Michael Stein, December 2023

Introduction

As an early-stage investor, I am always looking for companies that have a durable competitive advantage—or a “moat”—that will allow them to gain and maintain market share over time. While growth potential and margins are important, having defensible moats is what separates temporary success from enduring leadership.

In this article, I explain why assessing the moat is a critical part of my investment thesis for startups. I also provide examples of several types of moats founders can create to build an enduring business. My goal is to help both investors and entrepreneurs think through competitive dynamics and sources of defensibility from the earliest stages.

The Critical Role of Moats for Startups

When evaluating an early-stage company, I gather information through a “screening lens” where I look at five key areas: Product, Market, Team, Business Model, and Financing. Within this framework, assessing the moat is a key part of evaluating both the Product and the Business Model.

Specifically, I want to know:

• Does this company have a competitive advantage that will be difficult for others to replicate? This speaks to product defensibility.
• Are there barriers to entry that will prevent competitors from quickly eroding the company’s market position? This speaks to business model defensibility.

I care deeply about moats because new entrants into a market rarely gain significant share without them. Moats create space for startups to establish themselves before serious competition arises. They also enable startups to get more operating leverage from their capital, focus more on execution, and reach profitability faster.

In short, moats provide the time and space for startups to fulfill their potential. That’s why I believe assessing the moat should be step one in evaluating any early-stage investment.

Examples of Startup Moats

While every business is unique, I’ve seen startups leverage five main types of moats:

1. Intellectual Property: Patents, copyrights, and trade secrets that prevent others from copying a product or service.
2. Regulatory Approval: Licenses or regulatory clearance that takes time for competitors to obtain.
3. Proprietary Data: Unique and hard-to-replicate datasets that improve products over time.
4. Economies of Scale: Cost advantages from size and scale that are hard for competitors to match.
5. Network Effects: Products that become more valuable as usage grows, fueling flywheel growth.

IP protection can make it illegal for competitors to copy unique innovations. Regulatory approval creates time-consuming hurdles for competitors to clear. Data moats improve algorithms and provide insurmountable leads. Economies of scale lower costs across the board. And network effects create winner-take-most markets where competitors struggle to gain traction.

While IP and regulatory moats are more common in biotech and medtech, data, scale, and network effect moats tend to emerge in software and internet companies. Oftentimes, the most enduring companies leverage multiple moat types at once.

As an investor, I look for startups intentionally building moats into their products and business models from day one. With strong moats in place, founders can go all-in on execution with the confidence of having time and space to fulfill their vision.

Provisional Patent Applications

One strategy I recommend for early-stage tech companies is to file provisional patent applications regularly during product development. Unlike non-provisional applications, provisional applications are fairly quick and inexpensive to prepare. Filing these establishes an early priority date and allows the company to evolve its IP protection as the product evolves. Then, within 12 months, the company can decide which provisional applications are worth converting into non-provisional patent applications for full protection. This approach allows tech companies to adapt their IP strategy as their products change, while securing valuable early priority dates. Regularly filing provisional applications is a proactive way for startups to begin laying the groundwork for strong IP moats.

Here are some key benefits an early-stage company can gain from having a robust patent portfolio:

• Exclusivity – Patents provide the right to exclude others from making, using, or selling the patented invention. This exclusivity makes it difficult for competitors to offer similar products or services.
• First-mover advantage – By patenting key innovations early, a startup can gain a head start in the market while competitors need to design around the patents.
• Investor appeal – Evidence of strong IP protection makes a startup more appealing to investors concerned about competition.
• Increased valuation – Patents boost the perceived value of the company’s technology and can directly impact valuation. One study found each additional patent boosts valuation by 3-5%.
• Licensing revenue – Patents can be licensed to generate revenue from companies that want to utilize the protected technology.
• M&A appeal – Strong patents make a startup more appealing as an acquisition target, as the buyer acquires the patent rights.
• Defense against patent trolls – Owning patents puts startups in a stronger position to defend against patent lawsuits from non-practicing entities.
• Brand building – Patents signal technical expertise and innovation capabilities, helping build brand recognition.

Simply put, robust patent protection in the early stages can provide a durable competitive advantage, fuel growth, enhance valuation, and set startups up for long-term success. Investing in IP early is a key strategy for startups looking to maximize their potential.

Conclusion

For early-stage companies, competitive moats are the difference between temporary success and enduring leadership. Assessing the moat should be step one in evaluating any startup investment. I encourage both investors and entrepreneurs to think deeply about what will make their companies impossible to replicate or compete against over time. With durable moats in place, the runway for startup success grows exponentially.