I talked about whether network effects were overvalued in my last blog post. I talked a lot about the value of those network effects in increasing switching costs. Yet most of the examples I used were companies like Uber, Facebook and Microsoft. What about enterprise businesses? Many of the best enterprise businesses in the world have extraordinarily high switching costs, even without significant network effects. It goes without saying that any strong business needs to deliver significant value to retain customers, but beyond that, how do you go about building switching costs into your enterprise business? In this post, I will walk through five kinds of switching costs – Level 1 through Level 5.
Let’s start with why switching costs are important. They are about increasing the predictability and lifetime value of your customers. As you increase the switching costs, the lifetime value of your customers increase, and therefore your ability to invest in acquiring those customers at a higher cost increases with them – feeding the virtuous cycle of more customers, more revenue, more growth and more ability to drive growth. High switching costs are often (though not always) accompanied by high customer satisfaction. If your customers stay with you, their happiness will transfer over to help you sign more customers. If they are all switching out – prospects will question the value of your solution.
I believe there are multiple switching-costs levels:
Level 1 (“My lawyers will sue you if you leave me”): Level 1 companies build switching costs contractually – by signing multi-year contracts with onerous termination provisions. Many legacy software businesses and network providers sign multi-year agreements that prohibit them from switching away from the antiquated platform they have. Customers may not like the software – but the switching costs are so high that they stay. Level 1 switching costs don’t last – they just buy time until the contract expires; and they are increasingly hard to achieve in a SaaS world.
Level 2 (“I love you too much to switch.”): Emotional buy-in is definitely a form of switching costs. Not many enterprise products have the kind of emotional tie-in with their users that Consumer businesses like Apple have, but there are some enterprise products that have the “love” factor. Tableau is one such example – the Tableau user base loves the empowering nature of data visualization. Adobe’s creative suite products elicit similar responses. Graphic designers and other creative artists swear by the suite. You know you have a L2 business when your value proposition doesn’t require an analytical frame of mind to justify your product’s purchase. People buy it because they love it.
Level 3 (“My data and/or business logic is in your systems.”): Salesforce has Level 3 switching costs. The functionality of Salesforce CRM might be good, but even if someone else came along with a better product, the data investment that most companies have made to make Salesforce their customer data “system of record” is significant. Amazon Web Services has a similar story — having caused businesses to leverage Amazon as the data store for their applications makes it painful to switch. Replicating and migrating the data is possible, but just not worth it unless the service is really subpar.
Level 4 (“Your business depends on my business.”): Google might be the best example of this. Advertisers don’t have to love Google to stay with Google. For many of them, their business depends on Google. No CMO wants to show up with plummeting revenues because they turned off 20% of their customer acquisition, even if a marketplace (along with decisions Google makes) sets the price of their relationship. Oracle’s database business or SAP’s ERP business are a different form of “dependency.” Many of the world’s largest businesses run their entire operations on Oracle and/or SAP. Sure, they could switch if a better solution comes along, but the business disruption and the personal career risk would be so large that the threshold for switching is extremely high.
Level 5 (“You are my platform.”): The word platform might be the single most misused phrase in technology. There are, however, true platform businesses that enterprises build enormous amounts of business process and application logic on top of. Platforms may add value because of the network of applications that are built on them (that then add value to new applications) or because the key competitive advantages of the enterprise are tied into the platform they are on. Intel is a prominent example of such a platform. When a server manufacturer decides to build on the Intel architecture, you can assume that switching chipsets isn’t happening anytime soon. The distinction between L5 and L4 is subtle. In L4, my business depends on your business. In L5, my business and your business are so intertwined that the two have become indistinguishable.
So how should a startup think about these various kinds of switching costs? First, by caring about them. Too many startups are too focused on customer adoption, and too unfocused on switching costs. That’s just deferred and increased pain. Often the software that’s easiest to adopt, is also easiest to throw out. It might be worth having a product that has a longer sales cycle to materially increase switching costs. Second, the vast majority of startups aspire to get to Level 1-2, and rarely think through a path to achieve L3-5. Often, the longer one waits, the harder it can get to achieve that path. Finally, the key thing to remember about building switching costs is– if it makes sense for a customer to switch, they will switch. Obvious, right? Too many entrepreneurs and executives are too steeped in their own Kool-Aid to put themselves in the customer’s shoes and ask themselves the hard question: Is my product really worth it?