“In a business, look for economic castles protected by unbreachable moats”
Summary:
- Developing a “moat” within the start-up ecosystem has become a key differentiating factor
- The following read will give an overview of how moats are built and sustained within the ecosystem
- It will give a clear understanding of what types moats exist, supported with prime examples
What is a Moat?
Startups and growing companies are advised to build and sustain their “moat” to survive in the market. Oxford dictionary defines moat as “a deep, wide ditch surrounding a castle, fort, or town, typically filled with water and intended as a defence against attack”.
So how does that fit within the startup ecosystem?
In startup terms, this translates to creating a strong line of defense that prevents potential competitors and market forces from posing a risk to a new business’s profitability, operational efficiency, and outlook for success.
In its literal sense, a moat refers to a ditch that is dug around a castle or a fortress to prevent enemies from breaching this line of defense and attack the central building. Simply put, it is one extra layer of protection that serves as a barrier for rivals or competitors trying to displace the fortress from a position of power.
Now if we were to compare this translation of the word moat with the original, the analogy would look like this:
Analogy Represents
The Castle The Company
Attackers Competitors
Water Body (Moat) Protection (Sustained competitive advantage)
According to Investopedia, is a“business’ ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms”. Indeed, an “Economic moat”, just like the medieval fortress original, keeps the competitors at bay by raising barriers that lower the chances of a take-over. It is a defensive measure that allows a firm to build and retain its leadership position in the market.
What is an Economic Moat?
An economic moat is defined as the firm’s ability to maintain a competitive advantage over its peers in order to protect its long-term profits and market share from competing firms. It may seem synonymous to a firm’s competitive advantage. But they are not necessarily the same thing. Moats are one type of competitive advantage. They are more durable than other competitive advantages. It is often an advantage that is difficult to mimic or duplicate (brand identity, patents) and thus creates an effective barrier against competition from other firms.
Why are Moats important to build?
Moats are important from an investment perspective because any time a company develops a useful product or service, it isn’t long before other firms try to capitalize on that opportunity by producing a similar–if not better–product. Basic economic theory says that in a perfectly competitive market, rivals will eventually eat up any excess profits earned by a successful business.
Struggling against mounting competition and the fast pace of change, these fledgling new businesses could definitely do with a good line of defence, and that is where the concept of a moat can come exceptionally handy.
What are the different types of Moats?
There are essentially five types of moats:
1. Low cost production: If you can make it for less, you can sell at an ever lower price. Companies that can deliver their goods or services at a low cost, typically due to economies of scale, have a distinct competitive advantage because they can undercut their rivals on price.
- A prime example of building a low cost moat is- Walmart- as a dominant player in retailing, the company’s size provides it with enormous scale efficiencies, or operating leverage, that it uses to keep costs low.
- But the answer isn’t merely the reduced costs that come with scale, like buying in bulk. The company limits costs through a management and distribution structure that serves multiple stores in a geographic area. The network of stores allows Walmart to limit its stock in any given store and share managerial expenses across the network.
- The moat is deep—efficiencies flow from a 5,000-store network.
2. High switching costs: Switching costs are those one-time inconveniences or expenses a customer incurs in order to switch over from one product to another. For eg- while moving all of your account information from one bank to another, you know what a hassle it can be-so there would have to be a really good reason for making that switch.
- Companies aim to create high switching costs in order to “lock in” customers.
- The more locked in the customers are, the more likely it is for the company to add costs to the product, without the risk of losing the customer to competitors.
- This mechanism can be built by providing an ideal (almost) solution to a “specific need” of the consumer, that the usage becomes synonymous with your product.
- Interoperability between competing products is used as a way to create this specific moat. This is especially true in health care, where electronic medical record (EMR) providers know that making their data sync with other systems empowers customers to switch. They thus aim to restrict this movement.
- Social networks have their own switching costs. Twitter and Instagram are powerful platforms for personal brand building. Followers are non-transferable capital that users store on the platform. Leaving—or splitting time to pursue fans on a new network—comes at a cost.
3. The Network Effect: The network effect occurs when the value of a particular good or service increases for both new and existing users as more people use that good or service. It therefore is one of the most powerful competitive advantages, and the easiest to spot.
- Important examples of this moat development are- Uber and Ebay. Both companies built moats based on network effects. Their products become more valuable as they acquire users. (And competing products pale in comparison.)
- A closer to home example is of Nykaa. The brand launched itself as a single platform bringing all international and national brands within the cosmetic industry, just a single click away.
- The primary goal is user acquisition. As the users increase in number within the network, it exponentially increases sales for all stakeholders.
- Meanwhile, for buyers, the platform has the widest selection.
- This advantage feeds on itself, and the company’s strength only increases as more users sign on.
4. Intangible Assets: Some companies gain an advantage over competitors because of unique nonphysical, or “intangible,” assets.
- Intangibles are things such as intellectual property rights (patents, trademarks, and copyrights), government approvals, brand names, a unique company culture, or a geographic advantage.
- In some cases, whole industries derive huge benefits from intangible assets.
- “Brand building” is also a form of intangible assets moat.Companies build profits on the power of brands to distinguish their products.Consumer-products manufacturers are one example. For example- PepsiCo (PEP) is a leader in salty snacks and sports drinks, and the firm boasts a lineup of strong brands, innovative products, and an impressive distribution network.
- For eg- Elon Musk, strategized to make his fast chargers available to others and open-sourcing Tesla’s patents, and this has intentionally filled a potential moat. Doing so, has earned the company favorable publicity—publicity that digs an adjacent moat built on brand.
- Another strategy could be to “Create a brand-owned term”. HubSpot, which owns “inbound marketing,” has a brand moat, in part, because of its role defining the term. Even if other aspects of its brand diminish, it will always own the origin story of inbound marketing.
5. Efficient scale: If demand has firm boundaries, aim for geographic dominance.
- Moats built on an efficient scale apply to a small number of businesses. They also apply to private companies that enjoy monopolies on public utilities, like electricity.
- This type of moat is when you have a market that is limited in size–and that’s a very key attribute of this competitive advantage–a limited market being efficiently served by one or a very small number of companies, that alone is going to keep competitors at bay.
- A prime example of this would be the airport industry- when you have an airport, most cities can only support one airport, and larger cities can accommodate 2-3 airports, but only with a 50-60 mile monopoly in that area.
Another key factor to note is that it is possible for some companies to have more than one type of moat. For example, many companies that use the network effect also benefit from economies of scale, because these companies tend to grow so large that they dwarf smaller competitors. In general, the more types of economic moat a company has–and the wider those moats are–the better.
Conclusion: A brand with a solid moat assures itself of long-term profits, sustainability, and a healthy market share by successfully keeping the competition at bay.” That being said, moats should serve consumer interests. They should encourage, not stifle, innovation. Technology has reshaped moats to be narrower and shallower.
No moat, however wide or deep, can protect a company from complacency.!
