How companies build moats
NOTE : I plan to keep this article as a living document which i’ll continue to update as I come up with examples, feedback, questions or anything else interesting.
I’m sure a lot of you know this but the historical concept of a moat from wikipedia
A moat is a deep, broad ditch, either dry or filled with water, that is dug and surrounds a castle, fortification, building or town, historically to provide it with a preliminary line of defence. In some places moats evolved into more extensive water defences, including natural or artificial lakes, dams and sluices.
If you look at this picture of the Caerlaverock Castle, a 13th-century castle in southern Scotland, it looks pretty but really not intimidating today …
The concept of moats of course has been repurposed by the business world and we often hear about companies that have moats/advantages. Lots of companies have great moats that allow them to stave off competitors (the enemy) from encroaching on their market. This leads to (in most cases) superior economics and other companies can’t really attack back easily. To wit, they die trying to cross the moat.
So how do companies create moats today and how long can these effects last? My intent with this article is to break down the different types of moats that companies can create these days …
One thing to note is that a company can have multiple moats and the more moats a company has the stronger the business. Another thing to note is that there is not necessarily one type under a moat. For example for network effects there are many types of network effects. This article from NFX is a MUST read.
Economies of Scale
The premise of scale is that the larger the scale (of the business) the better they can serve their customer. I think that a good example of a company that has scale effects is Netflix. Think about the number of customers they have. For them any piece of content they create (a show that costs $100 million) can be amortized across hundreds of millions of customers. I am not specifying the exact number of customers since that changes and I hope that well, this will be an evergreen article.
Another good example is Walmart Stores. They have several thousand stores and that results in a lot of consumers. When they go to their suppliers and bargain you better believe that they have superior power thereby neutralizing the bargaining power of suppliers (Porter’s 5 forces). In fact if you look more closely in the Brick and Mortar world the threat of new entrants was a lot less but of course we have Amazon that changed the way people shop. I don’t need to belabor Amazon but the point I am trying to make is that by competing on a new dimension and a new business model can chip away at an advantage. Moats are not forever.
Economies of scope
The next one is economies of scope. One of the best examples of this is Disney. I am sure that you have seen the Disney flywheel before and even in the face of sheer competition from other SVOD’s such as Netflix they have been able to extend the effects of this. Disney has multiple moats (Intellectual property/cornered resource) is another one of those. By recycling their characters in movies that appeal to the next generation they keep the flywheel going on for what seems to be forever ...
Network effects are often conflated with virality but they are not the same, Virality is primarily about “rate of adoption”. It primarily deals with how fast a product/app grows. You talk to your friends about it and they use the product. Take for example Dollar Shave Club and their viral video. People shared the video, invited more people to try it (referrals) and this led to their growth, but the product’s value did not improve just because more people used it (I didn't consider shaving more because more of my friends bought the product. Counter that with an email address, telephone, or just blue bubbles (iMessages). I did send more iMessages as more of my friends joined). To be clear, the distinction that I’d like to draw out here is that virality helped the company improve their business. The point I’d like to make here is that Dollar Shave Club (to use that example) probably was able to negotiate better prices, or make better blades because they had the customer base. However these are still not network effects. The last point is a product can have virality and network effects at the same time.
Ok so then how do you define a network effect?
A network effect(and there are several different subtypes such as same side, cross side, direct, indirect). NFX has a bible on this. A must read!) is one in which more or less usage of the product by a user changes all other users behaviors. Let’s take the example of a product with positive cross side network effects : Uber
The cross side comes from the fact that if there are more drivers, there are more riders and they affect each other positively. More $ for the driver and reduced wait times for the rider. I don’t want to dig too deep into this but really you should read the above article.
Other examples of Network effects
Popular open source software such as Linux (and more specifically Redhat Linux). The reason RedHat and more broadly Unix and even more broadly open source is popular is switching costs and network effects. Linux has strong network effects, built over time and they started with a counter position (free v/s big $$ from, HP, Sun, IBM for Unix software)
Counter-positioning defined by Hamilton Helmer, the author of 7 powers:
"A newcomer adopts a new, superior business model which the incumbent does not mimic due to anticipated damage to their existing business."
A great example of this I think is Dollar Shave Club. Dollar Shave Club was predicated on having cheaper blades shipped to your door. They didn’t need to have retail partnerships or high margins and their marketing channel was social media. They did a fantastic job of creating a subscription product by counter positioning
Another great example is Robinhood or Wealthfront, they positioned their products at younger, less wealthy but tech savvy people that did not have the funds to even justify a personal investment advisor.
Switching costs are a very simple to understand and these exist for all kinds of products. The concept simply being that if you have put enough effort into learning how to use a product, creating data, or sharing data. Lets take several examples of this:
If your organization uses an on-site/on-prem database such as Oracle with all its applications, switching to another ERP comes with extremely heavy costs. Your users have to learn the new system, you have to spend millions implementing the system and you probably have to migrate your data.
Another example of this is Photoshop; you might have spent years learning how to use the product and now switching to another product is all the more harder. This is one of the reasons software companies offer free software or deals to college students; to get you hooked and learn the features, so you don’t easily switch
The question here is how does switching costs differ from network effects. A good example here would be your gmail address. Just because you have given your gmail address out to many people there is a switching cost for you but there are no direct network effects to all your friends to email you on only that gmail account. There is an argument to be made that gmail as a product can serve users better the more users they have or build features that create network effects (google chat within email) but notwithstanding that
Brands have been a successful moat for many companies for decades. People are willing to pay more money for a branded product because they expect a certain quality from the product, use the product to signal (or cultural imprinting) something about themselves. An example of this is Coke v. regular cola. In taste tests most people can’t tell the difference but shy away from regular cola. For physical products brands can also have leverage over distribution channels (customers ask for those products, they need to be available and easily located, which means a manufacturer can get a better deal from a retailer to showcase their products which in turn sell out more easily)
A brand is also a promise to the customer. FedEx for example is known for their promise “When it Absolutely, Positively has to be there overnight”. If you used FedEx consistently and one day, your parcel didn't make it to its destination you will be upset and will want this wrong corrected.
Brands as a competitive moat are undergoing a challenging time for certain products from certain generations these days (and some of it might be true v/s not true)
Cornered resources such as intellectual property, patents, access to capital, political power, favorable regulation allows a company to create impenetrable moats. Some great examples of this are
Patents : Qualcomm has invented a tonne and created lots of patents and licenses these patents at a significant cost.
Another example of patents being a winning game is ARM. However this could be at a risk in future with RISC-V. The primary appeal is its open source ecosystem. Just as Linux made UNIX technology free and ubiquitous, RISC-V aims to do the same for computer hardware. Already, companies have built CPUs using RISC-V technology and open-sourced them to the community. While it may not disrupt ARM or Intel overnight, “free” RISC-V could become the most disruptive force in chip design. RISC-V should debut in IoT and embedded applications this year and move upmarket to phones and servers during the next five years. This would be an example of counter-positioning since it is free (oh and also disruption theory)
Intellectual Property : Disney has access to a host of characters which are super popular among kids and even older people and is a source of competitive advantage for them
The DRC has naturally cornered cobalt and this gives them an edge
This (in some ways) links up with brands but is different. Let's take the example of Starbucks or McDonalds, they have large market presence. Having such a large market presence/distribution helps them source (if they don’t manufacture) raw materials for their end consumer product (coffee powder, potatoes etc). This is similar to economies of scale but not necessarily the same thing. A good way to think about it might be to use the example of a product such as Uber, they have significant market presence but that does not give them economies of scale. Their scale in one country doesn’t give them a direct advantage in another country (in other words they need to *mostly* start from scratch.
In closing, the one thing to add here is that moats are not exclusive. A company can have multiple moats and the more moats they have the more impenetrable their business. This does also not mean that a moat cannot be eroded. A great example of a moat that gave way was Walmart’s distribution once Amazon (and e-Commerce) captured the market. The moat mattered a lot less for most products with the exception of groceries.
What does not constitute a moat?
Great customer service is interesting. Amazon has great customer service but I think if there were no positive cross side networks effects (ie product supply and demand) , the best Customer Service wont keep you from going to Walmart. The point simply being that moats are hard to crack (I can't offer 150% refunds - i.e. best customer service) since I don't have the millions of SKU's that Amazon has (which is the moat)
So there you have it. I plan to add to this list more examples as we go along but I would also like to start using this framework to understand companies and see if a moat exists. I am by no means an expert but learning as I go along so if you have some cool examples or moats or eroded moats, I’d love to hear more from you.
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