting the need for sales staff involvement after deployment. However, external sales teams may play a larger role in customer onboarding of technologies like CRM software—fitting the Target-Rich Growth archetype—where increased headcount may mean favorable returns for investors.

Keep Pace with Adoption by Weighing Saas Maturity

The spread of Software-as-a-Service (SaaS) and cloud technology across many areas of commerce continues; however, much on-prem software—which is costly to replace or upgrade—remains in use today. Investors can measure SaaS penetration across horizontal categories to determine where more adoption could still occur. Lower SaaS penetration may mean that companies are still using on-prem software in those categories—where growth could increase as these companies replace the on-prem resources with SaaS solutions.

Exhibit 5 shows an estimate of cloud penetration by horizontal categories, derived from IDC data on both SaaS spending and overall software spend within a category. Areas of lower penetration—supply chain and office and collaboration solutions—appear to be horizontal categories where future adoption may occur.

At first, investors may think that plenty of whitespace exists for adoption of newer SaaS resources to replace older on-premises software installations. However, private equity teams should pause where SaaS adoption could be limited to a modest push. Transitions to SaaS from on-prem resources can be small in scale. In government technology, an on-prem incumbent vendor may offer a SaaS solution that includes processes already integrated into the existing on-prem solution. We have also seen this dynamic play out in other spaces—such as Real Estate tech—in which end-customer payment information is integrated with existing systems and transitioning to other solutions is costly. This smaller SaaS engagement would not necessarily translate into the sort of meaningful competitive shift to another vendor that could initiate larger growth in a sector.

The practical aspects of transition may impede adoption. Organizations sometimes balk at the major costs involved in replacing the ingrained workflows and processes that have built up around on-prem installations. IT departments and users do not easily give up the familiar planning and processes of ERP solutions, which slows down the trajectory of SaaS adoption—even if a SaaS model could be more advantageous for a customer to use in the long run.

Take the Measure of Vertical Specialization

Observers may think that vertical adoption of small solutions would be unlikely, as some of the world’s largest technology vendors address specialized use cases with horizontal solutions. However, a smaller vendor’s vertical expertise is often a convincing selling point to B2B customers with specific needs. For example, a vendor offering a customer relationship management solution designed for use in the fitness industry may compete for share against a larger, more generalized CRM offering by providing unique features such as class scheduling or POS integration.

Private equity teams should watch for this type of vertical growth that gains force wherever newer entrants set apart their solutions by offering unique use cases, bespoke features, or functionality, which larger horizontal platforms do not always match—and which specialty vendors often know well.

To assess how products are moving into vertical markets, we looked at G2’s database of product reviews for feedback from customers to see if reviews were showing up more consistently within verticals or across categories. If we saw a pattern change from customer reviews in a broad array of industries to reviews in only a few verticals, we identified increasing activity and adoption within a vertical. (See Exhibit 6.)

Several drivers explain the vertical adoption appearing in a handful of subcategories. Within OCFO (Office of the CFO), specific verticals such as retail or fashion often have much more complex planning requirements that necessitate a custom application. While ERP solutions have often used a universal data and workflow toolset, more and more ERP products are built with specific business management workflows in mind—for example, the processes found in equipment dealerships or industrial factories.

Another example of vertical growth is found in HR Tech, which we frame in the Disruptive Space archetype. While horizontal HR offerings often deliver more general functionality, many companies have specific people management needs as employment conditions evolve. In response, more customers are buying specific HR Tech solutions to serve specific types of workers or requirements, such as skilled tech professionals or compliance with employment regulations.

Look Downmarket for Growth Potential

To try to capture a sector’s total addressable market (TAM), software companies also move downmarket, adjusting their product and pricing model to meet the needs and capabilities of small and medium-sized businesses (SMBs).

Established enterprise-level B2B providers commonly try to expand their TAM by going after smaller customer segments. However, this strategy doesn’t reap rewards for all incumbents. Smaller businesses are often less sophisticated in their technology usage, and they tend to move slowly when adopting software. A vendor selling enterprise software that requires major post-implementation support or customer training will lose money guiding downmarket customers. Private equity investors stand to realize more wins with targets offering SaaS-native architecture that can be deployed quickly with less professional services support.

To assess movement in downmarket penetration, we analyzed median percentage of G2 reviews from SMB customers within each product category. If we found an increase in SMB reviews, we concluded that adoption and downmarket traction had grown. For example, Sales Tech, OCFO, and collaboration tools have seen increasing adoption, with plenty of whitespace still available. HR Tech and analytics show more stability and less growth downmarket. (See Exhibit 7.)

Opportunity certainly exists downmarket, but the scale of downmarket adoption is much smaller than the growth of analytics, HR Tech, or customer service solutions across numerous sectors. Legacy incumbent software vendors often struggle to migrate downmarket absent mergers or acquisitions. In certain verticals, horizontal platforms gain traction with smaller customers by offering very simple-to-use functionality to serve the basic needs of the vertical in a cost-effective way.

Conclusion

Software holds rewards for any investor who can find advantages in the mass of solutions, products, and services that will continue to power business for years. Investment strategy, then, must be built on rigorous analysis that goes beyond instinct and intuition. Using data sources that illustrate the way B2B customers are adopting software allows investors to more effectively understand patterns of growth. Framing these patterns in the right growth archetype is a key step in designing the firm’s investment style for the software category. The guidance that we offer here allows private equity investors to prioritize targets and build greater confidence in where they choose to invest.