Connecting The Dots: Economic Moats and Early Stage Technology Startups

I started writing about economic moats in September 2014. Since then I have written about Network Effects, Switching Costs, Intangibles, and Efficient Scale and Cost Advantages. The purpose of those posts was to outline how I think about economic moats while I am studying a seed stage startup and trying to determine how things might unfold in the future.

This is how I define an economic moat in relation to early stage startups:

An economic moat is a structural feature of a startup’s business model that protects it from competition in the present but enhances its competitive position in the future.

In this post I will wrap things up with some final observations;

First, in relation to economic moats, my responsibility as a seed stage investor is to identify startups that can build or acquire an economic moat as their business model matures and as the startup becomes a company. Directly tied to this, I have to make an assessment about the founders’ willingness to conceptualize and build such a moat if things go well. There’s no point worrying too much about a moat if the rest of the world is apathetic about what the startup is doing.

Second, An economic moat is not the same thing as a competitive advantage. A competitive advantage is temporary. This is because a competitive advantage is typically designed on the basis of Michael Porter’s Generic Competitive Strategies. A durable economic moat is unique, and typically can not be duplicated by others.

Third, to withstand the effects of sustained challenges from incumbent and new-entrant competitors startups need an economic moat that is derived from more than one source. In relation to Internet and other software technology business models, indirect network effects can prove to be as important as direct network effects.

Fourth, some of the strongest foundations on which a startup can build an economic moat are also some of the most difficult to come to grips with. Mainly, these are lumped together as “Intangibles” . . . Among the sub-items under intangibles Management & Culture, and Research and Development stand out to me as being things I should look out for at the seed stage because everything else emanates from those two.

An organization’s ability to learn, and translate that learning into action rapidly, is the ultimate competitive advantage.                                                      – Jack Welch

Fifth, cognitive costs are a real barrier to entry and till an early stage startup has established itself within a market, uncertainty works against it but in favor of the incumbents. This is especially true for startups building products for sale to other businesses. These aspects of buyer lock-in might be nearly impossible to articulate or measure, but that does not mean startups and their investors can afford to ignore them. At the outset a seed stage startup must find that niche of potential customers for whom the sum of cognitive costs and uncertainty is a minimum. It is worth thinking about this at the outset of product development.

Sixth, thinking about cost advantages has to go beyond the obvious advantages it confers on the startup in terms of its operations. The most important consideration is how a cost advantage enables the startup to create more value for its users or customers. A cost advantage that does not yield increased value for users and customers is not one that will last.

Lastly, as a startup scales it must pay attention to how that is affecting the macro environment in which it finds itself. A bad market can remain unfavorable far longer than any startup’s ability to scale its way to a profit. It is one thing for a startup to find product-market-fit, but quite another for that startup to scale efficiently in that market. Finding product market fit does not automatically lead to conditions that favor efficient scale. Extended unprofitable growth is one sign that a market might not have the characteristics to support efficient scale, or that the startup has not thought its business model through enough.

When I study a seed stage startup I am trying to answer a number of general questions about how the future might unfold for that startup, thinking about economic moats gives me a useful framework for doing so.