Competitive advantages in early-stage businesses are hard to determine. Yet, sustained Competitive advantage, will drive significant valuation as the company ages up to and including long-term success. In this article we look at the different shape these advantages can take in new age businesses.
Here is what Mr. Warren Buffett had to say on the subject:
“So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn’t necessarily mean the profit will be more this year than it was last year because it won’t be sometimes. However, if the moat is widened every year, the business will do very well.”
In the context of listed firms, where almost all companies (except digital disruptors – more on those later) have a 10+ year performance history, the depth and breadth of moats are easy to ascertain. For one, the regulatory disclosures and media coverage ensure that material information is available to investors. Second, the businesses have been shaped and weathered with ever-shrinking business cycles and have proven or learned resilience. Third, investment advisors and analysts are available at large who have (usually) informed opinions that investors can leverage.
All of this gets questioned in early stage contexts:
Clearly not doubting the wisdom of Mr. Buffett, Team ShiftAltCap set out to establish some ground rules when it comes to dealing with startups and economic moats. To understand this better, let’s take a step back and recap how moats are created.
While there is tons of research on the subject from several leading advisors, we have picked the elements that we feel make the most sense:
More applicable in B2C space where users typically run into millions, transcend socio-political and geographic boundaries.
Honest answer: if you are lucky, you will see some shoots emerging. More likely: you will hear the founders speak about their plan and if they don’t have one or more of the above substantiated through credible solutions and market opportunity, we recommend you (or they) reconsider the fund-raise. Here is a summary of the evidence that you need to look for:
|Switching costs||● Focussed on expansion of the market by driving new entrants rather than compete for a share of the existing product
● “Suite” of products that are complementary and can be bundled together
● Avoids price war: usually an advantage for a better-capitalized incumbent
● Land-and-expand approach to gaining market share
|Network effect||● The business is a first mover and can drive adoption
● The business has a plan to subsidize adoption with some in-network benefit
● Viral marketing
● Close-off access to other new entrants through constant innovation
|Intangible assets||● Impossible for the asset to be replicated in exactly the same way
● Clear path of monetization of the intangible asset
|Cost||● Direct linkage to R&D and/or intangible assets
● Non-linearity in financials
● Unfair access to critical inputs through location, infra etc.
|Efficient scale||● Market size that has remained flat or grown at very slow pace over the past few years
● Financials that support customer lifetime value or unit economics
● Clearly differentiated market dynamic before and after product-market fit:
○ Before: sales are tough and slow
○ After: demand outstrips startup’s ability to meet demand
● Technology play for enabling meeting after product market fit demand
You can see the dots connecting. The moats are not mutually exclusive, they are not visible to industry outsiders and they shapeshift with time. To discern true economic advantages as well as to review the potential of a startup to capitalize those advantages requires a great team, strong industry expertise and creatively solving hitherto unsolved problems.