By: Rick Zullo, GP & Co-founder at Equal Ventures
This company is growing like a weed!
This company is growing like a weed!
The product is amazing!
The team is killer!
The market is huge!
We’ve all heard this type of hyperbole (and frankly I’ve been guilty of it myself) in the startup ecosystem. While I’m glad to be in an industry that is anchored in positivity (despite the fact that we say “no” to 99.9% of the companies we see), the investor in me can’t help but try to create some structure out of this opaque chaos. Market size analysis is often flawed (and way too generous), assessing teams is subjective (and often highly rooted in bias) and growth at the earliest stages can often be hacked together in unsustainable ways (providing a false positive of product-market fit).
With that, there is only one thing that matters: moats.
There are nearly infinite definitions of “moats”, but Equal Ventures defines moats as:
“Proven, perpetuating and permanent unit economic advantages from peers within a competitive set”
We focus on the “3 P’s” since we often find the definition of moats to be far too opaque. We summarize the 3 P’s with the following:
- Proven — Measurable, quantifiable and significant enough to demonstrate economic leverage
- Perpetuating — The ability to provide increasing returns to scale and demonstrate sustainable margin growth over time
- Permanent — Long-lasting and resilient to tactical attempts from competitors (i.e. not just short term competitive advantages)
Our definition isn’t perfect, but we find that it is incredibly important to our internal discussions when evaluating the potential flight path of a business. As countless historical (and recent) examples demonstrate, a great product in a great market with a great team can generate phenomenal traction, however, without moats, the opportunity is likely to succumb to competitive pressures, limiting its potential greatness.
The focus on moats isn’t purely academic. The reality is that startups operate in a highly competitive environment where capital flows fairly freely. As these startups compete against each other, short-term advantages/profits are competed away to the cost of capital. This is how businesses have operated for countless centuries and one could make the case that short-term advantages are shorter than ever given the speed of and availability of information today. The only companies that survive and thrive over the long term (think, 10+ year time horizon) are those that earn returns in excess of their peers as a result of their moat. These returns have a tendency to compound over time, making these companies grow even stronger than their peers.
The persistence of moats becomes incredibly important as the vast majority of a company’s value (some would say 50–75%) is determined by its terminal value (the discounted value of future cash flows at steady state). While our industry tends to subjectively debate the presence of moats, other asset classes rigorously measure them based on observed differences in financial performance. As we evaluate opportunities, we like to think about how a company can leverage venture capital to establish and build moats (what we now refer to as a “moat trajectory”) to monopolize a position in its industry’s value chain.
Ultimately, we try to define moats, not in terms of impacts on an income statement (as some other asset classes do), but rather how a startup operates in real-time — via it’s unit economics. For us, that means 4 core parameters — COGS, OpEx, CAC, Willingness-to-Pay (WTP). We try to walk every company we invest in through the graph below to answer “How does your company create economic value?” and “What are the key assets we are acquiring/developing to achieve that value?”
A lot of this methodology is rooted in the concepts employed by value investors like Charlie Munger, however, we think that digital moats can be far stronger than those of the analog age. While most value investors focus heavily on the measurability and persistence of moats (for further reading, see how Berkshire Hathaway generated an 8000% return on See’s Candies), we think some analog moats ultimately succumb to diminishing marginal returns. Many brands lose their premium allure (WTP) as they are forced to mass market, economies of scale advantages erode to the point that OpEx/COGS actually grow at a certain point of scale (especially in a global economy where local advantages are strong) and customer acquisition economics can often grow more expensive once the highest performing channels are tapped out. For digital companies, features such as network effects, limited incremental cost of COGS and low transaction costs for distribution may enable moats to accelerate over time. This is particularly true with platforms, marketplaces, and software businesses with network effects (categories where we spend the vast majority of our time focused on).
At the end of the day, startups (like all businesses) are engines for future cash flows. Their ability to generate cash flows in excess to others in the market lives and dies with the strength of their moats, which is why it’s so critical to focus on identifying/evaluating moats early on (more on this to come in our next post). Ultimately, building moats is easier said than done, but the best businesses are inherently difficult to build. Building a business with moats helps ensure you have a business that sustains value over the long run and honing in on these levers early on can help you focus on where to allocate your scarce resources and position your business against competitors. These are the moves that will ultimately help you win in the long-term and drive the most value for your business.
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