Introduction

A business “moat” is a key competitive advantage that sets a company apart from its competitors. Many of the world’s largest companies, from Amazon and Uber to Starbucks and Disney, have built and defended their moats.[i] Warren Buffett helped popularize the concept, saying a company’s moat (or lack thereof) means everything when deciding to invest in it:

“The key… is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.”

In the world of early-stage investing, it is common for investors to focus on growth potential, and particularly a company’s gross margins, when deciding whether to invest in a technology company and at what valuation. A high gross margin is a preferred business feature since higher gross margins allow for more percentage points of revenue to be spent on growth and product development. Higher gross margins also tend to translate to a higher cash flow margin, and to a longer runway. For these reasons, high gross margin companies typically have higher revenue multiples than their low gross margin counterparts.

But the long-term quality of a business depends on more than margins. Business quality requires defensibility, which comes from moat.” And while high gross margins are often a reflection of moats, they are not a moat in and of themselves. When an investor is looking at a low gross margin business, the investor needs to focus more on moats. One or more moats can provide extra points of revenue to invest in sales and marketing strategies or research and development. Companies with low gross margins can still generate a large cash flow and thus be highly valuable. One of the highest valued companies in a major exchange, Apple, has a 38% gross margin, roughly half of that for many software businesses. In fact, many of the most valuable companies have low gross margins (as shown by Capital IQ, as of May 27, 2020): from Walmart and Home Depot to Disney and Netflix to Nike and Starbucks to Raytheon and Lockheed Martin.[ii]

In this article, I review why early-stage investors should care about whether a prospective portfolio company has one or more moats to protect itself against competitors. I also discuss where this issue fits into my overall company screening process, and I explain the different forms a defensive moat can take. Both investors and company founders will hopefully benefit from this article.

Company Screening and the Role of Moats

Experienced early-stage investors spend a lot of time screening prospective portfolio companies, and then performing due diligence on a small subset of especially interesting investment opportunities. This process for identifying companies in which to invest requires the investor to ascertain answers to the questions most critical to the investment decision. One example of such a critical question is “What is your moat?” This question is about whether the company has a particular competitive advantage or barrier to competition. It is an especially important question because a new entrant into a market is unlikely to achieve a significant market share without some form of competitive barrier.

I personally like to gather information through a “screening lens” in which I consider the following categories of risk and opportunity:

1. Product,
2. Market,
3. Management,
4. Business Model, and
5. Financing.

In considering the Product, it is common to ask questions like:

1. Has product-market fit been demonstrated?
2. How well is product/market defined?
3. Is product compelling?
4. What is the path to product acceptance?
5. Can product be easily copied?

I also like to ask the moat question in the context of evaluating the Product. Here I try to assess whether the company has is a competitive advantage or barrier to competition in respect to the product or service it proposes to offer. A moat can be legal or regulatory, or some other advantage that gives the company an edge in gaining and keeping market share.

For example, IP protection is one form of moat. For technology companies, strong patent protection in the US and other relevant jurisdictions can be a highly valuable moat. Such a moat can make it difficult for others to offer competitive solutions. It can also provide the company with good leverage in negotiating deals with potential acquirers making a “build versus buy” decision. For businesses that make software, especially software that runs in the cloud and is not distributed to customers, trade secret protection can be a suitable alternative to patent protection. The secret nature of such software makes it difficult to reverse engineer.

Certain products require governmental approval before they can be sold in the US. For example, pharmaceuticals and medical devices require some form of approval (or clearance) from the Food and Drug Administration (FDA). Unlike patent protection, FDA approval does not provide the company with the right to exclude competitors, but it can give the company a valuable head start and make it more difficult for others to enter the market. Therefore, FDA approval can be viewed as a form of competitive moat.

In the military sector, US Department of Defense regulations limit who can sell productions to the US military. Similarly, in the aviation industry, FAA regulations limit who can sell products deployed on commercial aircraft. Therefore, if a company I am evaluating has obtained approval from the relevant governmental agency, then this could be viewed as a form of competitive moat to the company’s advantage.

A moat could exist even without any legal or regulatory barriers. For example, a software product may be so technically complex and difficult to reverse engineer that it would take even well-financed competitors a long time to produce. In such a case, this form of moat could give the early-stage company enough runway to win a sizable share of the market before competition arises. For example, consider the Zoom online audio and web conferencing platform. The company has a significant patent portfolio, but its product is so large and complex that it would be difficult for companies other than the most well-financed companies (e.g., Microsoft or Google) to compete. Since the source code for the Zoom product is not available for public viewing, this complexity represents a significant moat.

Economies of scale and network effects can also provide barriers to competition and thus be considered “moats” that mitigate product risk.

Economies of scale refers to a cost advantage resulting from increased production. One of the most prominent examples is Amazon’s distribution network, but they are not the only one. The simplest question for whether economies of scale are achieved is: are your per unit costs defensibly lower than your competitors’? It is rare for startups to achieve such scale.

Most companies believe they have differentiated technology. Many companies claim their product is differentiated based on features, integrations, reportability, etc. But when entrepreneurs look to distinguish their technology enough to make it a true moat, they should be focused on differentiating their product and service in a way that matters to customers. Doing so enables companies to charge more (“premium” pricing) and spend less on sales and marketing (the product “sells itself”). Moreover, customer lock-in can be higher because there is a perceived switching cost of moving to an inferior tech solution. In the absence of IP, the clearest measure of differentiated technology is pricing power. Are customers willing to pay a higher price for your product than others? If so, you are selling a differentiated offering.

Network effects happen when a product or service becomes more valuable to its users as more people use it, creating a flywheel effect on growth. For example, the telephone wasn’t particularly useful when only a handful of first adopters had one. The more people that acquired telephones, however, the more useful they became. Once everyone had a telephone in their home, it became indispensable. The same logic has powered the growth of social networks. Despite having low gross margins, many public company internet marketplaces, such as Lyft and Uber, have leveraged network effects to drive organic growth, increase switching costs, and build scaled businesses. One way to assess whether a product or service has network effects is to measure engagement: does engagement improve as the number of users grows? Because network effects can allow a product to gain wide utility fast, they can help companies build formidable business moats. A product with strong network effects can be extremely difficult to dislodge.

Network effect moats come in different forms, including marketplace network effects, data network effects, and platform network effects.

Marketplace network effect moats exist when a company derives a durable competitive advantage from bringing together customers and suppliers in some kind of marketplace. In the best-case scenario, aggregating the supply and demand for a given good or service creates a self-reinforcing cycle of growth. As more competing suppliers join the marketplace, customers find that it provides a more efficient and less expensive service. As more customers are drawn to the marketplace for its quality or low prices, more suppliers join, driving further competition and growth. Amazon is a quintessential example.

Data network effect moats exist when a company can gain a competitive advantage by gathering user data and making that data more valuable. In a product with a data network effect moat, there is a central repository of data. The more people adding to this repository, the more useful it becomes. Companies can use that data both to attract other users to the platform and to build better algorithms to provide a better product. Google, for example, built its competitive advantage on its search algorithms, and then built a moat by applying that advantage to its advertising capability.

Platform network effect moats exist when a company builds a durable competitive advantage by keeping its users engaged in its product ecosystem. Platform network effects are generally built on one product — for example, the iPhone, or Windows — that becomes core to a user’s life or work. New products that are released — such as the App Store, or Microsoft Office — both reinforce the core product’s initial value and layer more value on top of it. Each successful new product makes staying in the ecosystem more valuable, increases the cost of switching, and keeps users’ attention and money within the platform.

These examples are far from the definitive list of moats, but they hopefully serve as a good reminder of how startups can build enduring businesses, even without high gross margins.

Conclusion

It is critical for investors and company founders to understand what the company’s moat is or will be. If moats are lacking in the earliest stages, one or more moats can be created by investing in IP protection and taking other measures to create other forms of moat as discussed above. Finally, readers are invited to submit any questions or comments they might have to Michael Stein at michael.stein@mdsadvisoryservices.com.

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[i] See “19 Business Moats That Helped Shape The World’s Most Massive Companies” at https://www.cbinsights.com/research/report/business-moats-competitive-advantage/.

[ii] See “Moats Before (Gross) Margins” at https://a16z.com/2020/05/28/moats-before-gross-margins/.