The Long View

Are Tech-Enabled Vertical Roll-Ups the Future or the Past?

The topic is a hot one—should venture capital be used to roll up service businesses?

At Tidemark, we don’t kid ourselves: we don’t have it all figured out. We spend our days rigorously debating and analyzing new opportunities. As you would expect, this often means that people will be thinking about the same topic simultaneously and come at it from very different perspectives and with very different beliefs on outcomes.

Normally, we synthesize those perspectives into a cohesive view and publish our research through our website, such as our hallmark series on Vertical SaaS: The Vertical SaaS Knowledge Project.

However, this time, we thought we would do something different and maybe a little dangerous. We decided we would publish two internal essays on the same topic, with not just different views but different ways of thinking about the same market opportunity. The first was written by our founder, Dave Yuan. The second is written by our Director of Ecosystem and Investor, Michael Tan.

Funnily enough, they coincidentally wrote their own pieces on the same topic simultaneously without consulting each other, and we've combined both of them into one single essay. We’ve left in both of their intros, even though they cover somewhat similar ground, as it's helpful to see how they are setting up the question.

The topic is a hot one—should venture capital be used to roll up service businesses? Let’s dive in!

Dave’s View

I’ve been getting many pitches to roll up local service merchants lately. These are “sleepy industries” such as HVAC, pool cleaning, etc., and use vertical SaaS goodness to modernize and improve those businesses.  

(By the way, I hate the term “sleepy” used by venture capitalists as faint praise for mainstream or bootstrapped entrepreneurs. Most of the Main Street and bootstrapped entrepreneurs I know out-hustle and out-innovate said VCs every day of the week).

In my opinion, these roll-ups mix conflicting strategies. Venture investing is about rapidly building enterprise value: build a product once and sell it many times at a 100% gross margin. Roll-ups are usually about financial engineering and cost-cutting.

The combination of the approaches can be either a really good or really bad idea. (Newsflash: an investor weighs in with “it depends.”) However, the outcome depends on the fundamentals of the underlying businesses and whether they support the financial engineering required to generate returns. In my view, the risk is less around technology and, thus, not always a great fit for venture capital.

A Guide to Financial Engineering

At its most fundamental level, financial engineering is all about OPM (other people’s money).  

This money comes in two flavors:

Equity: Other people own some of your company. The financial engineering involves raising at a high multiple, buying service businesses at a low multiple, and finding value in the delta between the two.

While equity can work over short periods, it has, up to this point, always fallen apart in the long term. Pitching a company that builds a portfolio of services companies that are slightly improved with technology has always resulted in the market being more important than any additional margin the tech can provide. Call it the “WeWork principle:” Eventually, even the most optimistic venture investors realized that WeWork was really a leasing company (one with mismatched duration and credit quality, terrible cost controls, and poor governance to boot).

Debt: Other people don’t have ownership, but they have a senior claim on your company, and you need to provide them with interest. This is a much more sustainable form of financial engineering. You are in business as long as the stuff you buy creates more cash flow than the debt costs you!

What matters is this—the thing that you're buying, after you implement your magical new tech, needs to create more excess cash flow than is required to pay for the debt you used to buy it.  Said in a very complicated way, the pro forma cash flow multiple of the acquisition provides a yield (~1/cashflow multiple) that is greater than the cost of debt, which these days is often in excess of 10%. The bigger the difference, and the more repeatable it is to create this difference, the bigger and faster the roll-up can be.

If you’re going to use debt, hire a hardened finance professional with experience with it. Your friendly ex-early-stage VC or business development guy may have worked at a fancy bank and be good with Excel, but you actually need a huge depth of understanding of finance, accounting, and key terms around collateral, redemption, etc.

Still, in either case of OPM, the issue is the quality of the markets, not the quality of the CRM.

Avoid Gold Plating

In the VC world, more software, more better. For a roll-up, you need to be careful about how much capital you’re putting into your magic tech platform. Upfront software development costs are fine—the tech creates the pro forma cash flow magic. But back to the WeWork principle, you should expect investors to eventually value you as a premium tech-enabled business, not the grandiose technology company you pitched to your early VCs.

Your investors will ultimately value you on free cash flows, so eventually, those upfront costs must be amortized by the businesses you buy. The more you invest upfront, the more businesses you need to buy to make it pay off.

Overall, “tech-enabled vertical roll-ups” feels like a traditional private equity strategy with a facelift. Looks better, but it is still the same old strategy. A couple of common variants:  

Special Case #1:  Software Buying Big Customer

What about a vertical software company buying a big customer to benefit from its software's power? Call me a software bigot, but if you’re a high-margin, high-multiple software company, why use your expensive equity to buy a lower-margin, lower-multiple (services) business?  

Competing with them will likely alienate your other customers and impair your software business. So, unless you’re running out of money or can’t find product market fit, this seems like an odd approach to maximizing value.

Special Case #2:  What If You’ve Convinced the World Your Services Roll-Up is a Software Company?

Let's say you somehow convinced the world your leasing company is a software company. Now what should you do?

  • Raise equity, a lot of it: Back to the financial engineering section. You have the golden opportunity to raise money at a high multiple and buy at a low multiple. Do it at scale!  As an entrepreneur, you’ve found a trade that works, so you might as well juice it for all its worth. Just know there’s likely a point where the world catches up and understands you’re not a technology business. And at that point, you will face many frustrated investors and some snarky headlines in the WSJ.
  • Watch your back: Those frustrated investors will likely pull out their knives and tell you to beat it. To prevent that, preemptively install a buddy on the board (maybe an early-stage investor who has also benefited from subsequent late-stage OPM). Getting super-voting rights will also be helpful.
  • Avoid debt: Your equity investors can try to toss you as CEO but have limited ability to reclaim their investment. Lenders have a senior claim and ongoing interest claims (although they sometimes will take those in the form of equity). Those folks don’t have knives; they have AK-47s and can take both you and all the shareholders down.
  • Sell: Get out while the world is enamored with the “World of We.”

Bottom-Line

A tech-enabled rollup is a tool (sometimes a very effective tool), not a strategy. The key leverage point is the technology, not in its own right (remember the WeWork principle), but as a tool to increase pro forma free cash flow. The other key leverage point is other people’s money—ideally debt—to scale and aggregate.

This can work well if you buy fundamentally good companies (stable, high-margin, and recurring). It is better if they grow organically independently, or you can significantly grow them pro forma. The best thing is to be able to buy bad companies and use technology to make them great companies. What doesn’t work well is pooling many bad companies for cost savings. And what doesn’t work in the long run is selling a tech company to investors and building a tech-enabled service portfolio. Eventually, investors will likely figure out the difference.

Got any pushback? Tell me where I went wrong.

Michael’s View

I am happy to tell Dave where I think he is wrong!

Vertical SaaS Vendors (VSVs) have become so valuable because they help their merchants make more money than they would by using horizontal software vendors. In return, VSVs capture a fraction of the value they generate and make their return by selling their tools to many different merchants.

Another model slowly coming into vogue is the “tech-enabled vertical roll-up.” In contrast with the traditional VSV capturing a fraction of the value they generate (but across a wide number of merchants), this strategy focuses on maximizing the value captured across just a handful of merchants. This is done by buying the merchants outright and then (often with the help of AI) implementing tech-powered improvements that create value. By virtue of owning the end business, all productivity gains from those improvements flow directly to the owner. Some examples of this buy-and-operate strategy include:

  • Pipedreams: plumbing and HVAC businesses (Raised $36 million)
  • Roofer: roofing businesses (Raised $7.5 million)
  • Splash Ventures: pool service businesses (Raised $4.5 million)
  • Sunday Carwash: car washes (Raised $6 million)
  • Commons Clinic: orthopedic surgery businesses (Raised $33 million)
  • Metropolis: parking platform that bought Premier Parking and SP Plus, two physical parking operators (Raised $1.9 billion)
  • Teamshares – family-owned businesses (Raised $202 million)

Source: Crunchbase & Pitchbook data.

While this may sound like private equity with extra steps, these strategies are fundamentally different. PE buyouts typically are about “trimming the fat.” Returns are created from financial engineering and outsourcing as much as they are improvements in the business itself. Tech-driven roll-ups are about making businesses grow faster and more efficiently.

You can visualize it as something like this.

Image: Tidemark illustration (wouldn’t be a VC blog post without a 2x2)

In most markets, we believe that becoming an industry platform—a multiproduct, multi-stakeholder piece of software connecting entire industries—is the way to go because you get both scale and higher ARPU. However, tech-enabled vertical roll-ups allow you to capture the most value per business of any other available option.

Why Isn’t Everyone Doing This?

Still, conventional wisdom suggests this is a mistake from an enterprise value maximization perspective. If you have, within a single entity, a software business that trades at a high multiple and a services business that trades at a low multiple, the public markets will usually just characterize the combined entity as a “high-margin services company.” These company’s multiples end up closer to their service peers versus their software peers. This is because the software component becomes captive to your services businesses (it can no longer be sold as a neutral platform to all merchants in the vertical). Thus, you sacrifice a high multiple business to enhance a low multiple services business. Up to this point, most founders accepted this conventional wisdom.

However, the new founders of these roll-ups are betting that:

  1. AI opens up an opportunity to easily achieve huge efficiency improvements and operating leverage in any small business.
  2. Pure software plays will only get more competitive and commoditized as AI increases in power, decreasing margins to the point where the profit pool flips to the merchant versus the software provider.

If these founders and investors are right, this strategy represents a material shift in the level of ambition Vertical SaaS can aspire to. The goal for founders could be to build the next tech-powered McDonald's, not the next Toast.

Why Now? The Case for Tech-Enabled Vertical Roll Up

A key factor for the success of the tech-enabled vertical roll-up strategy is the ability to improve operations. Of course, this is doable and has been done hundreds of times by private equity—investors have created an entire asset class based on a thesis with operational improvements as one of its core tenets. Typical roll-ups work because of economies of scale, cost-cutting, and operational playbooks. While these playbooks often involve using new tech, they are usually low-hanging fruit developed by external parties such as CRM. Tech-enabled vertical roll-ups take all these and add a crucial differentiator: home-grown (and potentially AI-powered) technology.

AI allows for automation beyond what the workflow apps of the 2010s could offer. With LLMs still in their infancy, we see AI-powered solutions that can dramatically improve back-of-house operations with customer service or front-of-house operations in places like outbound sales. We’ve heard examples of companies improving call handling and client bookings by an order of magnitude by simply plugging AI into those workflows. If this improvement curve continues, AI opens up huge, easily attainable efficiency improvements (e.g., allowing one customer support person to do the work of five). Many of the roll-up strategies of yesteryear are not prepared for this paradigm—workflow applications were helpful but were mostly unable to automate functionality completely.

The ubiquity of the operations that can be improved with AI also makes it easier to underwrite the operational improvements that drive value. Every business has intensive human-powered efforts in both the front-of-house and back-of-house. When the tech enablement happens in-house, your “captive software platform” no longer just needs to capture a sliver of the value it generates. Instead of making a SaaS fee for your accounting automation solution, you can capture all the cost savings from replacing an accountant to improve the margin profile of the services businesses that you own. To put that into perspective, Quickbooks costs ~$30/mo, whereas small businesses can spend upwards of $20,000 on accountants. That means owning the business can potentially capture/save 50x more dollars.

Dave mentioned above, “What matters is this—the thing that you're buying, after you implement your magical new tech, needs to create more excess cash flow than is required to pay for the debt you used to buy it.“

Today, with AI, maybe it is finally possible to consistently attain that dream and make that ideal a reality–in Dave’s words, the magical-excess-cash-flow-generating-tech may now finally exist. A new unlock in operating leverage may be on the horizon or already be here!

So the question becomes, what types of markets are best suited for this strategy?

What Makes For a Vertical That’s Ripe for a Tech-enabled Roll-Up Strategy

Not all markets are created equal. Here are the trends a roll-up founder should be looking for:

  1. Lower Growth, Consolidating Industry: In an industry that’s consolidating, the number of accounts you can sell to as a traditional VSV will decrease. In that environment, the equation tilts more favorably to being the player doing the consolidating (by rolling businesses up) than being a VSV trying to go after an ever-decreasing number of at-bats. You need some level of scale in each company you are buying to deploy your AI-enabled improvements for them to really have an impact. In that way, it's better to have a consolidating industry because there are more scale players to buy.
  2. High customer support labor costs: While GenerativeAI’s ultimate efficacy (and whether you should build or buy GenerativeAI solutions) remains unknown, one place where it is already successful is in customer support and service. For example, fintech giant Klarna used AI to automate away 66% of their customer support. SMB roll-ups that rely heavily on customer phone calls are ripe for disruption and present low-hanging fruit for driving margin expansion.
  3. Core workflows that can be fixed or improved with software: You can add software to both front and back office processes, but there is excess value when you can insert software into the core work of the business itself. You can only add so much software to a restaurant—someone still needs to cook the french fries. However, in some industries you can offer better products or use technology to actually "do the work". For example, Roofer uses drones and computer vision to entirely do the roof inspection service, displacing human-powered labor completely in that step.
  4. Cheap multiples for businesses in the industry: This is straightforward–buying companies at a cheaper multiple gives you more room to maneuver as you improve the business quality. And if you do it well enough, perhaps with the help of AI, it can become a business that trades at a higher multiple.
  5. Brand value matters: As is true in most roll-ups—tech-enabled or not—if each additional location added increases brand equity, the better off you will be.
  6. Economies of scale: Many software tools require a minimal density for breakeven. If you own the technology in house, you spend upfront to develop or buy the technology, and then you can deploy it across all the businesses you've rolled up at zero marginal cost. Being able to hit critical mass fast enough to achieve that matters as your breakeven on that upfront cost.

The Long and Short of Tt

If you spend too much time on vertical SaaS companies’ websites (welcome to the club), a common pattern you will see is a huge claim: “Cut down busywork by 50%!” or “Grow faster than ever.” Most of these claims are bullshit, but sometimes they are true. The tech-enabled vertical roll-up allows those claims to be put to the test. Perhaps with AI now promising to automate entire workflows away, the efficiency gains that are needed to justify a tech-enabled roll-up strategy are finally within reach.

Contributing Authors:
Michael Tan
Dave Yuan