Podcast Transcript

[00:00:00] Sean Steele: G’day everyone, and welcome to this week's episode of ScaleUps Podcast. It is just you and me today, and I'm excited to hear you or see you. I can't really see you, but I can hear you. So hopefully you're hearing me. We're in a good space to start with. Today, I'm going to talk about actually over the next few months, just every now and again, I really want to start to share with you some ideas around how you can optimise your business model for scalability or for valuation or for both. So, what I want to chat today to you about is Switching Costs. And what do I mean by Switching Costs? You know you've heard sometimes people talk about the fact that they've got like a sticky business model. “Oh, my business model's really sticky.” And what they usually mean is that there's some real or perceived or maybe both kinds of switching costs they've got in their model.

[00:00:50] What I mean by that is, you know, like an element of the product or the service or the business model that makes it less likely that customers are going to seek alternative solutions, more likely that they're going to stay longer. And in my head, there's probably three different types. And I want to chat to you about them today.

[00:01:07] The first one is penalties. And nobody likes penalties, let's be frank. But you know, think about some of the switching costs you've got in parts of your own life that actually make you have a second thought as to whether you'll stick with a business. You might have to pay out the rest of your minimum contract on your commercial or your rental lease or your mobile phone where there's a material break fee if you leave early or your home loan like a fixed term mortgage, which has got early exit fees or a software license where you signed a five year contract where you got favourable pricing and you worn out after one year but now you've got a material break fee because they're kind of out of pocket. And it sort of plays on our desire not to ever waste money because we see, you know, wasted money is dead money and none of us like parting with that. And so, whilst I'm not a fan of having penalties, only when there's a lot of value that you're getting. And there's also a bit of tension or a penalty or a negative consequence for leaving, it can be a valuable part of an overall builder switching cost. But I don't think it's the only thing to focus on, otherwise you feel trapped and that actually builds resentment and that can build real brand damage when you feel like you just cannot get out of a contract.

[00:02:14] So the second one, and of course the more interesting place is how do you create value. You know, there may be no direct cost to move, but if you've built your model in such a way that there's increasing amounts of value, the longer your customer is with you, then it starts to build resistance towards the idea of switching naturally.

[00:02:32] And that might be perceived value or it could be real value. So, for an example, you might be familiar with would be airlines. Okay? I'm sure many, you know, there's probably, if we're talking in Australia, there's Qantas people in the room and there's Virgin people in the room, and people don't want to lose the status points or the flying level they've accrued, whether they've actually used the benefits that they have or they haven't, they kind of fear the loss of what they've invested in and often won't move either because of ego or because they feel like they're going to lose something that they've invested in and they think they'll lose something that's valuable to them, whether it's again, a real or a perceived benefit.

[00:03:10] The third one is, and I will give you some more examples today. The third one is, Difficulty. So perhaps you don't feel like you're going to lose something, maybe that you care about so much, but you perceive that the level of difficulty, like the time that you're going to have to invest to rebuild a new service with a new provider, like switching CRMs, for example, which I've just done recently, where you're probably getting 90% of the same features, but actually the difficulty involved might be quite high. Or maybe it's not that high, but you're made to think it's really high and that can actually cause you not to move and stay longer. Now interestingly, these play on two sort of primary motivators for human behaviour. Because in reality, if you kind of go back to your Tony Robbins days, even though he's still around, you know, we behave in anyway really for one or two reasons, generally speaking, because we move towards things that we think will bring us pleasure and we move away from things that we think will bring us pain.

[00:04:06] And the first and the third ones, the Penalties and the Difficulty are kind of examples of this away from motivation, this pain driven motivation. We don't want to incur the pain, so we stay. The second one, the value is all about building up reasons to have people stay because they love what they have, they get value from it, and that value is increasing the longer they are with you, or at least they perceive they're getting value from it. So why does all this matter and why does Switching Costs matter? Well, there's a few reasons. Three, I would say. The first is Margin Expansion, stickier business models that have customers that are stickier and tend to stick around longer, they end up with a higher lifetime value per client.

[00:04:44] So just imagine a situation where it costs you like $150 to acquire a client that pays you $800 in revenue. So that's probably, I have another mask, but that's probably like 16-18% of your revenue you're paying to acquire the customer. Now imagine you can get that customer to purchase from you two times, three times, four times, five times, ten times over the next 10 years. All of a sudden, that same customer you paid $150 for is now giving 5,000, 7,000, 9,000, 10,000, and all of a sudden the percentage of revenue that you're getting from the customer versus the cost to acquire is massively expanding. And so, in that situation, your margins are usually increasing because your cost of acquisition is coming down as an overall percentage of your revenue. So fundamentally, how much you're spending to get customers as a percentage of how much money you make is coming down over time. So, your margins are going up if all other things are equal. So that really helps you to build better margins, better profitability, which of course can make your business more valuable. Businesses that have outsized profitability in an industry compared to their competitors, they are worth more people will pay better multiples for those businesses. Second reason is Cash Flow Predictability. As your customers get stickier and longer term, your ability to predict future cash flow becomes greater, and investors and buyers absolutely will pay more for businesses where they've got longer term cash flow.

[00:06:05] Predictability because fundamentally, you know, if you think about transactional businesses, they tend to get valued as a multiple of earnings, but businesses with really high expected lifetime value and long sticky customers can actually often achieve multiples of revenue. So, let's put that in commercial terms.

[00:06:25] Imagine you've got a business doing 10 million in revenue and 2 million in EBITDA or sort of earnings before interest and tax and depreciation and amortisation. Let's just say you're going to get five times your EBITDA as your enterprise value. So, you've got 2 million of EBITDA, you're going to get a five-time multiple, so it's worth 10 million in a transaction before any other costs.

[00:06:47] However, sometimes a software business with just one and a half to $2 million in annual recurring revenue could be worth four or five times revenue. So, it's actually also worth $10 million. But it often has to front load its customer acquisition cost to buy customers with the expectation they're going to get this long-term sticky revenue.

[00:07:05] So the yes, they have to capital raise, they have a different financing model. They have to capital raise early and regularly to fund the growth. But of course, they can become incredibly successful, like the unicorns, which are pretty much all SaaS businesses, they're all technology businesses, or although certainly the vast majority, it's just a different way of generating a higher multiple.

[00:07:25] So regardless if you're a services, if you've got longer contracts and customers that stay longer and who spend more with you, where you don't have to keep acquiring every new customer every year and replacing that revenue every year, you're going to get higher multiples than business that are having to replace all their customers with a new set of customers year in and year out, because they're going to have higher marketing costs and lower profitability than those businesses with the really long-term revenue.

[00:07:48] Okay. Third reason, a competitive moat. Well, it's difficult for people to leave, if it's difficult, I should say, for people to leave, and they don't want to leave either because the value built up or how hard it's to get out of your ecosystem or a combination of the two, it becomes harder for your competitors to compete.

[00:08:08] Because once you've got a customer, they know it's hard for them to woo them away. So, the pool, that gets gobbled up of customers by the number one and number two and the market leaves less for those people who aren't in the game to compete on. So, if they've got sticky business models, it becomes a real disincentive for new players in the market to try to get them away from you.

[00:08:25] And investors love that. So, it increases again, the value and the sellability of your business. So, now I'm going to give you an example just to prompt your thinking. I have a wonderful client called, The Backroom. They supply accountants and bookkeepers in the Philippines and other developing countries, and they supply them to mid-tier accounting firms in the UK, Australia, New Zealand, or the US. So simply they charge a fee per month per head. So essentially, you know, per person and because those team members, so if you're a UK mid-tier accounting firm and the position is like; Hey, well I'm spending, you know, a hundred thousand dollars per accountant, but I've also got some of these guys doing some really basic work. Why wouldn't I outsource that basic work to a lower cost resource, a team member in the Philippines who becomes a part of my business so I can get my hundred thousand dollars resource focused on higher value work that only they can do? Right. So, they charge a fee per month, per head, and because of they're part of the client's firm, they're not like an Upworker or Fiverr that'll come and go. They're really sticky. These team members are actually part of two cultures. They're part of the backroom culture and they're part of the client's culture. From the client, they're getting training and leadership and support and development and comradery and being part of the client's journey. And the client doesn't want to lose the investment they've made in that staff member. You know, they're wearing their t-shirt, they're part of their team, but they also get significant professional developments just like every other team member. But then they also get professional development, mentorship, camaraderie, and culture from The Backroom. And that makes them sticky to The Backroom as an employer, and to the client. So, their business model is super sticky. They've got very, very low client and team member attrition. So, every time they place somebody with a client, they've got a high degree of confidence that person will stay in place for a very long time. So, the business has this beautiful, it's a services business.

[00:10:15] It's a profitable business. It's not a SaaS business, but it has a nice recurring revenue style to it even though it's not a technology business, so it's got long-term cash flow predictability, it's going to be worth more than typical services businesses where they're having to replace that revenue year on year, their revenue builds and builds and builds and builds.

[00:10:33] I'm going to give you one final example just to prompt your thinking, and then I'm going to leave it with you to digest and see if you can build some Switching Costs into your business. The second example is BMT tax depreciation. I used BMT tax depreciation probably 20 years ago when I bought my first investment property. They do tax depreciation schedules for investment properties. It cost you about 700 bucks, and that's for an investor to get a essentially a service like somebody assesses the property, figures out all the fixes and fittings and the building costs, and all the rest, figures out what can be depreciated, which becomes at an expense. That expense offsets your tax and essentially lowers your tax bill, which essentially is money back in your pocket, which helps you become faster towards cash flow positive if you rents it going up four each property. Anyway, the problem with that business model is investors don't buy properties every year. So, in two years, you buy a property, you go to BMT, you get your tax depreciation done. Great. You could have used anyone. You don't know who these guys are. It's a $700 cost. It's just the cost of doing business. It's a bit annoying, but it makes you some money back, so you're happy to do it.

[00:11:39] But in two years or three years, or five years, or seven years, when you buy your next one, how did they make sure that you come back to them. So, what they did was they built this sort of no cost to the customer software platform called My BMT, that when you do your first one, it logs your property in there and from then on forever it sends you email notifications every time there's a development approval lodged in a nearby property.

[00:12:02] So you get a heads up anytime there's something about to happen that's going to encroach on your property's view or your position, or something that's going to make it harder to tenant your property to rent it out, or for the property value to increase, because now maybe all of a sudden you've got a gigantic apartment building and everybody's staring into your bedroom window, and so there's no privacy anymore, things like that. Now, if you don't know about those things, and if you're an investor and you're probably maybe in a different state or a different country, you're not going to know about it. So therefore, you can't vote on it. You can't do anything about it. You can't get other people involved. And so, every now and again, you're getting these emails from BMT, you know, hey, there's a new development approval. You should go and have a look at it. And because you're getting these every now and again and it's really valuable to you as an investor, but it's not costing you anything. In three year’s time when you need to come back and buy the next property, who are you going to go to for your tax depreciation schedule?

[00:12:50] Absolute no-brainer. You're going to be going to BMT. And if you're building a portfolio, all your properties go into that portal, and again, they'll prompt you if there's industry or regulatory changes that'll affect your depreciation schedules. So, they're adding all this value through unique advice which you would otherwise miss and which otherwise cost you money.

[00:13:07] These guys, over 25 years, have been able to build up 180 team members, and they have about 50% of the market. I'll say that again. They have 50% of the market. How many businesses do you know that have 50% of any market? It is absolutely massive for that industry. I did a interview with Brad Beer, the Managing Director.

[00:13:29] I cannot for the life of memorable episode number, that is, I think somewhere in the early 30s. I think it. 34 at a sort of rough guess in my head. But if you go back and you look for Brad Beer on the ScaleUps Podcast, either on YouTube or Apple or Spotify, wherever you get your stuff from, Google Podcast, yada, yada, you will find the Brad's story and you'll hear more about the BMT story.

[00:13:49] so that is a few different ways to stimulate your thinking on how you can build real or perceived Switching Costs into your business.

[00:14:11] So the question I would leave you with today is how can you shift your model, particularly if you've got a transactional one, how do you start to shift it from transactional to relational in some way where you're creating some kind of an offer that makes it more likely that people are going to stay with you for longer and possibly gets harder and harder to leave because the value's increasing, but also you're getting deeper and with further tentacles into their life or into their business and as a result it becomes harder, um, and less desirable to leave you; not so they resent you, you never want to be in that space, but so you have just become a bit of a partner for life. You're very easy to deal with and they get lots of continued value and that just becomes bigger and bigger over time.

[00:14:50] How can you do that? That is the question I want to leave with you today. Before I go, if you enjoy thinking about how to optimise your business model, you should be joining us at the next ScaleUps Roadmap Program, the doors to the ScaleUps Roadmap Program, the next one are going to be opening in May. If you would like to know more about what's in the ScaleUps Roadmap program, which is basically a course where we are going to step by step, take you through the development of an awesome kick ass compelling growth strategy for your business. In that process, we're actually going to go through 12 different ways to optimise your scalability and your valuation in the third module. It's one of the core focuses, everybody love that segment, everybody loves working on their business model, making it better and stronger. That's one of the most exciting things we do. If you'd like to know more about it, just go to scaleuproadmap.com.au, join the wait list there and you'll find everything you need to know about the course. Have a great day. Have an awesome week. I will speak to you next week. See you later.