Toast & Vertical SaaS

Back in November 2019 I wrote a quick and dirty memo evaluating an investment in Toast Inc. In light of the company’s recent successful IPO I’m sharing that memo below. Incredible to see how far the company and the vertical SaaS market more broadly have come. Congratulations to the Toast team!

Overview: Toast is a POS and technology solutions provider focused exclusively on serving the $833B United States restaurant market. Toast offers end-to-end solutions for restaurants helping them to attract and retain guests, recruit and retain talent, and improve operations and increase profitability. Toast is one of a number of well-funded, cloud based upstarts seeking to challenge legacy POS providers. They have raised over $500M from investors including TCV, Bessemer Venture Partners, and Tiger Global Management. Their most recent fundraise, announced in April 2019, valued the business at $2.7B. Toast is based in Boston, Massachusetts and has approximately 1500 employees.

Market & Background: Toast is focused entirely on the $833B United States restaurant market. Forecasted to reach $1.2T in sales by 2030, the industry is expected to grow roughly at the rate of inflation. There are over 660k restaurants in the United States employing 15.1 million people. They can be broadly segmented into three main categories: full-service restaurants (FSRs), quick-service restaurants (QSRs), and Bars & Taverns. FSRs (35.8%) and QSRs (30.1%) drive a lionshare of industry revenues. Restaurant profit margins average at around 3–5%. There is a significant longtail of restaurants with a majority of institutions handling less than $1M in sales volume per year.

Toast is focused primarily on the SMB and Mid-Market segment (<10 locations, $1M in sales volume/location) where their “best of suite” offering will be most appealing. This also happens to be the fastest growing segment of the market due to shifting consumer preferences in favor of bespoke dining options.

A classic definition of Toast’s addressable market would be the US Restaurant POS market, sized at $13.1B in 2018, and forecasted to grow at a 7.4% CAGR through 2025. However, their focus on value added software services (and restaurants desire to spend in that area) suggest that their market can converge somewhere between Restaurant POS and overall Restaurant margin.

Business Model & Strategy: Toast creates value for restaurants by helping them grow revenues and decrease costs. It captures value by taking a cut of transactions processed through the Toast POS, and by charging a subscription fee for access to their software products.

Toast maintains that the current fragmented restaurant software market creates headaches for the customer, and prevents them from holistically optimizing operations by keeping data siloed in assorted third-party software solutions. Conversely they argue a unified solution creates a richer data pool, allowing for more meaningful operational improvements. While software unification is fundamental to Toast’s customer value proposition, it is also central to their business strategy. Toast believes that for each additional software solution a restaurant uses, there is a commensurate decrease in subscriber churn, and increase in customer lifetime value. Let’s take a look at how each of Toast’s software solutions creates value for their restaurant customers:

• Front of House: Toast POS successfully helps restaurants decrease ticket times (total customer time spent from arriving to departing the restaurant) by increasing the speed at which restaurants can take orders, and by decreasing the time spent processing payments. Ticket time is an especially critical metric for quick-service restaurants. Toast Go has also proven effective at increasing server tips through seamless prompting and quicker table turn times. Server tips are a crucial variable in employee retention. As a Toast executive said on a diligence call “Outside of food costs the most difficult cost for a restaurant to manage is attracting, training, and retaining good employees.”
• Back of House: The Toast Kitchen display system (KDS) bridges the gap between the chaotic kitchen and the front of house. The KDS reduces ticket times and the number of comped meals by sequencing incoming orders by prep time and coordinating table and take out delivery. Toast inventory optimizes COGS helping to cut down on expensive food waste by tracking inventory variance and using historical customer order data to help with ingredient forecasting. Finally, the menu configurer marries these data streams to allow for dynamic menu management across multiple locations.
• Guest-facing technology: Toast online ordering and Toast loyalty allow SMB restaurants to utilize marketing tactics previously reserved for large restaurants or major chains. These tools help restaurants boost check sizes, grow “regulars” and increase sales.
• Back office operations: Toast offers reporting and analytics tool sets in addition to payroll, shift scheduling, and benefits management. This suite gives restaurant owners more ways to optimize operations while reducing the amount of time they need to spend on non-critical tasks.
• Toast Capital: Toast leverages it’s POS data to offer competitive merchant cash advance loans up $250k, allowing restaurants to manage cash flow variability and finance growth. The existing POS integration allows for simple loan applications, fast approvals and seamless repayments.

Competition: There are three main ways to think about Toast’s competition:

• Restaurant specific POS vs General POS: There are a number of general POS providers who have worked to retrofit their standard offerings for the restaurant industry. These larger players (Oracle, Stripe, First Data) compete against more niche players (Toast, Revel) who are either primarily or exclusively focused on building for and serving the restaurant industry.
• Cloud POS vs Legacy POS: The secular trend driving change in POS providers is this shift from legacy on-premises POS solutions to cloud based POS solutions. Legacy providers are racing to infuse cloud features into their solutions while cloud based challengers are racing to build out their distribution before the incumbents can respond.
• 1P POS integrated solutions vs 3P Module specific solutions: Given Toast’s ambitions to service the full restaurant stack, from front of house to back office operations, it often competes with module specific services. These services, like Gusto for payroll or LevelUp for CRM, have deep module specific knowledge that they offer across a range of industries. Presently Toast has a ‘co-opetition’ set-up with many of these companies as it allows some to integrate into the Toast POS stack, but also offers competing first-party solutions.

Financial Metrics: To get a better understanding of Toast’s financials I’ve built a model of their average per-customer unit economics using insights gleaned from pricing information, analyst reports, public comparables, and diligence calls with current and former employees:

Key drivers of this analysis include: restaurant transaction volume (informed by market sizing analysis from an earlier section and customer mix guidance gained through employee diligence), transaction take rate (see appendix for full analysis), churn (informed by SMB restaurant survivor data and diligence calls), and CAC (see appendix for bottoms-up analysis). Using these estimates, publicly disclosed location counts and growth rates, and public market next-twelve-month revenue multiples I arrive at a Toast Inc. Enterprise value of $2.8B.

Investment Positives: In order to believe in Toast you must believe in the long-term viability of their vertically integrated approach. There are many indicators that it has been and will continue to be successful. Survey data indicates that restaurant owners are quickly coming around to the idea that the success of their location will be driven by better incorporating software and data to improve operations. At the same time, it suggests that these owners are wary to spend a larger percentage of their time managing and overseeing multiple relationships with disparate software solution providers. This is a huge opportunity for Toast as it suggests the convenience of their “best of suite” solution can win over the superiority of “best of breed” module specific products. Additionally, as commodity payment processors continue to compete their margin away, there is real hope that Toast’s unique market position as a restaurant software provider who also does payment processing can insulate them from that value destroying price war. Defining and owning that market position can enable them to re-frame their market away from the $13.1B restaurant POS market, and towards the more enticing ~$35B US restaurant industry profit pool.

Investment Concerns: In order for Toast to effectively execute its vertical strategy it must successfully build, design, and operate a large number of very different software solutions ranging from front-of-house check splitting, to complex inventory management, to small business lending. As a general product principle I believe it’s easier to specialize in a product functionality and to scale it across different industries than to do the inverse. Beyond product execution there is reason for concern about the efficiency and scalability of their customer acquisition. Diligence suggests that the customized and variable nature of the Toast solution necessitates an extended sales cycle, intensive implementation process, and on-going post installation support. This stands in sharp contrast to the standardized, easy to set-up nature of some competitor products (Square). In order for Toast to be successful in the long-term they will need to further standardize and streamline their customer acquisition process, something that may be difficult to achieve in the highly heterogeneous SMB restaurant market.

Recommendation: Based off of my market research, company due diligence, and financial analysis I believe Toast is a compelling business and investment opportunity. I would recommend investing via available secondary shares while trying to gain primary access to the next round.

I believe the US restaurant industry is large ($833B) and heterogenous (660k restaurants) enough to accommodate a valuable vertical specific software player and that Toast is well positioned to continue as the leader in that space. Their existing products establish them as the most advanced “best of suite” solution on the market and the hesitancy of SMB restaurant owners to engage with multiple providers gives them sufficient protection against more advanced module specific solutions. Toast has a strong culture of hiring individuals with experience in and passion for the restaurant industry. That, coupled with their head start, can give them the perspective needed to execute on an ambitious software development roadmap. Additionally, diligence calls with current employees suggest that they are already taking significant steps to standardize and outsource parts of their customer acquisition and onboarding process, allowing them to further improve their CLV:CAC ratio.

Appendix

POS margin (sales figures are illustrative):

Bottoms-Up Customer Acquisition Cost analysis:

Valuation analysis: