Switching Costs
Switching costs are what a customer gives up to change supplier — the money, time, risk and disruption of moving a bank account, a payments integration, a core banking system or a data feed to a rival — and therefore the price a supplier can charge above the competition without losing the customer. In fintech they are the moat most acquisition cases are built on, and the thing an integration most often destroys.
- Also known as
- Lock-in, Customer stickiness, Cost of switching
- Used at
- pricing, retention, competitive strategy, and the valuation of any business whose customers stay because leaving is hard
- Binding
- no — an economic fact, though contracts (term lengths, exit fees, data-portability clauses) and regulation (account switching services, open banking, data-portability rules) set part of it
- Typical sources
- technical integration, data migration, retraining of staff, regulatory re-approval, contractual penalties, and the risk that the switch itself goes wrong
- Typical measure
- net revenue retention and churn by cohort; a business with 95%+ gross retention at a price above the market has switching costs, whatever it calls them
- Parties
- the supplier who benefits, the customer who bears them, the rival who must overcome them, and regulators who sometimes decide they are too high
How switching costs work in practice
Some switching costs are built and some are found. A payments API integrated into a merchant's checkout, order management and reconciliation is expensive to replace because the merchant's own engineers built around it; a core banking system that runs a bank's ledger cannot be replaced without a migration the bank's regulator will want to approve; a data vendor whose fields are wired into a lender's credit models is embedded in decisions nobody wants to retest. None of these were designed to lock the customer in, and all of them do.
For an acquirer the question is which costs the target's retention depends on, and whether they survive the deal. A software company whose customers stay because of the product's integration keeps them after a change of owner. One whose customers stay because of a founder's relationships, a pricing concession or a legacy contract does not. And an integration that migrates the acquired customers onto the acquirer's platform makes them do the very thing the switching costs prevented — so the moment of highest churn in an acquired customer base is the migration, when every customer must switch anyway and some switch elsewhere.
Regulators lean against switching costs in retail finance: current-account switching services, open-banking data access and number portability exist to lower them. In B2B software they are left alone, which is why B2B fintech commands the multiples it does.
Example
A merchant processes €30m a year through a payments provider at a blended 1.4%, €420,000; a rival offers 1.2%, a saving of €60,000 a year. Switching means re-integrating the checkout and the reconciliation feed (about €80,000 of engineering), re-certifying the merchant with the card schemes, migrating stored card tokens — which the incumbent will export only in a format the rival must convert — and a month in which two systems run and any failure is a lost sale. The merchant stays. An acquirer of the provider notes that the retention is real and priced accordingly; two years later it migrates the merchant to its own platform, the merchant is re-integrating anyway, and it takes the rival's 1.2%.
Common mistakes
- Valuing retention without asking what the customers would have to do to leave. - Confusing a switching cost with a relationship; the relationship leaves with the person. - Raising prices to the full height of the switching cost, and teaching every customer to plan its exit. - Migrating acquired customers onto the acquirer's platform without pricing the churn that migration causes. - Building a business on switching costs a regulator has announced it will remove.