Building Strong Moats

Why Moats Are Important

What is a moat?

A moat is your startup’s ability to maintain an advantage over your competitors - a set of competitive advantages that makes it hard for other companies to compete.

Building a strong moat is one of the best indicators of a startup’s lasting success. You could have a good idea - a great idea, even - that has the potential to generate massive amounts of value. But great ideas get noticed extremely quickly, and therefore all great ideas need to have a strong inherent mechanism (simply, a moat) to maintain their advantage and grow fast enough to dominate the market before being consumed by others. In some sense, you can only capture the value you create by deterring the competition from stealing it.

But building a moat is also extremely difficult to achieve.

In part, because they are just difficult to actualize at scale and they are not defined early enough, and thus optimized for, by founders early into their venture. The latter is hard to take action on. The former, however, is something that can be, and should be, clearly defined early in a venture.

So let’s explore the different kinds of moats!

Types of Moats

What Isn’t a Moat?

Let us start by identifying what aren’t moats that can be structurally obtained. For example, innate talent is difficult to scale and maintain and is rare to consistently achieve. As such, I would not count the following as “moats” that can be sustained in the long term:

• Engineering talent
• Management talent
• Company culture
• Company vision
• Founder connections

Even if these skills are somehow trainable (e.g., engineering talent), they are inherent properties of an individual and not properties of a company. Once the source of talent leaves, the moat is effectively gone. Therefore, it is difficult to rely on pursuing, maintaining, and retaining talent within an organization and should be ignored as a basis for forming moats.

State Derived Moats

State derived moats are advantageous mechanisms offered and governed by a state to deter competition. These commonly include patents and economic regulations that favor a specific company.

• Patent laws grant companies a temporary monopoly over a technology. This grants time for the company to further develop the tech and extract maximal value before competitors can legally compete against the value pool.
• Tariffs and other economic regulations can ensure economic advantages for domestic companies over foreign companies. This effectively ensures favoritism for the domestically based company.

State derived moats are strong but come with the risk of long-term unpredictability. What happens in 10 years when the patent expires? Or if the government is no longer interested in regulating foreign companies in your particular sector? As such, state derived moats are most valuable early in a venture but are not usually enough to sustain a permanent moat.

Knowledge Derived Moats

Knowledge derived moats are the special methodologies and mechanisms employed by a company to create something otherwise impossible. It is quite strong, as it completely prevents competition.

Knowledge as a moat, however, is only retained if it is regulated and controlled. One could argue that NDAs are effective in preventing knowledge diffusion (or knowledge theft), but they are actually difficult to enforce. Therefore, it is vital that most employees within a company are barred from this knowledge.¹ However, knowledge derived moats are generally a fleeting competitive advantage. And while extremely strong early in a venture, it becomes increasingly unsustainable as it becomes harder to scale and harder to protect.

Scaling Based Moats

Scaling based moats are a result of mechanisms that grow stronger as a company grows larger - and are thus different from state and knowledge derived moats, which are only strong and sustainable in the short run.

Scaling moats are also harder to specifically define, as they vary per industry and technology. However, it can be generalized that favorable scaling laws usually lead to either:

1. Decreased cost per unit.
2. Increased quality per unit.

Typically, the basis of these scaling laws is a reduction in the fixed cost of producing each unit or increased bargaining power over supplies.

In software, it is also common to see an increase in quality per unit take effect as a company scales. These are often referred to as network effects. For example, a telephone has zero value if there is only one user. As soon as there are two users, however, the value grows - and as a platform reaches more users, the value exponentially climbs.²

However, scaling based moats only deter direct competition - WhatsApp grew in spite of Facebook because WhatsApp pursued a distinct quality that certain users preferred.

System Based Moats

System based moats are advantages that arise from the difficulties of changing systems. An easy example is the idea of switching costs, where even if a product is individually better than the competition, the cost of switching away is greater than the advantages offered by the newer product.

And there can be a million reasons that contribute to a high switching cost. Learning how to use Excel is one, because if you switch to another software, your expertise in Excel will need to be relearned on a different platform. Or because Excel is known to be industry-standard and trustworthy to stick with. Or because users don’t even know that there is a specific problem with Excel that you fixed. And most importantly for Excel, because it integrates with the ecosystem that Microsoft has built - the integration of Excel into Windows and other Office applications.

A better, more prominent example is the case of Apple and their walled gardens. While it is being chipped away by the EU, for a long time, Apple’s blue messages in the United States created an unexpectedly strong moat for Apple products over Android competitors. The cost of switching systems - from Apple to a Samsung - probably meant the end of your blue bubbled group chats and integration with your Apple Watch, iPad, and Macbook.³

Author's opinions on consumer psychology

I find system based moats fascinating. They are very often ignored when describing moats. People also have difficulty understanding the scope and intensity of a system based moat, something I have struggled with too. When starting my first venture, I created a product that was objectively better, faster, and smoother than the existing product. But I underestimated the power of a system based moat: users were opposed to learning a new software, to switching their decades old workflow, and to switching into an unstable and newly released software. So in spite of favorable early signups and pilot tests, no customers in the end decided to adopt.

This experience has unfortunately led me to be heavily biased against new ventures looking to challenge a product with strong system based moats. As I’ve written in my other articles (Nanoneuro and First Principles and Impossibility), I believe it is easier to solve technical challenges than to break through the irrationality of consumer psychology. As an engineer, I come from a perspective where the outcomes of solving a technical challenge are concrete. It either works or does not work. However, breaking through consumer psychology and their biases is extraordinarily difficult. There could be a million reasons why, and you have to break through a good majority of them. Even discovering core consumer opinions and psychology is hard, as most people don’t know what they want and have difficulty articulating what is of value to them (the book Subliminal by Leonard Mlodinow covers this well). More on this is covered in my Investment Thesis.

And similar to scaling based moats, system based moats are only achievable after a company has surpassed a critical threshold of time and results. Likewise, system based moats are sustainable in the long term but difficult, if not impossible, to artificially create in the short term. However, it would be unwise to not prepare for an eventual system based moat. The process must and should be thought out carefully.

In a way, system based moats are the deepest, widest moat of them all. Preying on social statuses, individual psychology, and perception, it is difficult to understand and subsequently destroy. As of now, there are only two well-defined ways to bypass an incumbent’s system based moat:

1. Demonstrate existing systems as obsolete or unfavorable while creating an alternative system.
2. Exploit system rigidity by developing a hard-to-pursue (and thus deeply disruptive) innovation.⁴

Idea Drives Moat Strength

I subscribe to the theory of finding great people and investing in them. Similar to YC’s viewpoint, a great idea is not hard to find if guided, but a great team is very hard to find and establish.

In spite of team strength and dynamics, an idea must be good to begin with, as a moat’s strength is usually inherently defined by the idea. Some ideas naturally lend themselves to being easily defendable, while most aren’t. Therefore, a strong criteria for whether I invest in a company is the inherent defensibility value of an idea. Of course, most times, it is hard to know.

And finally, all sufficiently new ideas generated from a first principles perspective will naturally default with a starting moat: the moat of uncertainty. New technologies are uncertain. New methodologies are uncertain. And no incumbent will pursue uncertainty unless that uncertainty is proven to certainly extract value.

What I’m saying is, build in public! Nobody will steal your idea. And you have time to work out the uncertainty. It is only when you have proven yourself that it’s time to hit the ground sprinting.

Footnotes

1. Such is the case with KFC’s secret recipe and Coca-Cola’s secret recipes. ↩

2. Network effects are the primary reason for the enduring strength of social media apps like Instagram and Snapchat. ↩

3. Reiterating on the idea that there are endless reasons that contribute to a high switching cost, a lesser known switching cost from Apple’s iPhones is the perceived idea around Apple and Android phones. Individuals with iPhones are irrationally viewed as those with greater wealth (and thus status), as most American citizens believe that iPhones are more expensive than their Android counterparts. Which is untrue. ↩

4. Deeply disruptive innovations prevent incumbents from imitating the innovation because they require incumbents to abandon either their existing processes or their existing customer base. ↩