Why You Need An Economic Moat For Your Startup

"In business, I look for economic castles protected by unbreachable moats" - Warren Buffett

When you think about a “moat”, you’re going to imagine an impenetrable castle, surrounded by a deep trench of water. That trench is what makes it so hard to successfully attack the castle. In business, the same principle applies—by creating a “moat” around the business, you can protect it from other businesses and threats.

This principle goes all the way back to the father of capitalism himself, Adam Smith. “Any company whose earnings are growing consistently or more importantly, are likely to grow consistently, has something unique about it,” Smith wrote in The Money Game. “A company that has something unique about it has something the competition cannot latch on to right away. Whatever it is that is unique is a glass wall around those profit margins.”

Smith called it a “glass wall,” but we call it a “business moat” or “economic moat” today. Whatever you want to call it, however, the principle is the same: If you want to build a business that will scale and thrive, you’re going to defend yourself by having something different.

What is an economic moat?

Like with so much of business, military strategy translates well. The idea of a defensive perimeter—like the castle moats of the middle ages—is pertinent to businesses of all sizes, from startup to global enterprise. By having some kind of defensive asset surrounding the (conceptual) perimeter of the business, the company then has something that will protect the core business and its assets. This is important, because as soon as the business begins making waves in the market, the much larger forces of incumbents and enterprises will begin to test those defences.

Now, for startups in particular, they’re not likely to have a moat from day one. However, it should be something that the founders are thinking about, because investors are certainly going to want to know how the startup will protect its valuable and innovative ideas.

Often, the startups who are unable to dig that moat early, are the ones that get acquired or simply steamrolled by their larger, more established, or powerful (i.e. wealthy) rivals.

Types of economic moats

Of course, a business moat is an abstract idea rather than a physical trench, and there are a number of different forms that it can take:

1) Patents and Copyright 

When you’ve got legal ownership over a concept, you’ve got an enormously powerful moat that becomes hard to scale. When Amazon successfully patented one-click checkouts in 1999, it immediately established a very deep moat. The sheer convenience of one-click checkouts speaks to the very core of e-commerce. 

Apple, for example, pays Amazon what we all assume must be a fortune for that technology concept. It has to, because otherwise the app store simply would not work. Amazon’s patent will eventually expire, but not before Amazon used its moat to build the business behind it to an almost impossible scale.

IP rights are as compelling as patents. Here's a quirky example: A Japanese company called Crypton created a digital voice bank that allowed users to input words, and the voice would “sing” them, allowing the user to create fully vocalised music without needing a singer. It’s not unique technology, nor is it patented. Crypton actually licensed the underlying technology from Yamaha. 

What Crypton did, however, was have the creative idea to design a character to visually represent that software. That copyrighted art asset became so popular that “she” performs as a hologram in live concerts across the world and has given Crypton the ability to scale to a truly unique, global business.

2) Branding 

Consumers become very attached to their favourite brands, and it is difficult to undermine that loyalty. Here is one very simple example: Nintendo, the video game company, lacks the sheer scale of its immediate rivals (which include Microsoft, Apple and Sony). Its technology tends to be less powerful than those companies. What Nintendo has going for it—and the reason it regularly outsells its rivals in its niche—is sheer brand loyalty. The company’s mascot, Mario, overtook Mickey Mouse as the most recognisable character in the world, after all.

A startup that can cultivate a fierce loyalty from its customers can rely on their ongoing support as its economic moat.

3) Switching Costs 

Apple released iTunes at the same time that it released the very first iPod, and years before the first iPhone landed on the market. It all seemed innocent enough at first (you didn’t need an iPod to use iTunes, which was—at the time—a revolutionarily legal and convenient way of buying music online). However, as iTunes was expanded to include TV and Film, and the iPhone brought apps, people realised something: it was going to be really difficult to move to the newer, rival Android platform. It would mean they lost access to all their entertainment and apps, which were incompatible with Android. 

Other common examples are telecommunications providers, banks and insurance companies. In all of these cases it’s not just the cost of switching that disincentivizes customers to do so, but also the effort, time and psychological toll that switching has. This ability to retain customers on an incumbent basis is a powerful moat effect.

A startup needs to walk a very fine line here, since “lock in” and high switching costs are things that consumers take a very dim view of (they realised too late with Apple, but if a company tried to pull that today they would be criticised heavily for it). However, it remains true that if there is inconvenience or cost involved in moving off your technology or service, you’ve got a business moat.

4) The Network Effect

Many would argue that the network effect (often abbreviated to “nfx”) is the single most potent moat—especially in the tech space. Research even suggests that as much as 70 percent of all value in tech is created through nfx.

In simple terms, the network effect is one of scale: the more people that are using a product or service, the better it tends to be. This can happen in a number of ways. For example, as more people use something, they tend to contribute back to it, making it more valuable for others to use. In this example, Yelp is an enormously successful company because so many people contribute reviews to it. That is a competitive moat for Yelp, because Yelp’s rivals do not have the same body of content that can draw yet more people to the platform.

Another common example of the network effect is that as more people use a product or service, more related companies become a “partner” to that base product or service. The most clear example of this is Visa and Mastercard. These two companies dominate global payments, and the reason for that is simple: Try and use a Diner’s Club card in stores. Unless it’s one of a (declining number of) restaurants, then it might be difficult. Now, try and use a Visa card. There’s the benefit of a network effect.

Any new business that wants to get into the payments industry would need to contend with the fact that at this point most people are happy making payments with the incumbents, and the retail industry has galvanised behind them.

5) Economies of Scale

Being able to simply invest and spend your way to scale, product innovation, patents and other competitive advantages is, itself, a kind of moat. Twitter, for example, has been making a loss in virtually every year of its existence, but thanks to some enormously successful capital raising, it has been able to invest its way to a massive and stable audience. It also now has a product suite that other social networks could only dream of, and is now starting to convert this massive pool into revenue. 

This is fundamentally why so many startups target a stock market listing as their major medium-term goal. The additional resources that it brings into the company can fuel further expansion, and enable the company to make investments into defending itself from competition. 

Such a moat can dry up more quickly than others. Money is finite, after all, and investors only have so much patience. However, deployed well, it can be an enormously effective short term moat that contributes towards the development of other types of moats. 

These are just five of the main forms of moats that you’ll see in the market. There are plenty of other ways to defend your business—some might apply more to one sector or niche—and it’s worth taking the time to identify the moats of other companies in your space when considering what might be your own.

An economic moat and a competitive advantage are not the same

At this point it’s worth noting briefly that while competitive advantages and economic moats are related, they are different concepts. A competitive advantage is a temporary thing, and something that can be undermined and replicated by competitors.

An economic moat is a much more long-term advantage that is an integral and durable quality of the business. It is something that cannot be duplicated by another business (or, at least, not easily or legally). Having an excellent product is a competitive advantage. Having an iconic product is an economic moat.

Okay, so how do I build a business moat?

Not all moats are considered equal, and some are more powerful and enduring than others. An ideal startup is one that has a wide economic moat, rather than a narrow one.

1) Build a wide economic moat: 

A wide economic moat is a moat that is difficult to cross because you’ve combined factors to build your defence, and you enjoy a broad advantage that cannot easily be caught.

Google is an almost iconic example of this. Google’s depth of data, across its broad suite of technology services (including e-mail, search, YouTube, analytics and more) allow it to provide a service so superior that its brand name has become iconic to the Internet. This allows it to weather the storm of far more focused brands that attack part of its moat. 

Facebook competes with Google in some areas (such as a search and video resource), but lacks enterprise cloud and business features. Twitch has eaten away a chunk of YouTube’s prominence in some areas, but the deeper search functions on YouTube make it a better broad entertainment platform.

2) Build a narrow economic moat: 

A narrow moat is much more common, and also far less powerful. A narrow moat is a single advantage and, while it is an advantage, it is also far easier to erode and can be expected to disappear as competition comes calling.

Blackberry is a perfect example of this. Blackberry’s moat was that it was a smartphone specifically designed for the enterprise customer. From email to security it became a standard issue for the increasingly mobile professional who needed more than a Nokia (at the time) to properly keep on top of their workloads. 

But once other smartphones graduated from quirky consumer devices, and Apple and Android devices had app stores filled with deep functionality for professionals, Blackberry’s moat dried up.

3) Build a deep moat: 

A much more rare beast, a deep economic moat is an example of a company that might only have a narrow advantage, but it’s also such a difficult one to erode that it is fundamentally impossible to undermine.

We can call this the Hello Kitty effect. Sanrio—the company that produces Hello Kitty—only really has one trick in its moat. It creates mascots that are cute, turns them into merchandise, and sells them. Sanrio has rivals (such as San-X), and there is nothing about its merchandise and products that can’t be freely replicated by those rivals. It owns no patents. It maintains retail outlets, but there’s nothing unique about them.

However, no matter what its rivals do, they cannot make Hello Kitty. It’s a very narrow moat, it will likely protect Sanrio into perpetuity.

Does my startup need a moat?

To turn that question around, consider what would happen if your startup didn’t have a moat at all. Say you had a great invention and, in the rush to get it to market, didn’t bother to patent the things about it that made it unique.

Six months later one of the big incumbents have noticed it, replicated the product, and now your customers are using that instead because it’s cheaper and benefits from the support of the rest of the bigger business.

Or, for another example, say you’ve started up a challenger brand in the food delivery app space. You’re offering customers much the same experience, but there’s nothing unique about your app. It costs about the same to use and the few drivers and restaurants you’ve been able to convince to sign up to yet another delivery service are available on the other apps.

With no moat, you struggle to get more riders and restaurants to sign up, and the business fails to scale. When one of your rivals offers you a mild amount to acquire your assets and mailing list, you gratefully exit.

You can have a startup without a moat, but without that moat, you’re at the mercy of the incumbents and general market forces. With the right patents and approach to building a moat, a startup of one or two people can withstand the might of even Microsoft or Amazon.

Furthermore, a business with a moat is going to look like a more viable business to investors. Early stage investors in particular will be looking for moats as a sign that the vision has legs and can grow into something.

Make your business unique with a moat… and then continue to build

An economic moat takes your business beyond having a competitive advantage and gives it a long-term durability and basis to scale. However, as a final note, it’s important that you don’t get complacent. 

Even the widest and deepest moats can be undermined. Consider Yahoo!, MySpace, and Blockbuster. At one stage all three of these businesses had massive, dominant moats. And yet Google, Facebook and Netflix, respectively, found ways to innovate around the moat, while building their own to defend against the counter-attack.

Finding a moat is no guarantee of success, but it’s the best available defense that entrepreneurs have in a competitive and aggressive marketplace. By developing that moat around their business, an entrepreneur is going to have far greater control over how their business moves into the market and how it responds to competitive challenges.