startup moats

Figuring out the business strategy for most startups is a hard problem, should there be a focus on users, conversion, margins, licensing, etc? These are all operational aspects that can be changed and adjusted over time and unfortunately these are the primary areas of concern for most startups. What is missing is figuring out where the startup fits in the overall picture, what is their strategic advantage relative to other businesses (young and old)?

I came across this tweet by Brad Burnham from Union Square Ventures, they clearly get the question about strategy and have formed an investment thesis around this understanding.

USV in 140 characters: invest in large networks of engaged users, differentiated by user experience, and defensible though network effects

— Brad Burnham (@BradUSV) June 8, 2011

Looking at USV's track record, they appear to stick to their investment thesis and it is clear that the companies they invest in do have this moat that Brad describes "defensible through network effects".

Of course businesses with moats like this are not the only great businesses in the world, but when you look at a business like twitter or Facebook it is easy to see the moat they have built. Does that mean they will always be able to maintain their moat? NO... look at MySpace for example, they had the same moat that twitter and Facebook have (the same moat that USV invests in). The problem for them was they didn't recognize this moat, instead they allowed their moat to get smaller and smaller by allowing their network dynamics to change.

There are alternatives to moats of course, the primary alternative being operational advantages (lower operating costs, higher margins, unique processes, etc.). Look at this map of strategic competition from Bruce Greenwald's Competition Demystified: A Radically Simplified Approach to Business Strategy
and carefully think through where your business or a business you are investing in falls. Does the business have a competitive advantage? If so, what is the competitive landscape like? Are there other firms with similar businesses and other competitive advantages? Do you have a competitive advantage (like MySpace had) that you need to manage above all else?

strategicCompetition

On the other end of the spectrum, do you have no competitive advantage, but have a method for managing operational efficiency? Are your costs lower, your margins higher, etc? These can be good businesses as well and you see companies on this side of the spectrum continually trying to gain more efficiencies and small competitive advantages. Look at the FedEx/UPS strategy - they compete on efficiency and cost and continually try to add advantages (although there are no barriers to entry for the other).

The third business type that isn't listed here and unfortunately is the most common in the land of internet startups are those that have no competitive advantage and no operational efficiency. These are businesses that are only interested in developing a product and gaining traction in a shorter time than a larger firm could. These are not startups like LinkedIn, these are startups like Picnik. Where the product itself can easily be replicated, yet a larger firm could acquire the startup business for less than it would cost them to build the technology themselves. Designing businesses for this type of rapid exit is tough as the barriers to entry are very low and virtually anyone can build a competing business with the same product in the quest for acquisition. Think of these businesses as circling the words "All Markets" in the diagram above waiting for an acquirer to scoop them up and take them in a ride in either strategic direction.

As you think about your business or a business that you are looking to invest in (regardless of whether that business is young or old, private or public, large or small), think about where they fall on this spectrum and how well you believe the operators of that business can execute on maintaining that location in the spectrum.

 

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