I started writing about economic moats in September 2014. Since then I have written about Network Effects, Switching Costs, Intangibles, and Efficient Scale and Cost Advantages. The purpose of those posts was to outline how I think about economic moats while I am studying a seed stage startup and trying to determine how things might unfold in the future.

This is how I define an economic moat in relation to early stage startups:

An economic moat is a structural feature of a startup’s business model that protects it from competition in the present but enhances its competitive position in the future.

In this post I will wrap things up with some final observations;

First, in relation to economic moats, my responsibility as a seed stage investor is to identify startups that can build or acquire an economic moat as their business model matures and as the startup becomes a company. Directly tied to this, I have to make an assessment about the founders’ willingness to conceptualize and build such a moat if things go well. There’s no point worrying too much about a moat if the rest of the world is apathetic about what the startup is doing.

Second, An economic moat is not the same thing as a competitive advantage. A competitive advantage is temporary. This is because a competitive advantage is typically designed on the basis of Michael Porter’s Generic Competitive Strategies. A durable economic moat is unique, and typically can not be duplicated by others.

Third, to withstand the effects of sustained challenges from incumbent and new-entrant competitors startups need an economic moat that is derived from more than one source. In relation to Internet and other software technology business models, indirect network effects can prove to be as important as direct network effects.

Fourth, some of the strongest foundations on which a startup can build an economic moat are also some of the most difficult to come to grips with. Mainly, these are lumped together as “Intangibles” . . . Among the sub-items under intangibles Management & Culture, and Research and Development stand out to me as being things I should look out for at the seed stage because everything else emanates from those two.

An organization’s ability to learn, and translate that learning into action rapidly, is the ultimate competitive advantage.                                                      – Jack Welch

Fifth, cognitive costs are a real barrier to entry and till an early stage startup has established itself within a market, uncertainty works against it but in favor of the incumbents. This is especially true for startups building products for sale to other businesses. These aspects of buyer lock-in might be nearly impossible to articulate or measure, but that does not mean startups and their investors can afford to ignore them. At the outset a seed stage startup must find that niche of potential customers for whom the sum of cognitive costs and uncertainty is a minimum. It is worth thinking about this at the outset of product development.

Sixth, thinking about cost advantages has to go beyond the obvious advantages it confers on the startup in terms of its operations. The most important consideration is how a cost advantage enables the startup to create more value for its users or customers. A cost advantage that does not yield increased value for users and customers is not one that will last.

Lastly, as a startup scales it must pay attention to how that is affecting the macro environment in which it finds itself. A bad market can remain unfavorable far longer than any startup’s ability to scale its way to a profit. It is one thing for a startup to find product-market-fit, but quite another for that startup to scale efficiently in that market. Finding product market fit does not automatically lead to conditions that favor efficient scale. Extended unprofitable growth is one sign that a market might not have the characteristics to support efficient scale, or that the startup has not thought its business model through enough.

When I study a seed stage startup I am trying to answer a number of general questions about how the future might unfold for that startup, thinking about economic moats gives me a useful framework for doing so.

At KEC Ventures, I have been largely focused on finding and meeting the founders that we can become most excited about and partner with. I will continue to maintain that focus over the course of 2016 and 2017.

Here are some notes for the founders of the startups I am most eager to meet.

About KEC Ventures

We are a team of early stage investors based in New York City. We invest in information technology startups that are pursuing business models with the potential to transform the way business is done in their market. In such startups, we generally invest in the first institutional Seed Round or, less frequently, we will invest in the Series A round of financing. Often, but not always, we act as the lead investor. On rare occasions, we might invest earlier than this when we meet a founder pursuing a vision that we believe in. Currently, we focus on investing in startups based in the United States or Canada.

Connecting With Me

If you know someone who knows me, an introduction would help. If you do not, never hesitate to communicate with me directly. I am easy to reach on the major social networking platforms. Also, I hold regular and frequent office hours at various co-working spaces in New York City. Some allow non-members to sign-up and attend.

The best time to start communicating with me is at least 6 – 9 months before you believe you will raise a round in which KEC Ventures might invest because I believe it is important to build trust before entering into the kind of working relationship that exists between startup founders and their early stage investors.

That also gives me sufficient time to understand the problem you are solving, so that if we invest, we are doing so with conviction. Time enables me to become a more effective advocate on the startup’s behalf when my colleagues and I have discussions about making an investment.

Communicating With Me 

If we are not meeting through an introduction, I will respond quickest to founders who get straight to the point, and explain why we should meet in 250 – 400 words in their first email to me. I try my best to respond. However, depending on what else I have going on, I may not respond if I feel the startup is outside KEC Ventures’ areas of interest and that the founder could have easily found that out before emailing me. Please follow up with me once or twice if you believe I have made a mistake.

If you are not connecting with me or anyone else at KEC ventures through a warm intro, you can email me at: pitch@kecventures.com. I’ll go through submissions to that email address every Friday.

Characteristics I Look For in Founders, and Teams 

I look for teams in which the founders have known one another for a considerable amount of time prior to launching their startup. I look for teams in which the level of trust and respect between the co-founders is high. I look for teams that will not have difficulty attracting other great people to join the startup. I look for founders who inspire confidence and loyalty from others because they are good at what they do, the kind of people I could picture myself working for.

I look for founders for whom solving the problem that their startup is solving has become their life’s mission and they plan to solve that problem with or without help from outside investors. I look for founders who have an unconventional opinion about the market opportunity they are pursuing, and can explain why their position is correct with evidence which investors can analyze independently.

At the outset I look for teams that can focus on building a simple product that their initial customers love, and who can focus on a niche within which to launch their product. I look for teams that are judicious and frugal in how they deploy the startup’s resources.

I look for founders who value teamwork, and who can become great leaders if they desire to do so. I value transparency, honesty, and openness. I value self-awareness. I like people who are determined and tenacious, who do not give up just because the going gets get uncomfortable and things seem bleak.

I look for founders who have a hard time doing something simply because it is what someone else expects them to do. I look for founders who are not afraid to be different.

Characteristics I Look For In Markets 

I look for large markets that could ultimately be served by the startup’s product, even though the initial target might be a small portion of the whole. I look for customers capable of and willing to pay for the product, and who are looking for and eager to find a solution to their problem.

I look for markets in which the pain is acute because the problem suppresses customers’ profits significantly, or because the problem makes users less happy than they could be.

If currently the addressable market is between $1B and $10B, I want to see evidence that it is growing quickly enough to support the startup’s future goals, and the competition that I assume will quickly follow if the team is successful.

Characteristics I look For In Business Models 

I look for products and business models that:

• will benefit from network effects as time progresses,
• can scale efficiently and quickly, and
• can eventually benefit from an economic moat.

The Themes I Am Focused On

Notes:

1. These themes cut across different industries and sectors. That is a deliberate choice.
2. The technology sector evolves constantly. Accordingly, our team’s interests might ebb and flow in response. The themes I have described below should serve as a rough guide to how I think about the universe of startups in which we wish to invest.
3. Ideally, a startup raising its first institutional seed round should have raised less than $1.5M – 2.0M or so prior to the round in which KEC Ventures would be investing.

I am currently interested in hearing about:

• Marketplaces: Platforms that enable the participants in large, global markets to interact with one another in ways that reduce waste or create new, untapped opportunities.
• Interconnectivity: Platforms that enable large numbers of different types of connected devices, machines, apps, and websites to communicate with one another and with the people managing or using them within a secure environment.
• Data & Analytics: Platforms or applications that help people or other machines to manage, analyze, interpret, make decisions, and take actions based on vast and growing troves of centralized or decentralized data.
• Effectiveness & Happiness: Products that enable people to accomplish more at work, or to become happier outside work. Products that help large enterprises and other types of businesses and organizations to grow or function more effectively.
• Distribution: Products that make it easier to create, manage, distribute, and consume existing and emerging forms of digital media and content.
• Asset Management: Technologies for managing different forms of enterprise, business, or individual assets. Technologies for managing different forms of enterprise, business, or individual risk.
• Other: New, and as-yet unknown technologies and innovations founders are building to solve problems that exist only because no one else has developed a solution.

Things I am Not Interested In

1. Exploding rounds: An exploding round comes with a caveat like “Seed round in ground-breaking tech startup closing in 1 week!” I do not like exploding rounds, not even exploding rounds that are being led by a name-brand VC. I need time to do my own homework.
2. Meetings led by an advisor: I prefer my first few interactions with a startup to be with the team of co-founders, not with an advisor. It is okay for an introduction to come from an advisor, but I do not like to have advisors or mentors micro-manage my interactions with startup founders. That does not inspire confidence.
3. Lack of control over core technologies: I try to avoid situations in which the startup has a product that has launched to the public, but the startup’s team has no primary responsibility for actually building the core product.
4. Founders who will not share bad news: I only want to work with founders who will not hide bad news until it is too late for investors to do anything that might help the startup make a course-correction. I absolutely want to hear about difficulties, challenges, and problems. I expect the good news, but I think we have an obligation to try to fix the bad stuff before it becomes unfixable.

My Commitment to Startup Founders

Based on Gil Dibner’s VC Code of Conduct;

1. I will be transparent.
2. I will respect your time.
3. I will not ask you for material I do not need.
4. I will not string you along.
5. I will let you know about any competitors in our portfolio.
6. I will be transparent about conflicts of interest.
7. I will not share any of your material without your permission.
8. I will not speak with your customers without your permission.
9. I will educate before I negotiate.
10. I will be honest about what standard terms are.
11. I will not issue a term sheet unless my firm has made a firm decision to invest.
12. I will reflect the term sheet in the final legal documents.
13. I will not seek an unreasonable equity stake.
14. I will avoid surprises.
15. I will always act in the best interests of the company.

This is the fourth post in my series of blog posts on economic moats. I have already written about Network Effects, Switching Costs, and Intangibles. In this post I will discuss how Cost Advantages and Efficient Scale might develop as an early stage startup travels through the discovery phase of its life-cycle. ¹

My goal for writing this post is to provide one example of how I might think about this topic when I am studying an early stage startup that is raising a round of financing from institutional venture capitalists.

To ensure we are on the same page, I’ll start with some definitions. In the rest of this discussion I am primarily focused on early stage technology startups. If you by-chance have read the preceding posts in this series, you would have seen some of these definitions already.

Definition #1: What is a startup? A startup is a temporary organization built to search for the solution to a problem, and in the process to find a repeatable, scalable and profitable business model that is designed for incredibly fast growth. The defining characteristic of a startup is that of experimentation – in order to have a chance of survival every startup has to be good at performing the experiments that are necessary for the discovery of a successful business model.¹

A company is what a startup becomes once it has successfully navigated the discovery phase of its lifecycle. As an early stage investor one of my responsibilities is to assist the startups in which I am an investor to successfully make the journey from being a startup to becoming a company.

Definition #2: What is an economic moat? An economic moat is a structural barrier that protects a company from competition.

That definition of a moat is the one provided by Heather Brilliant, Elizabeth Collins, and their co-authors in Why Moats Matter: The Morningstar Approach To Stock Investing.

I take things a step further in thinking about startups and companies with business models that rely on technology and innovation. I think of a good moat as performing at least two functions; first, it provides a structural barrier that protects a company from competition. Second, it is an inbuilt feature of a company’s business model that enhances and strengthens its competitive position over time.

As a result I have arrived at the following definition of an economic moat pertaining specifically to early stage technology startups;

An economic moat is a structural feature of a startup’s business model that protects it from competition in the present but enhances its competitive position in the future.

Definition #3: What is a cost advantage? According to the authors of Why Moats Matter, a cost advantage arises when a company can sustainably lower its costs of doing business relative to its competitors. Such a reduction in costs can be due to process advantages, superior location, economies of scale, or access to a unique asset. In other words;

A cost advantage is a structural feature of a startup’s business model that enables it to maintain sustainably lower overall costs of doing business than its competitors while earning equal or higher margins over time.

Definition #4: What is efficient scale? According to the authors of Why Moats Matter, “efficient scale describes a dynamic in which a market of limited size is effectively served by one company or a small handful of companies. The incumbents generate economic profits, but a potential competitor is discouraged from entering because doing so would cause returns in the market to fall well below the cost of capital.” In other words, from my perspective as an early stage investor;

A startup can scale efficiently if doing so does not drive its customer or user acquisition costs to unsustainable levels over time, and if the startup’s decision to enter that market does not drive returns in the market to levels that are below the cost of capital for incumbent companies in that market over the short term.

Sources of Cost Advantage

For early stage technology startups, these are the most important sources from which a cost advantage may be derived.²

People & Culture: This cost advantage arises when a startup develops a unique organizational culture, management processes, and organizational structures that enable and empower members of the team to consistently generate results for the startup’s business that are significantly better than the results of its direct competitors and that beat the adjusted-performance of more well-established incumbents in that market. This source of cost advantage is intimately connected to the intangibles of Management and Culture, and Research and Development.

Systems & Processes: This cost advantage arises when a startup develops unique organizational processes that enable it to consistently generate comparatively superior results. The key categories of such systems and processes are Marketing and Sales Processes, Operational Processes, Distribution Processes, and Support Processes.

Marketing and Sales Processes focus on the activities that the startup takes in order to create demand for its product or service, and subsequently to satisfy that demand by delivering the product to its users or customers.

Operational Processes focus on the activities in a startup that take inputs and turn them into the final product or service through which the startup’s value proposition is delivered to the market. These are the processes that enable the startup to turn tangible and intangible inputs and turn them into something the market is willing to pay for. I have previously discussed this in: Why Tech Startups Can Gain Competitive Advantage from Operations.

Distribution Processes focus on the channels through which the startup’s product or service will be delivered to its users or customers. A key consideration that has to be made here is the choice between direct distribution and indirect distribution channels, and how the startup’s choice in this respect will affect its ability to maintain an overall cost advantage over its competitors.

Support processes focus on all the activities that make everything else that the startup does possible; for example HR and Talent Management, and Financial Planning and Analysis fall under this category.

This source of cost advantage is intimately tied to People & Culture, since the two combine to create an environment in which unique tangible and intangible assets are developed consistently over time such that the startup’s competitive advantage over its peers increases, and evidence that this is happening is seen in the startup’s historical key performance indicators.

Facilities: This cost advantage is derived from the physical infrastructure that a startup needs in order to operate. For early stage tech startup the hard decisions related to this source of cost advantage begin to be necessary when the startup has scaled to a point at which off-the-shelf hardware products are no longer good enough for what the startup seeks to accomplish. This is often the point at startups must consider the advantages or disadvantages they may derive from building custom hardware instead of relying on what’s available from outside vendors or partners. It can also be tied to a geographic location which gives the startup unfair access to an input that is critical for what it does.

Capital: This cost advantage is determined by the startup management team’s ability to allocate capital in such a way that the startup successfully navigates the path it must travel between being a startup and becoming a company. Cost advantages due to capital are determined by external sources of capital – potential outside investors and sources of trade credit, and internal sources of capital – existing capital raised from investors, financial management of money the startup expects from its users or customers and money it owes to the vendors and business partners with whom it has a working relationship.

Key Considerations for Efficient Scale

Here I am assuming that the investor has determined that the startup’s customer or user acquisitions costs will most likely decline over time, or in the worst case scenario they will stay relatively flat.

How I think about efficient scale for an early stage startup is closely linked to the concept of product-market fit. An early stage startup is approaching the product-market fit milestone when demand for its product at a price that is profitable for the startup’s business model, begins to outstrip the demand that could have been explained by its marketing, sales, advertising, and PR efforts.

When I am chatting with startup founders and I am trying to explain this concept I use the analogy of a cyclist on a steep hill to represent the founder’s startup. It’s probably a poor analogy, but I think it gets the point across in a way that is easy for them to internalize.

Before Product-Market Fit (BPMF) everything takes a lot of effort. Every sale is tough, everything that can go wrong will go wrong, and most of the sales deals will fall apart for reasons that are hard to explain. The cyclist is pedaling very hard to get uphill, and even maintaining balance on the bike is quite a challenge. Every breath brings with it the possibility that the cyclist could fall off the bike. With luck, the cyclist makes it to the top of the hill. Then, there is that moment when the cyclist senses that it is possible to keep going without as much exertion as it required to get to the top of the hill. Now the downhill journey begins. Gravity kicks in. The bike is gaining momentum even as the cyclist is frantically trying not to careen off the path. The cyclist’s exertions are now focused on skillfully applying the brakes at sharp turns and corners on the way downhill, and speeding up when then the path is straight and clear of obstacles. If this is a race and there are other cyclists ahead, then our cyclist must also focus on overtaking then one after another, and must also avoid getting caught in crashes caused by other cyclists in the race. After Product-Market Fit (APMF) demand for the startup’s product threatens to outstrip the startup’s ability to meet that demand. This is when a startup must scale, and scale fast and efficiently. There are two reasons to scale at this point. The first and most important reason is that there is demand for the startup’s product and the startup should meet the demand from its users or customers. The second reason is that APMF is also the point at which copy-cat competition starts to materialize from new entrants, and possibly from incumbents too.

Efficient scale means different things at different points in the startup’s lifecycle: The way a team of 2 co-founders scales the startup’s business is much different than the way that same startup will scale its business when the team has grown to 20 people. In other words the way to pursue scale BPMF differs markedly from the way to pursue scale APMF.

Premature scaling seems great initially, until it leads to startup failure and death: The Startup Genome Report Extra on Premature Scaling reports that startups that scale prematurely tend to start scaling earlier than startups that do not scale prematurely, they often also raise 3x as much capital and have valuations 2x as high as startups that do not scale prematurely. This trend continues till they fail. Also, 74% of startups scale prematurely. I will not go into the details of that report in this post, because I covered that in Notes on Strategy; Where Does Disruption Come From?

The cadence of hiring is important: BPMF hiring should be slow, deliberate and methodical since it is not yet clear what new team members will be working on and if what they will be working on is relevant for the startup’s overall success and longevity. APMF the challenge is to hire the right people for the startup as quickly as is necessary to keep up with demand, and cope with competition. For this reason building sound and cost-advantageous systems & processes, and modifying them as the startup grows is important. Startups that scale prematurely, and then fail tend to hire more people sooner in their lifecycle than startups that do not scale prematurely.

Technology-enabled scaling wins: Whether a startup focused on consumers or enterprises, it is important for the founders to think about ways in which technology can be used to enable and support the scaling process. This should go beyond the obvious area of gaining new users or customers. Rather, as the startup scales thought should be given to how it ensures that:

• Teams do not become too large to get critical work done quickly, and that they have the tools to promote communication and collaboration once the startups physical layout is taken into account.
• Customer or user acquisition is not slowed unnecessarily by a failure to account for what customers are willing to do in order to get the product.
• Sales and revenue generation is not hobbled by a failure to use tools that will make salespeople as effective as they can be, given other existing constraints.
• Operations can seamlessly transition from one order of magnitude of scale to another without a deterioration in customer or user satisfaction.

Culture makes a difference: All things being equal, startups with a strong culture will scale more successfully than startups that do not. Why? Culture ensures that as the startup grows by hiring new people, the entire organization continues to solve the problem the startup set out to solve in a consistent manner.

Eventually, most founders must also become managers and coaches: It gets to a point where the founders job evolves into one of mainly facilitating and enabling the work of other people, setting strategy, nurturing a vision, and managing a team of executives. This is how founders gain managerial leverage. Not every founder is cut out for this. Some want to remain as close to building the product as possible because that is where their passion and drive comes from. I prefer founders who are self-aware enough to know if they want to remain close to building the product, or if they want to make the transition from building things to managing people, and setting strategy. Usually, this is not an issue at the Seed or Series A stage, where I am most involved. Still, I like to get a sense of what might happen. I’d rather not invest if this could become an intractable problem before the startup has reached escape velocity.

This wraps up my main posts about economic moats.

As a sector, technology is notorious for being one in which economic moats are hard to maintain. However, every tech startup that was able to build a wide moat around its business earned fantastical returns for its earliest investors. Many have also had a lasting impact on how people live life, and how the businesses that use their products get work done. You would recognize so-called “wide-moat” or “narrow-moat” tech companies if I mentioned names. You might also recognize the “no-moat” tech startups that initially seemed destined for great heights, but then were dragged back down to earth by a combination of market forces.

In either case, I will be thinking about economic moats almost daily.

Further Reading

1. Scaling Up Excellence
2. Traction: Get A Grip on Your Business
3. Scaling Up: How A Few Companies Make It . . . and Why The Rest Don’t

1. I am paraphrasing Steve Blank and Bob Dorf, and the definition they provide in their book The Startup Owner’s Manual: The Step-by-Step Guide for Building a Great Company. I have modified their definition with an element from a discussion in which Paul Graham, founder of Y Combinator discusses the startups that Y Combinator supports. ?
2. I do not include Materials and Supplies under this discussion because I do not think that is a sustainable source of cost advantage for an early stage technology startup. ?