There needs to be a division between the companies depending on whether they posses a competitive advantage (s), unfair advantage (s), or defensibility features. I dare to make three categories:
- a) Weak, defined by owning only “competitive advantages”. Their growth is capped. Highly susceptible to competition. As a result, they may go out of the market in the shortest period. Though they can generate a nice profit during its time-being.
- b) Strong, manifest one or more “unfair advantages” along with “competitive advantages”. Has a sound standing against other competitors until its unfair advantage (s) is valid. Yet, it is not bulletproof to the competition. Strong companies usually have linear growth, no revenue cap. With proper management, business models/ideas can turn a company into the defensible one.
- c) Defensible or Economic Moat. A company dominates the competitive landscape. It can stay profitable for a long time and has the necessary prerequisites for exponential growth. Depending on the sectors of the economy the company operates within, defensibility comes either from owning one or several defensibility features.
Specifically, such defensibility features as brand and barriers to entry are very case-specific. In most cases, we cannot regard them as the only factor to build a defensible business. But in connection with the other defensibility factors – their equity multiplies, business growth compounds, turning them in the true Economic Moats.
Please, follow me on Twitter: Follow @aynur_nuriev
Introduction to “Competitive Advantage”, “Unfair Advantage”, and “Defensibility”
If you looked at key features the startup accelerators (e.g. Y Combinator, AngelPad) or VCs seek in tech companies, then you would notice that «defensibility» is the most popular one. According to the Webster dictionary, it means – «capability of being defended».
To put it simply, defensibility refers to one or several traits of the product that protect it from competitors, copy-cats, analogies. It is a guarantee for the exclusivity of the solution a company offers or promises to deliver that will outperform any other on the market on the long-term time horizon, let’s say 10-15 years at least. Defensibility applies equally to other markets, be it DTC, manufacture, or services.
There is a debate among the founders operating in different sectors of the economy as to the nature of defensibility. How can we define it? To answer this question properly one needs to discern the terms «competitive advantage», «unfair advantage» (or exclusivity as some put it) and «defensibility» as many people mix or conflate one phenomenon with another. For the sake of fairness, sometimes a «competitive advantage» may become an «unfair advantage», and «unfair advantage» progresses to the «defensibility» which is an organic prerequisite of the Moat (or as business people call it an Economic Moat).
A brilliant way to understand the nature of the said dynamics is to refer to some sports examples before diving deep into the traditional business analysis. Imagine, Arsenal FC (London, England) won the opponent 4-0 in the first round (1/16) of the English League Cup. In the away-match, they can let their bench-players or youth play the game, as it is highly unlikely the opponent will recover from 0-4. Let’s say we have Tottenham Hotspur (London, England) which played 0-0 in the first game of 1/16 round and won the second one 2-1 in a very nose-to-nose game but could advance to 1/8. Given both teams of similar quality, it is likely that Arsenal beat Tottenham in ⅛ finals because they have more time to properly train and recover. This is an example of a specific “competitive advantage”.
Now, assume, Cristiano Ronaldo joins Arsenal FC on a 4-year deal, i.e. for 4 seasons. This means the club will probably advance to ⅛ round every single season or even quarter-finals. But even he alone will not avail the team to advance into, let’s say, semi-finals or finals. Along the way, Arsenal FC will be able to bolster its revenue stream by capital infusion from the increased sales of merchandise, tickets, and tv-rights (yes, Cristiano Ronaldo is very popular!). Here, Cristiano Ronaldo is an “unfair advantage”.
Finally, let’s switch on a time-back machine and return to 2008 when Josep Guardiola joined Barcelona FC (Spain) as a head coach, the club already had such players in its roster as Lionel Messi, Xavi, Gerard Piqué, Carles Puyol, Samuel Eto’o, Dani Alves, Sergio Busquets, A. Iniesta, Eric Abidal, Pedro. In his debut season, Guardiola won all three trophies available. After a winning start to the following campaign in 2009/10, Barcelona became the team of the Six Trophies, all won in the calendar year of 2009. The run of success continued with Guardiola claiming 14 titles of a possible 19 as a coach in his four seasons in charge. Guardiola and his Barcelona became a benchmark for modern football success. During almost 5 years they have dominated the world football market completely and remain on the top tough with some turbulent results. That was a “defensibility”.
What defensibility was based upon?
- Team. The roster of talented players and the legendary coach.
- A highly qualified club’s management team.
- La Masia – the Barcelona youth football academy where from all its stars came from including Puyol, Messi, Iniesta, Xavi, Busquets.
- Capital. Having won the La Liga, Spanish cups, Champions League and other competitions generated a massive amount of prize money. The popularity of the club and its players turned into the cash-generating machine from tv rights (very high price tag for rights), merchandise (globally), ads contracts, tickets sold outs, etc.
- Generated revenue helped to maintain the star players on the contract and attract new talented youth, buy established stars (or even buy out rising stars from other teams) to accompany the star-squad, and continue to dominate the league.
- The more money and better players at Barcelona FC meant less money and less talented players for the competitors to acquire as an asset to strengthen their teams.
- The bigger popularity of the team, the more youth players want to get into La Masia football academy. The trials are highly competitive. It would be fair to say – the academy sifts the best junior players all over the world that try to apply, who subsequently might turn into next stars and strengthen the team more.
Some real data/statistics for your consideration. If the club reaches the group stage in Champions League in season 2019-20, it receives 15 mln. Euro. Each extra round of the competitions adds more money: 1/16 + 9.5 mln., ¼ +10.5 mln., ½ + 12 mln., final +15 mln, win the final + 4 mln. Overall, the team can aggregate up to 83 mln during this very tournament. UEFA will also pay teams 2.7 million euros for every match they win and 900,000 euros for every match they draw. And this sum does not include revenues from TV rights and other contracts. Add to this prize money from national championships, national TV rights, sponsorship contracts, match day revenue, merchandise on a global scale. One can see the point – it is very difficult for competitors to fight a fair battle with the team which has so many resources working as a smooth mechanism for its future success yearly, creating a compounding effect.
|Prize money for La Liga, season 2016-2017|
|Prize money for La Liga, season 2015-2016|
|1||FC Barcelona||€140 million|
|2||Real Madrid||€140 million|
|4||Atletico Madrid||€42 million|
Please see Figure 1 below.
Had a pleasure to receive feedback on this football analogy from the legend investor Josh Wolfe, and he makes two great points.
It is indeed very true. Sometimes clubs can buy a player who either gets injured or disappoints in terms of his quality of play.
Now, to put it in the business like context, competitive advantage helps your company to succeed in the short-term but does not guarantee you stay there. Unfair advantage gives you the chance to get even to the top-tier of the market and hold there for some time. Defensibility helps you stay there for long, usually dominate the market, buy out the competitors if there is a need, generate massive revenue and put it in R&D, and continue to stay on top of the innovative curve.
From an economic perspective, the logic here is simple. If there is a demand for the product -> the market exists already and people/customers satisfy the demand somehow. The existing supplier is our competitor. For a customer to switch from the current supplier to your company, our product/service must be better.
To be better on a marginal scale of 10-15% is not enough, you’d have to be better 5-10x (it can be one or different features in totality). Only in this case, people would start changing their consumer behavior and flocking to your side. Now your competitor sees the looming threat, and it comes up with a bunch of solutions, maybe just copying your approach. If your existing advantage is subject to easy coping – then you to lose your market share again to the old competitor.
To avoid such a fate, one needs to have an unfair advantage, i.e. the fence which protects your business and helps to keep it afloat with expected profitability. However, there might be still a room for the competitor to bounce back to the top unless you build defensibility. As mentioned earlier, it could be built upon the existing unfair advantage or overlap that.
So I would like to take the following stance on the matter:
Let’s dive deeper into each category.
Technology as a category may encompass many competitive advantages pertaining to the product itself, services, operation processes, etc. For example, a grocery store with self-checkout terminals would be in a better position than its rivals with employees at the cashier. This way the former can process more people, decrease the expenses on the salaries, increase NPS of the customers as they won’t need to stay in the lines. Amazon Go stores is an explicit example of even a bigger leap in this direction.
Innovation is closely linked with technology, but here I refer to out-of-the-box thinking about finding a solution to the customer’s problems. Take an example of CraigsList where one can find a supplier of almost any product or service. However, people saw an opportunity there and unbundle it by going deep in one vertical/category. It is the same technology so to speak, a customer uses the Internet to find and buy a product or service on CraigsList, but spin-off companies offered users a better experience and a wide pool of relevant products. That is they innovated. E.g., look at the «Sale – Tickets» category on CraigsList, and from that point, SeatGeek launched with a platform dedicated only to event organizers and tickets buyers.
Experience is what customers feel when interact with the product or service. Disney animation parks are a superb example if we talk about household brands. Children and parents know that if you go to Disney park, you will get an amazing experience by immersing in Disney universe with different fantastic heroes (e.g. from Marvel), shows, and quests. Looking down to the level of e-commerce, one can take, for instance, any decent DTC brand which has a high-quality packaging & unboxing experience for its products. Haus Drink is what comes to my mind when I think about eye-catching unboxing (photo credit goes to Nik Sharma). The bottom line here is that customers have «wow» experience when they interact with the company’s offers, which makes the company stand out among its peers or competitors.
When a company can adjust its offering to a customer’s specific needs, it might outperform competing suppliers. Customization has gained significant traction in the past decade, as many companies saw a competitive advantage. Consider such a niche as woman’s underwear. For years the manufacturers produced only fixed sizes and forms of bra disregarding the natural specifics of women breast, as a result for some of them the bra would be ok, for next – tight, for another – loose, though in all cases it was, e.g. size M. But then some companies and founders recognized an opportunity in this pain point and started using either smart materials/fabric which organically aligns with women breast, or offered customization depending on the exact measurement the women were required to submit and so on. Once it was done, they got customers turned into raving fans and a cash-generating business.
I reckon for some of you it might look similar to customization, but from my perspective, it is a different beast. Personalization is more about the marketing side of the product rather than its functional nature. It helps to add a personal touch to brand-customer interactions. Do you remember when Coca Cola put popular names of local people on its drink cans. E.g. in the USA, it was like John, Steve, Frank; in Spain – Carlos, Pedro, etc. It was spearheaded in the eve of the FIFA World Cup 2010 if I am not mistaken. Then, other FGC brands applied the same approach. On a smaller scale, compare two bakery stores/producers. The one which produce and sells standard cakes, and the other which can add the name of the birthday-hero on the top of the cake if requested by the customer. It might cost a bit of more in price, but it adds so much to the birthday-hero, especially for kids, and subsequently for parents turning them into loyal customers, and thus lead to a higher LTV of a single customer.
We might discuss scale from different perspectives that depend on the sector the company operates in. For instance, Burger King has a wide net of cafes spread around countries and continents. For such a scale of operation and its big market share, Burger King may a) decrease expenses on raw materials as it buys it in bulk for significantly lower prices from the manufacturers; b) it can decrease the expenses on opening a new franchise as they have developed a handbook on how to do it fast and efficient; c) decrease in price leads to a possibility to lower the prices of the products for customers and focus more on quality or marketing, etc. The point is when a company has a scale it can operate on another level, often disregarding local competition.
If we turn our attention to tech products, there are many unicorns of this category be it Lyft (taxi service), GrubHub (delivery), DigitalOcean (server, storage), etc. The bigger they got, the more market share they pulled into their hands, became more profitable (given their unit economics is fine or expected to be fine once reached a certain point of scale).
It is one of the most important elements of business success. An exceptional team may bring much value to the table-turning a loss generating company into a cash machine. The history knows many examples thereof. The one I like the most is a story of “Teledyne” company under Henry Singleton who turned local radio station business into a national media juggernaut in the USA; as a result, the stock of the company outperformed the S&P index like almost 20x times. Surely he did not do it alone but gathered A-team to whom delegated the execution to “the level of anarchy” (c). I cannot recommend more to check out the book “8 unconventional CEOs” by W. Thorndike and this deep-dive analysis.
8. Variety of offers
When a company may offer customers more options to choose from than its rivalry (given the products or services are of a similar category), the former will highly likely get more traction, customers, and revenue. The logic here is that if a customer can go to one place and buy everything he/she needs within the particular category of interest (e.g. food, apparel, home appliances, etc.), then it will be done by most of the target audience. Again, examples are everywhere, be it Costco (food), HomeDepot (electronic devices), Farfetch (clothes), etc.. It is difficult for local shops to compete with them in terms of inventory, as it incurs more capital infusion, more retail space, etc, which they cannot afford in comparison with supermarkets that operate on the economy of scale.
9. Customer Service
Efficient and timely assistance executed by company personnel may easily become a clear competitive advantage, especially in the industries where switching costs for customers are not material (e.g. clothes stores, pizzerias, IT products and services). That is if a customer’s inquiries would not be addressed systematically or addressed in a way that the feedback gives no value on the matter – a customer may withdraw from a company and go to another supplier. I reckon many of you have witnessed it within your own buying experience or word-of-mouth. it specifically true for local businesses, subscription-based businesses, where each customer is of great importance for the company’s profitability in the long run, as no one wants to have a high churn rate. It is of no surprise that the customer support became such an enormous market that cir. 50 noticeable technological companies offer their own solutions to manage the customer’s inquiries (e.g. Zendesk, HubSpot, Zoho, Intercom, Drift, Olark, etc.).
For a traditional retail business, there is a mantra – «Location, Location, Location». The better the location, the higher traffic of customers you have, whether it is grocery stores, cafes, beauty salons. A retail space on Time Square Garden in New York – having bought it once you are guaranteed to get lease payments almost forever (save for such «black swans» as COVID-19) because the human traffic will be almost always high and permanent in that location. Or if an owner does not want to lease the property, it can open his/her own retail spot out there. The same is true for manufacturers, as it is significantly more efficient to deliver goods to the customers when the production lines are near the target audience, especially for perishable products. Location is also important in a greater context of the overall environment for business development. It is a fact that Silicon Valley (CA, USA) has produced the sheer volume of the most iconic tech companies in the modern era. They have better access to talents, capital, advisers, research, international markets etc.
11. Brand / reputation
Every brand building is based on reputation. Small, early-stage companies do not yet have a brand, they only have a reputation. It might be any on the scale from «1-10» for which NPS (Net Promoter Score) is attributed. Excellent reputation induces a word-of-mouth effect and attracts more customers without paid marketing. Word-of-mouth is the very top reason new referrals (advised by friends, colleagues, etc.) buy a product or service. With time, we may build a reputation into the brand. The brand is a strong association of the product with a specific company in a customer’s mind. The bigger the company, the more difficult to sustain an excellent reputation and a powerful brand. Many books and articles have been written about the topic. The bottom line is that brand building takes time and resources to maintain its power on the market. Just imagine that The Priceline Group, the owner of Booking.com spends about 2 billion dollars per year on paid marketing and brand promotion.
12. Supply chain management
Having a stable and efficient supply chain and logistic operations can make a company a big favor in terms of its standing on the market. COVID-19 pandemic showed it explicitly. Those companies which had supply chains entangled with storages and manufacturers in China had suffered significant delays in delivery time. In opposite, the ones with manufacturers within the country, e.g. in the USA, had no problems with the timely delivery of the product to end customers.
Given online-shopping grew up 12% globally during the coronavirus lockdown measures, I reckon some online brands have eaten up some market share from their traditional competitors. However, even in normal times, the supply chain is a significant element in the company’s success. For example, Inditex, owner of Zara, has excelled in logistic operation on a global scale and known as a textbook case study, be it in Harvard or Stanford and other business schools.
Having protected intellectual property might be a good competitive advantage if it actually adds value to the product or service and solves customers’ problems hastily. There are thousands of patents for a product which have long since disappeared or just laid still without practical implementation. Likewise, there are plenty of examples when patents really drive the company’s bottom line. For instance, IBM and Intel, the manufacturers of microchips and computers, both have tons of patents that protect their property from coping.
Or The Walt Disney Company holds thousands of patents, copyrights and trademark rights for its licensed properties, be it names and images of the cartoon and heroes, movies, songs, other audio and video content.
It is worth noting that patents in the tech industry, meaning in the software and IT services & product development, have become less important. As companies can usually re-create each other products if they wish to and had the necessary resources (team, capital).
14. Mission and Values
The mission and value of the company can really stand out on the market not only for customers but also for potential employees, partners, investors. When we refer to mission and values, one usually thinks about non-governmental organizations like Red Cross, Feed America, etc. But those features are equally attributable to commercial companies.
People buy Tesla electric cars because it does not use petrol and thus helps to reduce CO2 and save the planet. Highly professional engineers work in SpaceX despite getting sometimes market average salaries or even subject to burnouts during the work (check Glassdoor reviews for that). Why? Because people wanted to be a part of something significant, launching a spacecraft into space. Certain DTC brands, especially in the beauty industry, also base their commercial strategy on a mission – e.g. to use only organic products, to use products from Africa’s merchants to help them strive, etc. Such an approach attracts customers’ attention.
15. Local partnerships
Anyone who has ever thought about or started doing business in MENA countries, e.g. in the United Arab Emirates, knows that if to run a business in their country one needed to have a local partner before 2019; in 2018 the regulation was changed and they allowed it to have 100% foreign ownership in certain sectors of the industry. So if a company thinks about expanding its business operation into the UAE market, which is very attractive, for example, to many luxury brands (because of high GDP and income of locals), it would need to have a local partner to proceed.
16. Buzz / Hype
If a company or its founders can exploit buzz or positive hype in the media to the benefit, it may become a real competitive advantage over the rivals. Imagine if tech influencers be it TechCrunch or VentureBeat or media household names like Forbes, Entrepreneur, Inc., tell the story of your brand in bright colors, – it will induce a high volume of traffic and customers. It helps to get traction faster, raise investors’ money easier, hire talented employees, etc.
17. Relationships / Customers
Having great customers may help in many ways. For starters, their testimonials may help in promotion as social proof, induce word-of-mouth effect, and bring additional revenue. Sometimes, having even one good customer is a substantial competitive advantage.
Imagine, you have developed a new tech product that tackles the automatization of grocery stores, and you need a nationwide franchise supermarket with many stores to pilot-test it as to how it would work on a scale. Partnering with such a franchise store gives a company advantage against the rivals as the former will have test results, customer feedback and may update the product to customer needs, thus increasing its value for other customers.
For instance, Grabango, started by Pandora cofounder Will Glaser in 2016, and raised $12 million to expand its “cashless store” technology. Grabango signed four U.S. customers that collectively serve 600 million shoppers per year.
18. Labor costs
Many companies gain competitive advantage by reducing the labor costs for production or manufacturing goods, deliver services. It is common practice now for clothes, machinery, electronics and many other things to be made in China, India, and other low labor costs countries. This way companies push cheaper products on the market, or in the opposite, put the same prices as their competitors but just get more profit margins.
The reduction of labor costs nowadays touches almost any sector of the economy.
II. Unfair advantage
In the previous chapter, we have discussed the competitive advantages companies may have to get ahead of their competitors on the market. But matter-of-factly, any competitor may level the playing field by reaching out to the same competitive advantage as they are reasonably easy to gain. Yet, sometimes, a competitive advantage may grow into an unfair advantage which a way harder to build for the company. For example, Patents, Team, Buzz/hype may really become an unfair advantage.
Let’s say a company has a successful media business with a portfolio of high-traffic online media outlets or/and print media magazines, – then this company internally builds a new IT product, e.g. a digital publishing platform for convenient content management, and use its own media outlets as a) a customer; i.e. finding product-market fit; getting feedback from the writers and content managers; that is the way for a faster customer development; (Team) and then b) use the media outlets to promote massively (Buzz/Hype) the newly launched and fully tested IT product. It gets quick traction, new customers, and revenue. Is it easy for a newcomer with a similar idea to break into the market and compete with the media resources of the rivalry – no, it is not, not even close. Possible? Yes. But it would be an uphill battle to fight, at least at the beginning.
The said example relates to the actual case of Chorus, content management, and publishing platform, developed and used internally first for such household outlets like Vox, Recode, etc. and then offered for a third party use for a high-ticket price.
Or let’s talk about Team. Do you know that Airbnb has so many (50+) alumni (early employees) who have gone to pursue their own projects after Airbnb and founded different but successful companies (for instance: Coinbase, D2iQ, Flo, Future.fit, Tourlane, etc.). They call this phenomenon a «mafia», i.e. Airbnb mafia, Uber mafia, PayPal mafia. That is people who have worked previously for globally successful businesses, get experience, and then launched their own companies.
I am driving at the point that Airbnb had a top-tier team, and that is why they outplayed, outgrow and sometimes acquired almost all of their competitors in the first 1-3 years (and there were about 100+ similar platforms at the time). Is it an unfair advantage? – you bet, it is. I cannot stress enough how much your team means for the success of the company business.
There are plenty of other examples in history when the team had impacted the growth of the business the most. Before Bob Iger joined Disney as CEO in 2005 when it was a sinking ship in the entertainment and media industry, but after some 15 years in with the help of Iger and his A-hires for specific departments the company turned in multi-billion corporation (the stock price raised cir. 10x times), with YoY growing cash flow, tens of new Disneyland parks, acquisitions (Pixar, CNBC, ESPN, etc.), and global audience of target customers.
However, there is also a list of the unfair advantages which, in my personal view, do not stem from competitive advantages but are created on its own. Let’s dive into some of them.
1. Exclusive contracts / protected territories
It happens, for example, when a big company signs an exclusive contract with a supplier and requires that it will be the single company that sells specific products on the agreed territory. As a result, if the customer wants to buy the products manufactured by the said supplier/brand – they will have to buy it from this very company and nowhere else.
For example, International Olympic Committee and Visa (payments) signed an exclusive agreement according to which only Visa cards could be accepted by merchants that run their businesses on the territory of the Olympic Games (such territory is usually the sports event location itself and like 10-15 km around them; this is being enforced legally by exclusive agreement between IOC and Host Country Government). As a result, when a sports fan comes to the event and wants to buy something from the merchant, he would need to use a Visa card only.
Similar way the franchise network works when, for instance, McDonald’s sells only a limited number of licenses to third parties to open its restaurants on a specific territory. If a customer wants to buy McDonald’s products, she/he will have only one place to go within its geography. Overall, the economy of scale also applies here. Everyone knows that, for example, prices for burgers in McDonald’s are cheaper than in other burger restaurants of a similar level. Why? because McDonald’s operates on the economy of scale: can buy raw materials in bulk, have the technology, brand, etc.
2. Access to capital
In certain cases, access to capital can make a company number one on a particular market or even globally. This was the case with Uber, Square who could raise big money from venture investors regularly, although the former is not even profitable so far and still operating to reach its break-even. Access to money can help to hire the best talent, pay above the market salaries, acquire smaller rivals, even subsidize the price of the product or services to the customers, and thus grow faster.
Like in past years, Uber just offered 50 USD for a ride to each customer who would install its application, burning tens of millions of dollars per week sometimes. One exceptional book I can recommend here is the Super Pumped: the Battle for Uber by Mike Isaac if you want to know the details of its growth and underlying story.
In the retail market as one of the traditional sectors of the economy, those companies that have a cheap credit line from a partner bank can get sizeable amounts of money and speed up the growth of the company, pushing more rivals out of the market along the way. Capital can really help to build a fundament for defensibility of the company if there are other necessary elements in place already such as a high-quality product, product-market fit, team.
3. focus/niche exclusivity
A small company can feasibly outperform a larger rivalry by going deep into a specific niche or focus. Customer will always choose a solution which caters for his/her particular needs rather than for a general solution which usually offers a half-baked product that addresses some customers pain-points. Such niche companies usually dominate first search results in Google, Bing, local search systems like Yandex (for Russia), because they use many long-tail keywords. For example, you can go searching for houses on Craigslist or sites of different real estate agencies or use Zillow to review the houses and current prices. If you look for organic products you would go to Whole Foods rather than to Walmart. It would surprise you how much cash such niche companies generate and outperform generalists.
4. Speed / First-to-Market
There is a popular saying «If you cannot become a number 1 in the category, create your own category». Speed helps to create a new category, become a leader there within, get a bigger bite of the market (e.g. sign exclusive contracts with counterparts) before competitors emerge. Speed helps to build a perception in the minds of your future customers that you are number 1. Perception is reality.
Speed means to work faster over the product or service and thus, ship more frequently, get feedback from the customers, adjust the product, rinse and repeat. And eventually to release or build such a product that wows the customer and gets much traction. Speed is one of the most important traits the tech company may have. Booking (.com) was one of the first in the travel booking niche back in early 2000. Now it is a behemoth that fears no one. How to increase vertical jump.
I have covered Brand in the previous chapter, but it can easily become an unfair advantage. Brand build an association with the product in the minds of the customers. Once these bonds are solid – it is very difficult to break it down. McDonald’s have been as profitable as ever with his reputation of «fast food» company at the time when there was a huge hype of health & fitness trends in the last years in the USA. Like if you were in California in the last couple of years, every other person would talk about gluten-free, sugar-free products, keto diets. Yet, it did not affect Mcdonald’s brand much, though they adjusted their menus to organic foodies.
If you like mineral water, you know Evian as one of the best mineral waters on the global markets. If one talks about car safety – you go to Volvo. Some brands become a verb and are used by people in their daily life, e.g. Google – to google smth; you do not say give me a napkin – you say pass me Kleenex. Or think about Balenciaga, luxury clothes and apparel brand, whose wallets from alligator leather cost upwards of 600 USD. However, if you check out some YouTube videos, you would see that the same product might be handcrafted for 30 USD. This what brands do in terms of customer perception. A brand may become a part of defensibility, however, brands alone do not lead to Moats (we will come back to this later below)
Content is another important factor that can become an unfair advantage. It could not be more clear in the modern world when everything is about its consumption and distribution. I like the phrase of Gary Vaynerchuk who says that «to succeed today every business has to become a media company».
In different sectors of business, the nature of content differs. For example, Zillow aggregates tens of thousands of listings of houses and apartments for sale, social media giants like Facebook, YouTube, Instagram has its own content – posts, videos, photos; NBA produces millions of games highlights per month for a consequent distribution all over the globe, etc.
Apparently, if a company can become a place-to-go for users to find unique content, they can grow exponentially within the shortest period from the launch. Content may take material things, applications, outputs. For instance, content for 3-D printers is unique, one can print clothes, construction materials, human body elements, etc. Thus, the company which produces content for 3-D printers is in a powerful position from the start. In art, content has a different appreciation. Paintings of popular artists like Andy Warhol, as a piece of exclusive content, would always draw buyer’s attention. Thus it will probably get increased in price regularly with time passed.
We have covered location earlier, but it would not be excessive to remind that location might become an unfair advantage. For example, American Electric Power company has almost a monopoly position in Arkansas (under the brand name of Southwestern Electric Power Company) while in other US states there are plenty of other electricity providers to choose from. How likely its position stands strong for a way forward? – Highly likely. Because even there is another electricity supplier in Arkansas, Energy Arkansas, it does not have a household name and resources behind its back as AEP does.
Or for the tech industry, Silicon Valley is a premium location for tech companies with direct access to capital (VCs), talent (e.g. Stanford), advisers (hundreds of founders with successful exits), overall networking (thousands of startups), YC Combinator alone does a great job to promote Silicon Valley.
Patents in the manufacturing industry, pharmaceuticals, hardware, software, home appliances are the most popular categories of products where patents play a significant role in protecting companies’ interests, market share, and overall profitability from the competitors and copy-cats. Though in certain countries it is difficult to protect IP, like in China, it is still a potent weapon in the company’s arsenal.
9. Exclusive distribution channels
If exclusive contracts/protected territories apply more to the traditional businesses, this one – more to internet products and services, though it might be equally feasible and for other markets. For example, Expedia Group as far as I am concerned owns partially or in full 23 travel brands including Expedia.com, Hotels.com, HomeAway.com, VRBO.com, BedandBreakfast.com, Abritel.fr, Fewo-direkt.de, Trivago.com, Travelocity.com, Orbitz.com, Wotif.com, and some more – please, see a detailed brands overview of Expedia group here.
So when Expedia pushes paid marketing, SEO marketing for its umbrella sites (apartments, tours, tickets, cabins, luxury villa, etc) – it is just “burns out” the whole field of paid keywords in Google, local search engines, social media channels – and a customer knowingly or not – lands out on some Expedia Group sites. For fairness, Booking Holding (ex-The Priceline Group) does the same. I reckon the examples above are the showcases of true defensibility. I just wanted to show how owning the distribution channels may become an unfair advantage, and in certain cases even defensibility feature.
10. Customer base/ Trust
Sometimes, a company has a very loyal customer base that trusts in the company, its products, executive leadership, reacts with a top NPS score, keen to make referrals, and take part in word-of-mouth. The very customers about which a company might have aggregated detailed information throughout the years of operational activity. As a result, it becomes a valuable asset one cannot gain easily and almost never in a brief period.
In this context, customers are not only like retail buyers but also partners who trust the company, have been in business together for many years, formed strong win-win relationships. There are plenty of examples in history when such relations based on trust have spearheaded an exponential growth of companies, saved from epic fails etc.
For example, there is an accurate story from Russia about a mattress manufacturer company called “Askona” founded by Vladimir Sedov. They started in the late 1990s in Russia. In 2006 they have been #1 already, produced millions of mattresses, and distributed all over the country generating tons of cash. However, in about this time their factory was set on fire and it burnt to the ground. Huge losses, enormous debts, huge potential layoffs. And almost no savings as everything went into the expansion and extra production lines.
However, one of the C-executives of the partner-company from the USA (who supplied equipment lines to produce mattresses to Askona) vouched for Vladimir Sedov by putting his money, house, and real estate assets as collateral (though Sedov did not know about this at the time, just imagine!). Askona could reassemble the entire factory in 3 weeks with extra equipment and started production within shortly. In a year they paid out all debts, credits and delivered on other obligations, reasserting themselves as #1 on the Russian market. They became the exclusive manufacturers of many renowned brands on Russian territory. Would it be possible to build from scratch such a factory without trust, partnership, and established through years partnerships (distribution, delivery, sales representatives (remember, it is 2006, no internet almost), customer base)? -No, it would not be. But it happened.
|After Photo credit: gorodkovrov.ru|
11. Inside information / Personal connections
Sometimes having close connections within the industry may become a significant advantage over the competitors. One need not go far to come up with a real-life example – the finance world. Inside trading is the beast, though we might frame it both as legal and illegal. The former – when you have representatives in many parts of the world and you get information firsthand, faster than competitors and act accordingly. The latter – when one trades using inside information in violation of legal rules.
12. Platform exclusivity
Platform exclusivity means that once a customer buys a particular product and gets tied up to it by any means, he/she will unlikely to change the product for another one soon. Though a customer can switch the product or service, it is not an issue of price usually, it is just the matter of “need/ no need; make sense / makes little sense”. For example, having purchased Sony Playstation, one would unlikely consider buying Xbox in the short term. Though, in most cases, the price is not an issue. Just the product (be it SP, or Xbox) solves the pain to the level of customer satisfaction: playing at home; playing online; similar games; similar quality of the player’s experience.
13. Price exclusivity
The company’s possibility to set a very competitive price for a product or service is one of the classical moves towards an unfair advantage. If the company has a vertically integrated business model – for example, it manufactures products cheaper in China, has its own logistics lines to transit it to the USA; has its own stores or/and online presence, – it could set up a lower price than its rivals (have to pay for production, logistics, commission fees to stores or supermarkets for their products to be placed etc.). Or when robots produce products or services instead of the men and thus reduce the end cost of the product to the customer. For instance, robots in the warehouses → lead to a lower price for storage; robots in medicine (e.g. dentistry) → lead to a lower price for services; robots in the food market (e.g. making coffee or pizza) → lead to a lower price for food products, etc.
Wrap-up: Obviously, exclusive products and services induce demand amongst customers and subsequently among investors. This, in turn, makes them low-profitable as time passes (e.g. lease payments for a top location are always within the expected price bracket; once the electricity market is saturated in one state (disregard, for now, other revenue generation options), the electricity company cannot grow revenue exponentially or even linear, just sustain on the expected level within the projected range.
Thus, the investor itch is to find a product which would be exclusive and beat the market in terms of profitability not only at the time of the market disruption with linear revenue growth but for a long run, whereas the longer the product exists on the market the more defensible it becomes, the more exponential its revenue curve. The need for defensibility is of particular importance for tech products and services because one can build an early prototype of the product in no time nowadays and thus there are tons of copycats to deal with.
That being said, the founders should think in the same paradigm and seek to build a product or service which has or will have defensibility and can be protected from competition, and thus would be highly profitable in the middle- or long- time horizon. This is the way the startup company becomes an Economic Moat.
III. Defensibility (Economic Moat)
1. Switching Costs
It is the case when a customer is so tied up to the product or service that it cannot withdraw without significant setbacks (waste of money, time, customer base, other high-value resources). More often it applies to the situations when a customer is an entity (business, government, etc.), rather than to B2C.
Tech industry examples: a) a company has integrated a complex business solution such as SAP or Salesforce some five years ago and run the business on one of those platforms since then; after this time all business processes were so integrated and immersed into the soft (e.g. business process, CRM, ERP, distribution, logistics, marketing, last-mile sales) that it would be impossible to switch the platform for the competitor’s product without incurring significant costs; b) Apple has built an ecosystem of the products and services in such a way that even if Apple customers were to withdraw from Apple and go for another brand, they would think twice before doing that.
Specifically, the customer has his Apple phone, with Apple Pay wallet, iTunes (music and podcasts lists; some people create and maintain them for years), synchronization with Mac laptops and related software, usage of voice help solutions like Siri.
Industrials example: an airline company (customer) has been working with some airplane & airplane equipment manufacturer for many years (company) – e.g. Air France and Boeing: bought fully equipped planes, bought engines and other details when needed for maintenance purposes. Then something happens like Boeing 737 Max failures (or just a partnership does not seem to be good anymore) – it would be very costly to switch to another provider.
2. Barriers to entry
Imagine you have a high-quality waste destruction company which has been operating in Berlin, Germany for some time already. Very profitable business, but very high entry costs to enter the market for new competitors. It is not only about the costs of building another efficient waste destruction factory but also about setting out sales pipeline (to convince clients to switch to you), it takes many resources to break into the existing level playing field.
Or, let’s say you have a Gazprom – a natural gas supplier in Russia which is the leader of the gas production in the country followed by Novatek, Rosneft, and few other giants who shared control over the strategic natural gas resources. How likely does one see a new contender on the market? I would say close to zero.
It worth noting here, that still many people believe that low prices can be a barrier to entry and become defensibility for a company. It is not true, and history knows many examples. Low prices might become a decent unfair advantage, but not defensibility. For instance, once back in time such companies as Kroger, SafeWay, Tesco likely thought their low-cost strategy would be unbeatable, but then new contenders, e.g. Aldi, Lidl, Mercadona, disrupted the landscape with even lower prices.
Photo credit: Prevatt Capital What is also interesting that such “black swans” showed how fragile many companies could be without true defensibilities.
In a certain sense, we might consider any of the competitive advantages or unfair advantages as a barrier to entry into the market, depending on what one understands by the “market” in a particular case. Like, one has a top retail location in Munich, Germany near the Allianz Arena (a home stadium for Bayern Munich football club) – thus, most matchday revenue related to the company’s business would be accumulated by this very company. The competitors would not enter this specific market as they do not have a location to settle in.
However, such deliberations seem to fit better for business classes rather than for practical purposes. Why? Because, for starters, certain competitive advantages and unfair advantages listed above – do not apply to tech companies at all leave alone consider any of them as a barrier to entry. One can build a copycat of the tech product in a matter of days and weeks. That is one needs to separate presumed barriers for entry from true barriers to entry. Yet, for traditional businesses “barrier to entry” factor might be considered real defensibility.
3. Economy of scale
We have talked earlier already about economies of scale and what benefits it gives to the company if clicked properly. The bigger the company gets, the more advantages it receives over its competitors. More customers lead to more revenue → more capital on expansion; more raw materials to buy allows the company to negotiate the lower price with the suppliers (given the big volumes per contract) which leads to a lower price on the products for end customers; lower prices on the market turn into more customers, more orders, more cash to spend on higher salaries and R&D; the list can go on and on. It is just a kind of vicious cycle when one leads to another and they accrue onto each other like a snowball.
However, if the company’s unit economics are bad, the economy of scale might draw the business within shortly. Thus it is of particular importance to make a proper unit-economics analysis. Walmart (retail), Amazon (marketplace, everything), Apple (phones, laptops, computers), Microsoft (similar), Chevron (oil production and refinery), McDonald’s (food franchise), LVBM (the owner of several luxury clothes and apparel brands), Lululemon (sports apparel), etc. – all of them use an economy of scale business model and enjoy it in building defensibility.
4. Network effects
The network effects suggest that the value of your product or service (in most cases it applies to platforms and marketplaces) growths with every new user joined thereto. Every user extracts more value from your service, enjoys more benefits when every other new user becomes a customer.
Classical examples, eBay, CraigsList, Facebook, Youtube, Snapchat, Uber. There are different categories and modes of network effects exist.
Take eBay. Many merchants keen to join the platform because there are many potential buyers already ready to spend money. Buyers go to eBay because they know there are many merchants with unique products and prices to choose from. The retention rate of both user categories (merchants and buyers) is high: a) merchants always there to sell; b) buyers always looking for something new to buy as there are different categories of products; c) buyers sometimes become sellers, and sellers become buyers. eBay makes money by taking a take rate/commission fee from each transaction on the platform. For this reason and for a few others formed along the way (e.g. brand, first to the market) eBay built strong defensibility and became a Moat long ago. Simply put – there would be no place for another eBay.
In Europe, there was a competitor to eBay once Alando.de – but eBay bought it. In other countries – there might be their own national “ebays”. Yet, eBay is a global player and its user from all over the world.
Game platforms, like Fortnite or League of Legends, have been building successfully their own ecosystems with the network effect in place. More players in Fortnite means more online games; more players and games → means more subscriptions and in-game transactions → more revenue for the publisher; more players → more time they spend on playing → more possibilities to show the players ads of third-party advertisers which built-in into the game environment.
More money and revenue allows the publishers to build fresh worlds, recent updates, keep top retention rates of the players. Network effects are the most powerful factor in building defensibility and Moats overall. It is also the most practical and applicable defensibility factor for the tech industry.
However, even if you have Network Effect per se, it does not guarantee a company has defensibility and turns into a Moat. Because it depends on the quality of Network Effects, on the quality of the product itself (does it solve customers’ problems; or offer necessary solutions the customers did not know they needed it?). In the past, there were MySpace and Friendster who had also had network effects but failed to keep the users from churning. If you would like to dig deeper on network effects, I would recommend to check the guide from Nfx team who focus on it since forever.
5. Brand or
From my perspective, the brand as a defensibility factor is overrated yet impossible to ignore. It is the very reason I got the title as “Brand or
Brand”. It is a fact that people may associate themselves with the brand whatever the brand-company produces and stay as a loyal customer no matter what.
For example, it is the war of decades between Apple and Android fans. Apple attracts its customers not only by top-notch products all over the years but by pushing its mission and values into the minds of the customers “Think Different”, ‘Innovate’ are the dogmas of the Apple fans introduced by Steve Jobs. Apple buyers are not “go-shoppers” or “settlers-for-less”, you know.
Notwithstanding that, I truly believe that Apple might have lost at least part of its customers if they did not do such a terrific job on building innovative products separating themselves from competitors. We all remember the stories of Nokia, of Blackberry – in the past they seemed to hold the market forever, but they plummeted. Why? Because they stopped innovating. And brand alone did not help.
That is why I believe that such brands as Apple, for sure, have a powerful brand, but I do not base its defensibility on the brand alone, but also on other factors. Or let’s take Booking.com – I reckon anyone who has ever looked for travel tours or tickets stumbled into Booking. But be reminded that Booking Holding spends 2 billion dollars per year on its maintenance in a broad sense: Paid marketing, SEO, Social media, Affiliates.
Imagine, 2 billion dollars to maintain its first positions in Google search, presence in social media. Would it be so powerful if it were not for such expenses? Maybe, given that over time Booking built impressive network effects as well with tens of thousands of hotels, and millions of visitors per day. But I would not risk claiming it affirmatively.
If within the tech industry brand really can add much to building defensibility (sometimes alone, even though with some strong reservations), then in the traditional business brand alone is not enough to create a Moat. In assessing the historical landscape of traditional brands, I would upvote the words of Jonathan Tepper, founder of Prevatt Capital (ex-VP in Bank of America), that “Brands are not Moats”.
Image: Tech brands that went bust.
Image: Retail brands that filed for bankruptcy.
Now, I trust, you know what features one needs to build to become a long-lasting company that could weather the crises and grows exponentially. Apparently, it is very difficult to do. Hell, it is very difficult just to disrupt the market and make a successful company, at least in the brief term, let alone to build defensibility and create a true Economic Moat.
Often founders do not even need it at all. I mean, not all of us want to build an Economic Moat, just a quality business to run over and succeed. But whatever the case, your company won’t have chances to stand the competitor landscape if it does not have competitive advantages or unfair advantages. The more factors you have intrinsically or can build intentionally, the better for the overall growth.
The most controversial defensibility features such as brand and barriers to entry are very case-specific. In most cases, we cannot regard them as the only factor to build a defensible business. But in connection with the other unfair advantages or defensibility factors – their equity multiplies and business growth compounds.
Please, follow me on Twitter: Follow @aynur_nuriev
Join the discussion or share it with your friends and collegues!
A thread: for a while, I have been studying what core features turn a startup into an Economic Moat. I have dug into the theory & practice and come up with the following approach to building a defensible company. /1— Aynur Nuriev (@aynur_nuriev) July 19, 2020