How does uncertainty drive moat building & Innovators Dilemma

“The internet is not a friendly place. Things that don't stay relevant don't even get the luxury of leaving ruins. They disappear.”

Unpredictability drives innovation. It can be seen everywhere in the startup ecosystem: be it the people, the technology, the product or the market. It should not be viewed as a nuisance that startups must avoid, rather should be incorporated into the integral growth process. Whether a company is developing a new technology or aiming to capture a new market segment, the degree and type of unpredictability they encounter may vary, but its presence is assured.

So should unpredictability be viewed as worrisome?

Not entirely. The unpredictability a startup faces cannot be quantified but it can be distinguished. Between a risk and an uncertainty.

A Risk is a quantifiable unpredictability -

with past performances, trend analysis and future projections, a company can crunch numbers and derive a calculated risk it may encounter,

with a target number in place, mitigation plans can be developed,

established businesses are comfortable with taking calculated risks, as they can build moats to sustain it, and

If it makes business sense to take risk, many businesses will take it, and the risky innovation will have competition from the start.

Whereas, Uncertainty is an unquantifiable unpredictability -

• when a new technology is developed or a new target segment is identified, the unknown associated with it, can be termed as uncertainty,
• it cannot be known prior as a measurable probability,
• dominant players in the market do not always venture into this domain, as their investment process demands quantification of market sizes and financial returns,and
• for startups that aim to create value within uncertain domains, uncertainty is what protects them from competition, until a competitive advantage can be built.

Innovator’s Dilemma

The Innovator’s Dilemma is a path-breaking idea floated by Clayton Christensen (1997), that demonstrates how successful, outstanding companies (incumbents) can do everything "right" and still lose their market leadership – or even fail – as new, unexpected competitors (disruptors) rise and take over the market.

It can best represented through the following matrix:

Source: Data from Christensen, C., The Innovator’s Dilemma, Harvard Business School Press, 1997

He stated that established companies cater to the needs of the existing customer base, and the non-consumers are categorised into “new markets”. They downplay what the non-consumers ask for, and aim to improve their product by adapting new technologies. The new entrants (startups) can’t survive the direct competition with better resourced incumbents, and so those that offer new technology rarely survive. They must aim to target a class of consumers, that the incumbents do not serve.

It could be new technology adoption to serve these new customers, as they can do so by trial and errors, at low margins. Their low cost structure allows them to operate sustainably , where incumbents may not. The factor to note is, it is the new market and not the technology that is the differentiating key.

The incumbents can calculate the risk associated with new technology adoption, and have sufficient resources to make this transition happen seamlessly. However, with new markets, there is uncertainty involved, which the incumbents strongly dislike. They would prefer to wait for those to be mitigated first, before venturing into it.

This is where startups can aim to capitalise and capture. Make uncertainty their moat.

From Uncertainty to Moat

A startup’s strategy must be composed of two factors:

• Managing and mitigating the uncertainty
• Building a moat

Which moats are available depends greatly on whether the uncertainty the startup is resolving is novelty or complexity uncertainty

1. New Technology Company Moats - when a new technology is developed , the uncertainty associated with it is generally termed as “novelty uncertainty”.

It raises questions such as:

• Will the technology work?
• What would be the time and costs associated with building the product?
• What would be the time and costs associated with making it commercially available?
• What will be the quality of the resulting product?
• How can the product be improved over time? ...and more…

These can be mitigated by action. Through trial and errors, prototype development and testing, these questions can be answered, provided sufficient resources are available.

However, once a new technology is commercialized, it can be hard to protect. For an economy with rapid technological progress, no single innovation can remain indispensable. If the moat is to develop a single technical innovation, it cannot sustain if the competitors can easily find a substitute innovation.

Without a patent, a new technology cannot be protected. When a new tech startup introduces a new technology to customers, the incumbents tend to take notice. And if the product is found viable and acceptable to customers, the incumbent will either copy the technology or find a substitute.

If the moat must be a patent, the technologies that can be protected are limited. Reason for this could be that sometimes the ideas behind a technology can be so fundamental, which can make the patent broad and vague enough to preclude any competitor. Only if the costs associated with developing the technology are high (eg- pharmaceutical drug trials), can the incentive to create substitutes by competitors, be lowered.

Given time a startup can build economies of scale around a new technology, or special know-how–either closely held knowledge or tacit knowledge. Special know-how works as a moat when the product being sold is not the technology itself but the result of using the technology. The real moat can come in building the tacit knowledge to keep creating new products using the technology. When introducing a new technology, startups must build sustainable moats in time, to keep competition at bay.

2. New Market Company Moats- when a new market is targeted , the uncertainty associated with it is generally termed as “complexity uncertainty”. Since systems (new markets) are composed of many interacting agents with feedback loops, making the prediction of outcomes difficult to assess.

It raises questions such as:

• Who and how many users will want this product?
• How can we convince potential customers to buy it?
• What price will they be willing to pay?
• Are strategic/ channel partnerships possible?
• Will the established companies decide to compete with us?
• How will the government, media or society react?

Generally when a startup targets a new market segment, it faces the complexity uncertainty, which can’t be entirely mitigated by learning because you can’t ‘learn’ what a system will do when it does something different each time.

This mitigation is only possible through two ways:

• Surviving through the uncertainty, till the system reaches an equilibrium (For eg. Amazon launching its sale of books online, sustained itself through the uncertainty, built a brand value by the time incumbents entered the market)
• Working with the system to reduce the complexity, by building market specific contracts, standards, narratives ( For eg. Netflix developed contracts streaming rights, making it harder for potential streaming companies to compete)

Once a startup launches a product in a new market, different stakeholders (customers, suppliers, society at large) take time to react and accept the new idea. This time consuming process, gives the startups opportunities to build many sorts of moats. By the time incumbents enter into the market, the startup can secure its position in the market.

These can include:

• Building a brand value
• Economies of scale
• Network effects

The one question that remains, “if we build it , will the customers buy and more importantly continue to use the product /service and stay with it?”

It is essential to understand that when the startup aims to mitigate these uncertainties, they must have a strategy in place to build sustainable moats afterwards.

The strategy must ask these 4 key questions:

• What are the uncertainties this business faces?
• How will these uncertainties be mitigated?
• When will they be mitigated, relative to product launch?
• Will competitors be able to see that they have been mitigated (and/or how we mitigated them)?

If the company is launching a new technology, they must build a moat around their idea, before incumbents can adopt or imitate the technology. Dont assume a patent is enough for protection, make sure the tech fits into one of the few buckets that deters imitation.

If the company is creating or entering a new market, figure out the uncertainty in the market, how uncertain it would remain after the product launch and how the startup can shape the evolution of the market to leave themselves with a moat when they launch.

Conclusion: The goal is to determine the protectable & monetizable manifestation of the company’s innovation (be it new technology, new market or even both) and how moats can be built in place to sustain competitive advantage.