Do economic moats occur naturally or by accident? I had never contemplated this question till Andy Rachleff graciously emailed me back after I sent him my presentation on economic moats seeking his comments about two weeks ago.
Why did I email Andy? That’s a great question.
In early 2010, when it started becoming clear that we would head down the path of building an independent venture fund, I put together a list of venture capitalists I admire and started reading some of their work. I noticed that invariably, at some point some of them would make a statement like; “I did not fully understand this concept until Andy Rachleff explained it to me.” After encountering this more times than I expected, I decided that I should find a way of learning as much from Andy as I possibly can. I started by connecting with him on LinkedIn and later followed him on Twitter.
Since then I have emailed him about once a year, perhaps somewhat less frequently, to ask him a question . . . A book recommendation, for example. Each time he has responded by pointing me in the direction of an answer to my question.
Here’s Andy’s comment about economic moats; “. . . I do not agree with your assertion. Successful companies do not create moats. They happen naturally or by accident. Companies that attempt to create moats usually do so at the cost of not spending time on further delighting their customers – which almost always backfires. This is a major point I teach in my product market fit class because it is a common misperception.”
Andy is a legend in venture capital. He co-founded Benchmark Capital in 1995 and was a GP there till 2004. He is a co-founder of Wealthfront, and now serves as executive chairman after having previously served as CEO and president. He also currently teaches courses in technology entrepreneurship and venture capital at the Stanford University Graduate School of Business.
So . . . as you might imagine, his comment gave me pause.
It was just before 6:00 AM when I read his email. I walked away from my desk, drank a cup of strong coffee and thought about his comment. It was then I realized that I am more aligned philosophically with Andy’s view on economic moats than it first appears.
Yes, in trying to communicate the concepts on which the idea of an economic moat is based we often speak about “building a moat” or “digging a moat” . . . . That can be misleading in the context of early-stage technology startups. However, I am not surprised that misperception arises since much of the vocabulary for economic moats is borrowed from value investors who invest in publicly traded, or mature privately held, companies. Specifically, it is a concept first attributed to Warren Buffet and Charlie Munger and it is one aspect of their approach to investing at Berkshire Hathaway.
Sometime in late June, I made an observation to my teammates at KEC Ventures; I had come to the realization that each time we met the founder of an early-stage startup who spent a lot of time talking to us about the economic moats around that startup’s business model we usually later discovered that the startup was failing to keep its existing customers/users and was also failing to recruit new customers/users. Andy’s comment helped me connect the dots . . . The early-stage founders who talk to us at length about economic moats are insufficiently focused on creating value for their customers/users.
When founders ask me about the role KEC Ventures plays as an early-stage investor, I have always said that once we decide to make a Seed-Stage or Series A investment we believe that we have a responsibility to help create the conditions that will allow our founders to do 4 things well;
First; Keep their existing customers as happy as possible.
Second; Improve the startup’s product, in order to make existing customers happier than they already are.
Third; Recruit additional team members, to enable their startup to do a better job of executing the two preceding tasks.
Fourth; Win new customers.
If we deliver on that promise, I think we would have fulfilled our primary obligations as an early-stage investor. Doing this involves a mix of activities that basically boil down to taking on assignments from our founders when something arises that needs to be done, but that does not directly help the startup accomplish the 4 tasks I have listed above.
Nowhere on my own list do I expect our founders to “Build an economic moat.”
However, when I am thinking of the startups in which KEC Ventures should invest I think about the potential for economic moats to develop if the startup’s founders;
- create value for their customers and delight them,
- find product-market-fit,
- discover a business model that scales profitably, and
- build a team to do those 3 things successfully.
My interest in studying economic moats is so that I can recognize those instances in which the probability that they emerge is high, whether naturally or by accident. Seed-stage technology startups with a high potential for economic moats to eventually emerge are the ones that I personally find most attractive as potential investments.
But Andy was right; After reading my blog posts and the accompanying presentation deck, one could come away thinking that I am suggesting that founders of early-stage technology startups add “build an economic moat” to the list of things that they should be doing. I am not.
At the stage at which we invest at KEC Ventures, I believe founders need to focus on only the things that directly enable them to delight their current customers/user and find new ones. Everything else proceeds from doing that successfully. Failure to do that? Nothing else will even matter.
So, perhaps it is fitting for me to now say; I did not fully understand why early-stage startup founders should not focus on building economic moats until Andy Rachleff compelled me to think about it more critically.