Building Long-Lasting Advantage: The Role of Moats in Startups
Startups create value through innovation. This value is at risk with the arrival of new competitors who copy what has been done. To discourage them, it is necessary to put barriers to entry that make it difficult for them to arrive.
There are some things money can't buy. These include users, community, network effect, brand perception, trust, and so on.
These are elements, are the building blocks of moats, that make a company irreplaceable. They increase a company's defensibility and chances of winning in the long run (or at least not dying).
What Are Moats?
In the context of startups and business strategy, the term "moats" refers to the factors a company builds around its business to protect itself from competitors.
To put it briefly, it’s your company's defensibility. Just as a moat protects the castle around which it is built.
The concept of economic “moat” was first introduced by Warren Buffet who uses it to assess the long-term profitability and competitive strength of companies when making investment decisions. From 1986, he used this word more than 20 times in his famous shareholder letters. and the one from 2016 is the most recent containing the word moat.
Moat ≠ Competitive advantage
Although they are similar and related concepts, moats and competitive advantage are two different things.
Competitive advantage is temporary. It can be represented by a feature, for example, that competitors will easily copy over time.
Moat, on the other hand, is something that makes you unique from rivals. Something very difficult to copy, that makes you irreplaceable. Most importantly, something that represents a long-lasting advantage.
Moats before Margins
Many companies find themselves fighting with their competitors for a small piece of the cake. They look at margins as THE metric for growing and succeeding. It could be a good business feature but it’s not what it’s going to set you apart in the end.
The way venture-backed companies capture value is through the development of moats.If you look at the most valuable companies today, they have low margins but they have really strong moats.
There’s an article from a16z, that says “Business quality is about defensibility. Defensibility comes from moats.”
Moats are something that define whether or not your startup will make it.
Competition is for losers
Paul Graham (great essayist and founder of Y Combinator) say that you should have a barrier of entry in what you are doing. He believes that the best businesses are really hard to copy. For him, you should have a technical advantage that your competitors don’t understand.
Peter Thiel devotes an entire chapter of his book called “All happy companies are different”, arguing that you should aim for monopoly. He makes the example of Google, having its monopoly from the intersection of large different markets. Also, there is a lecture of his on Youtube in Stanford's CS183 course entitled "Competition is for Losers", in which he explains these concepts in detail.
Types of Moats
Different startups have different moats, I will try to list the most common and how they are used:
Intellectual Property: When you have a specific technology, you want to protect it with patents, copyrights or trademarks. Today it isn’t the case for software companies but it is mostly used in the biotech industry. Humane's founder, Imran Chaudhri, knows this well. In fact, taking a look at his website there are more than 1,000 patents, many from his time at Apple.
Network Effects: We have this when everyone is using the same platform. Take for example Facebook or Twitter, if a new entrant wants to directly compete with them, it would be really hard because their platforms have so many users. Same for Whatsapp. If I don’t want to use it, it will become difficult to give up because everyone is using it and the network effect is too strong.
Branding: It occurs when there is a company providing great products that a lot of people love and their brand perception sticks in your brain. This video explains well the effect that brands like Apple or Nike have on us.
Economies of Scale: The bigger you grow, the better are the cost advantages. "I buy it on Amazon, it's cheaper" is a result of this moat. In that position, you can lower your prices to lower competitor chances as well. Tesla's Gigafactories are another example: they lowered the cost of producing a car while increasing automation and efficiency.
This point does not apply to newborn startups.
Switching Costs: This happens when users need or trust too much a company to switch to another provider. The company understands that and raises prices as far as it can. Slack is a tool that fits this concept well and teams are afraid of switching and then losing their work habits or message history.
Regulatory Barriers: Recently, I saw a fantastic speech by Bill Gurley where he makes the case for all the companies blessed by regulations. During all his years as VC, he noticed companies lobbying with the government, taking advantage of regulations they made and then playing an easy game without competitors. He points out that this is happening even now with OpenAI and that they want to write the regulations together with legislators to benefit from them.
What about the people?
Some will agree if I say that people also represent a moat. When creating a startup, it is the team that makes the difference. The first people you hire are like founders and must share the same vision. If a company can recruit talent from the very beginning, its chances of success increase.
It is no secret then that when you expand, companies do everything they can to get the best talent and keep them within the office playground. In fact, it’s not a coincidence that companies like Meta and Google go out of their way to treat well their employees by paying them more than necessary and offering them a whole range of benefits.
This article illustrates well how McKinsey has managed to build a reputation over time by becoming a people-centric business. The consulting firm realized early on how to attract and retain top talent, ensuring long-term success.
Be kind with your competitors (and continue to innovate)
In 2014, Tesla opened the door on its intellectual property by making its patents open source. The reason behind this choice is to accelerate the transition to sustainable transportation.
If Tesla's intellectual property had been its moat, it would have perish under the weight of competitors by now. Instead of failing, the company has continued to grow, becoming the automaker with the largest market cap.
This teaches us that Tesla's real moat is to be an intrinsically innovative company. When something is ingrained in your culture, well it's really hard to copy it then.
What happened to Clubhouse?
There are many reasons for a startup to fail. Take Clubhouse as an example: you have a problem if you are really popular but also easy to copy. When your company it’s easy to replace, it’s a matter of time that new entrants will come to substitute you. This is what happened with them, after a couple of funding rounds from Andreessen Horowitz.
At the time of the pandemic, Clubhouse enjoyed great notoriety, and this made it benefit from a network effect. However, if a giant like X.com comes along with an even larger audience, then it takes little to disappear. In fact, today what remains of Clubhouse is a feature named Twitter Spaces.
For those who are curious
All about Network Effects from a16z
Bill Gurley speech about regulations at All-In Summit
29 business moats that helped shape the world’s most massive companies from
CB InsightsPeter thiel lecture “Competition is for losers”
The Defensible Startup from INSEAD
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