Startup Survival Kit: Mastering the Art of Building Moats
The hidden strategies behind building your business fort
There’s a myth in the startup world that having the best team, product, and rapid growth means you don’t need to worry about protecting your business from competition.
But that’s far from the truth.
The most successful companies are precisely the ones that need the deepest and beast-fed moat surrounding their castle.
Why? Because success attracts competition. Once your startup gains traction and becomes notorious, others will come to challenge your kingdom. That’s when you need to have your safeguarding moats in place.
Neglecting to dig moats is like sailing a ship without hull reinforcement — smooth shore waters may be fine. But as soon as storms of competition hit, your business will be at risk of sinking.
So, What Are These Moats?
They’re the barriers that shield your business’ margins from competitive pressures.
There are seven types of moats:
1- Scale Economies
Scale economies create a cost advantage for companies as they enjoy lower fixed costs per unit with increasing volume. Toyota, Boeing, and Uniqlo benefit from this moat in their operations. This advantage can also extend to other activities, such as McDonald’s bulk purchasing, resulting in lower costs.
This moat points to a subtlety: scaling matters relative to the next competitor. You don’t need to be the biggest, only superior to the next in line.
2- Network Effect
A network gains its strength when it acts as a bridge, connecting two fragmented markets or industries that comprise numerous individuals.
Housing and travelers, auction markets, job seekers, and hirers are fragmented markets that consist of many individuals.
This moat hits when a network’s value increases with each new user joining. Uber, AirBnB, and PayPal leverage network effects making their platforms more attractive as they gain more users.
These companies know critical mass is everything.
The first-mover advantage and winner-takes-all nature in such markets further reinforce the power of network effects.
3- Switching Costs
When applied, this moat creates a barrier, making it costly or challenging for customers to switch to competitors. If all your interests are on Twitter (sorry, X), why would you switch to Threads losing all the benefits of your networking?
This moat best applies to companies that provide a high benefit-to-cost ratio: a product or service critical to the end product but only costs a fraction of the total cost.
An example would be a specialized machine part used in the assembly line of an automobile manufacturer — finding an alternative supplier would require reconfiguring the entire production line and could lead to delays in manufacturing.
Companies like SAP, Rolls Royce, and Bloomberg Terminal benefit from high switching costs due to their mission-critical products or services. Long-term relationships and strong brand loyalty contribute to this moat.
4- Branding
A strong brand confers positional value and legitimacy, changing customer behavior and lowering search costs. Companies like Coca-Cola, Louis Vuitton, and Nike showcase the power of this moat. It is crucial to distinguish brand recognition from true brand power, which alters customer behavior. They confer a sense of identity that changes how we feel.
Some companies may produce a bag as strong and distinctive as a Louis Vuitton. Still, you won’t pay the same price for it because they don’t change how you feel.
5- Counter-Positioning
In his book Innovator’s Dilemma, Clayton Christensen coined the term disruptive innovation, where incumbents ignore the entrants by dismissing the new invention or business model as unproven and/or low margin.
This moat develops a superior business model that challenges entrenched incumbents. Those incumbents often fail to respond effectively, fearing disruption to their existing models.
And it may or may not involve new technology.
Netflix’s mail-order service against Blockbuster’s video rental business model didn’t include any new technology.
6- Cornered Resources
Whether:
- physical (property)
- human (expertise)
- organizational (patents)
These resources, in order to be considered moats, have to improve a company’s performance relative to competitors in two ways:
- Reduce cost
- Increase revenue
And it has to be inimitable to be sustainable.
Unique production processes, patents, and location advantages are examples of cornered resources that provide a sustainable advantage.
7- Process Power
This moat references a complex and opaque system that you just can’t copy.
Through trial and error, these companies learn how to deliver the best value to their customers, manifested in the company’s culture.
Companies like Toyota, IKEA, and Southwest Airlines have strategies that involve trade-offs and unique cultural integration.
Understanding Moats
Moats are not static.
They can:
- decline
- maintain
- grow over time
Different moats may emerge at different growth stages of a company. And the durability of a moat determines its value, with long-lasting moats being more valuable than short-lived ones.
Further From the Ditch
Now, moats won’t guarantee you Product-Market Fit (PMF). You need to find that first. But once you’ve achieved it, you must build your defenses against competitors.
The goal of a startup is not just to get marked up by investors but to go public or get acquired for a life-altering sum. And that can take years, during which competitors will emerge. Moats can be the difference between a successful IPO and a cautionary tale.
To understand when to dig moats, consider the uncertainty surrounding your business. Uncertainty creates the first moat for new startups. The less obvious your idea and the harder it is to build, the more time you have to dig moats. Conversely, if your idea is obvious and easy to replicate, you must act fast.
There are two types of uncertainty:
- Novelty Uncertainty (technical risk)
- Complexity Uncertainty (market risk)
As uncertainty surrounds your business, you have time to dig moats.
Peter Thiel, the co-founder of PayPal and Palantir, emphasizes the importance of moats in capturing value in the long run. He explains the differences between perfect competition and monopoly:
“Under perfect competition, in the long run, no company makes an economic profit,” Thiel states.
In contrast, with its moats in place, a monopoly can set its own prices and maximize its profits.
Thiel’s insights shed light on the nature of high-growth industries. Many assume that rapid growth guarantees winners, but Thiel warns against this misconception. He notes that “high growth is easy to measure, but durability isn’t.”
Focusing solely on growth without building moats can lead to a vulnerable business model.
At actual cases that reinforce these ideas
Hugging Face is a company that started as an AI chatbot before the AI boom. During the complexity uncertainty phase, it focused on building a solid community and became the “GitHub for machine learning.”
As a result, Hugging Face reportedly achieved revenues of $30 — $50 million and is rumored to be valued at $4 billion today.
On the other hand, Runway was founded in 2018 during the AI boom. It faced novelty uncertainty as it aimed to build the “world’s first end-to-end AI generation platform.” Runway secured a $141 million funding round from tech giants like Google, Nvidia, and Salesforce, valuing the company at $1.5 billion.
While Runway’s growth seems impressive, they must act quickly to establish real moats before their novelty uncertainty advantage fades away.
Conclusion: Digging Moats to Success
In the fast-moving world of startups, moats are a must.
The journey to success is not just about having a great product but about building robust defenses. Even more, moats are training wheels, keeping you steady until you cross the finish line of a thriving and sustainable business.
Because it’s not just about hitting short-term growth targets but thinking critically about the qualitative characteristics that ensure long-term durability.
The sooner you get digging, the better equipped you will be to face the challenges ahead.