Vertical SaaS Moats, Part 3: Switching Costs
In part 3 of our series on vertical SaaS moats, Fractal senior associate Evan Gabriel explains how startups can build high switching costs into their products. Missed Part 1 and Part 2? You can read them here.
Churn is a major concern for every SaaS company, but vertical SaaS businesses have to be particularly mindful of this metric given their highly focused target market. There are many ways to prevent churn, but arguably the best tactic is for vertical SaaS founders to maximize the value they are providing to customers and thereby raise the cost of switching to a competitor’s platform.
Vertical SaaS companies that build systems of record are uniquely positioned to create products with high switching costs because their software is integral to their customer’s business. They may contain important information about customers and vendors, run mission-critical processes, or track the financial health of the user’s business. The specific use case for the system of record is less important than the fact that the longer the customer uses the system the higher costs they must bear to switch to a different platform.
There are three main types of cost a customer might incur by leaving a sticky vertical SaaS platform. The first is the cost of time. Depending on the size of the customer’s business, migrating data and business logic to a new system of record can take anywhere from several weeks to several months. The second is the cost of disruption. It can be extremely challenging to accurately port customized business logic and data to a new system. There are countless examples of inaccurate or incomplete migrations to new systems of record that resulted in substantial losses from disruptions to a business’ normal operations. The third is the cost of learning. Employees will have to dedicate time to master the new system, which includes everything from keyboard shortcuts to building relationships with the support team at the new vendor. If the new system is complex, the learning curve can create a substantial sunk cost for the user.
For vertical SaaS companies, the primary benefit of building a product with high switching costs is that it enables the company to charge higher prices than their competitors for comparable offerings, especially when the company is upselling or cross-selling existing customers. It also creates a formidable barrier by forcing competitors to compensate customers for the high switching costs through tactics such as free training or discounted data migration. These compensation strategies can get expensive quickly and may make targeting these customers an unattractive growth strategy for competitors.
The question for vertical SaaS founders is how to build their systems in such a way that they create these high switching costs for the user. Here, we’ll consider four primary strategies: controlling data, selling long term contracts, creating a multi-product ecosystem, and extending through the value chain.
1. Control the Data / Business Logic
This is a strategy that comes naturally to vertical SaaS companies building a system of record. Since these products control critical data and workflows, it is often prohibitively expensive in terms of both time and money to migrate those data and processes to another vendor’s platform.
A great example of this in practice are student information systems such as Ellucian. Not only do these systems own their customer’s core data (i.e., student records), the nature of educational organizations that use this software means that these providers must often customize the software to meet their customers’ idiosyncratic needs. The fact that these systems own the core data elements provides a springboard for building a multi-product ecosystem by cross-sell existing customers with new products like admissions CRMs, which further enhance switching costs.
When a vertical SaaS company controls its customers core data and workflow processes, any competitor will have to absorb the substantial costs of moving those data and processes to a new system. In some instances this may just be a matter of migrating data, but in industries where customized software is the norm, the costs of rebuilding bespoke business logic for these customers can be immense.
2. Create a Multi-Product Ecosystem
A common growth strategy in the software world is known as “land and expand.” The basic idea is to make it as easy (and/or cheap) as possible for customers to start using your product. Once you have them hooked, you can start upselling or cross-selling them to increase the value you provide to your customers while boosting your revenue. It’s important to understand that building products with high switching costs is not a cynical strategy that “traps” customers on a software platform. Instead, high switching costs are created when vertical SaaS companies build a great product that facilitates key workflows for its customers.
In the context of vertical SaaS, expansion typically takes one of two forms: expanding through a customer’s organization or expanding through an industry’s value chain. In addition to driving more revenue, both expansion strategies also raise switching costs for existing customers. As we discussed earlier, a vertical SaaS company is well-positioned to establish a multi-product ecosystem because (a) it controls its customers’ key data and workflows and (b) its customers tend to have similar pain points. These features mean that a vertical SaaS company can cross-sell existing customers by offering new verticalized software products that are targeted to different functions within a business.
A legendary example of a vertical SaaS company using a multi-product ecosystem to establish a moat is Veeva, which provides software for the life sciences industry. Veeva originally started out providing CRM software for pharmaceutical companies, but now offers a suite of products that help life sciences companies with clinical operations, regulatory compliance, safety needs, and so on.
The lesson from Veeva and other vertical SaaS giants that have followed a similar playbook (e.g., Toast and Procore) is that the more employees in different departments that interact with a particular software platform, the more expensive and disruptive it will be for the company to switch to another provider. This is because these companies ultimately own more mission-critical organizational data, they have trained more people in the company on how to use their specific software system, and their competitors have to convince stakeholders from multiple departments to switch to a new system.
3. Extend Through the Value Chain
The second aspect of a land and expand strategy means expanding a software product beyond the needs of a single customer. In this case, a vertical SaaS vendor expands through the industry value chain, selling software to their customers’ customers and/or their customers’ suppliers. This works similarly to establishing a multi-product ecosystem insofar as the more a business’ customers and suppliers use the same software system the more incentive that business has to stay in that software ecosystem instead of switching to a competitor.
One of the strongest examples of this in practice is CCC, a vertical SaaS platform for the automotive industry. CCC has relentlessly expanded through its industry value chain by selling to their customers’ suppliers and their suppliers’ suppliers. They started with a product offering estimation services for auto insurers before expanding to providing software for auto body shops and parts dealers. From there, CCC has essentially expanded to cover the needs of the entire automotive industry, including, rentals, financiers, and medical payers. The company provides a masterclass in establishing a moat through high switching costs, which has kept major competitors at bay for more than 40 years.
4. Sell Long Term Contracts
One of the major advantages of the SaaS model is that it enables predictable recurring revenue. While many software providers may offer month-to-month billing options for a premium, savvy vendors will try to lock in new customers into at least a year-long contract. This not only allows for more accurate revenue forecasting, it also plays on customers’ natural tendency to succumb to the sunk cost fallacy. Once a customer has already spent a meaningful amount of money on a software product, they are less likely to abandon it, especially if they’ll be on the hook for a large fee for breaking the contract.
This won’t be news to any SaaS founder, but vertical SaaS companies have a unique advantage insofar as they can use the “winner-take-all” dynamics of industry-specific software markets to lock customers into substantially longer contracts. For example, take Maxient, a school conduct management system for colleges. For a long time, Maxient was the only vertical SaaS provider in this space and was primarily competing with horizontal SaaS companies like I-sight. Its superior product meant that Maxient quickly conquered its market and used its quasi-monopoly to negotiate customer contracts that were sometimes up to 8 years in length.
To the extent that a vertical SaaS provider has established significant market share in its target vertical, it can use this position to establish stronger customer relationships and longer contracts that raise the cost of switching. In general, the length of a contract — and the cost of breaking it — will be inversely related to the likelihood of a customer switching to a competitor’s service.
Ultimately, vertical SaaS founders are able to leverage high switching costs as a moat because their product is good at what it does. It handles their customers’ most important data, it is customized to their business’ unique needs, and it enables everyone in their organization to do their best work. By focusing on building a product with these characteristics, vertical SaaS founders can reap the benefits of long term satisfied customers while limiting their competitors’ ability to siphon them away.
