Broad and Deep Moats: Where do they come from, and where can I see them in my startup?
Competitive advantages in startups are hard to determine. Yet, sustained Competitive advantage, will drive significant valuation as the company ages up to and including long-term success. In this article we look at the different shape these advantages can take in new age businesses.
Here is what Mr. Warren Buffett had to say on the subject: “So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn’t necessarily mean the profit will be more this year than it was last year because it won’t be sometimes. However, if the moat is widened every year, the business will do very well.”
In the context of listed firms, where almost all companies (except digital disruptors — more on those later) have a 10+ year performance history, the depth and breadth of moats are easy to ascertain. For one, the regulatory disclosures and media coverage ensure that material information is available to investors. Second, the businesses have been shaped and weathered with ever-shrinking business cycles and have proven or learned resilience. Third, investment advisors and analysts are available at large who have (usually) informed opinions that investors can leverage.
All of this gets questioned in startup / early stage contexts:
Where is the moat? The startup is usually a few years old and is in a stage of infancy when it comes to market or industry maturity.
How deep is it? The areas that startups operate in are, intended to be (even though our experience suggests, otherwise), unique. Is that uniqueness ascertainable? Who else is working in the same areas? What about the old established warhorses who have PnL might to take the market by storm?
Is it sustainable? Will it be there tomorrow… will it fall down like a pack of cards
Clearly not doubting the wisdom of Mr. Buffett, we set out to establish some ground rules when it comes to dealing with startups and economic moats. To understand this better, let’s take a step back and recap how moats are created.
Where do Economic Moats come from?
While there is tons of research on the subject from several leading advisors, we have picked the elements that we feel make the most sense:
Switching cost: Significant sunk cost in adopting a solution usually makes customers stick to a company. Especially true for mission-critical products. Usually, customers perceive the non-financial costs viz. learning costs, compatibility costs, cognitive costs to be more of a hurdle than financial costs viz. transaction cost, lost-benefits etc. Not so long ago, Microsoft and IBM would’ve touted this moat in the IT infrastructure space. Obviously, since then, cloud has disrupted the trend. In general, this moat will apply more in B2B space where relationships run longer tenures.
Network effect: LinkedIn, Facebook and other social networks have a unique property in that the value of a particular good or service increases for both new and existing users as more people use that good or service, creating a virtuous circle. Also, reminiscent of telephone exchanges (where the term was actually coined). There are variations such as indirect network effects (e.g. Android, iOS), two-sided network effects (marketplaces such as Airbnb) and Local network effects (e.g. Whatsapp). More applicable in B2C space where users typically run into millions, transcend socio-political and geographic boundaries.
Intangible assets: IP, licenses, brand recall — elements that are not replicable easily or at all. What makes this moat interesting is its ability to drive an entire ecosystem around the company. Can apply to B2C (pharma) or B2B spaces (commercial technology) accordingly.
Cost: Sustainable price advantage through stronger value chain integrations, technology advantages, economies of scale or access to a unique asset. Exxon and Diageo are examples that come to mind
Efficient scale: Taking a profitable position in a market of limited size which discourages new entrants as it makes the market unattractive for all players. Premised largely on customer acquisition costs being sustainable and marginal costs not being so high as to drive down the returns below the cost of capital.
Where do I see them in my startup or early stage business?
Honest answer: if you are lucky, you will see some shoots emerging. More likely: you will hear the founders speak about their plan and if they don’t have one or more of the above substantiated through credible solutions and market opportunity, we recommend you (or they) reconsider the fund-raise. Here is a summary of the evidence that you need to look for:
(1) Switching cost:
Focussed on expansion of the market by driving new entrants rather than compete for a share of the existing product
“Suite” of products that are complementary and can be bundled together
Avoids price war: usually an advantage for a better-capitalized incumbent
Land-and-expand approach to gaining market share
(2) Network effect:
The business is a first mover and can drive adoption
The business has a plan to subsidize adoption with some in-network benefit
Viral marketing
Close-off access to other new entrants through constant innovation
(3) Intangible assets:
Impossible for the asset to be replicated in exactly the same way
Clear path of monetization of the intangible asset
(4) Cost:
Direct linkage to R&D and/or intangible assets
Non-linearity in financials
Unfair access to critical inputs through location, infra etc.
(5) Efficient scale:
Market size that has remained flat or grown at very slow pace over the past few years
Financials that support customer lifetime value or unit economics
Clearly differentiated market dynamic before and after product-market fit: Before: sales are tough and slow; After: demand outstrips startup’s ability to meet demand
Technology play for enabling meeting after product market fit demand
Your investment decision
You can see the dots connecting. The moats are not mutually exclusive, they are not visible to industry outsiders and they shapeshift with time. To discern true economic advantages as well as to review the potential of an early stage business / startup to capitalize those advantages requires a great team, strong industry expertise and creatively solving hitherto unsolved problems.