Companies Build “Capabilities” Before They Build “Moats”

By: Rick Zullo, GP & Co-Founder at Equal Ventures

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While “moats” is a word tossed around venture circles a lot, we often think it’s misunderstood. What others may see as a moat, we may more earnestly see as “stickiness” or “defensibility” rather than as an outright moat. As we wrote about in “What is a “Moat” and why does it matter?”, we define moats as “Proven, perpetuating and permanent unit economic advantages from peers within a competitive set”. These moats need to be rooted in quantifiable advantages and persist (or even better, grow stronger) over time. Ultimately, we think moats represent the only way to create sustainable, long-lasting value as a company and are ruthlessly focused on evaluating them and building them with the companies we invest in.

While moats represent the economic advantages of a company, they aren’t had on Day One. As early stage investors, we don’t evaluate the company’s current moat, but rather its path to a “moat trajectory” (highly recommend listening to this podcast from Mike Tian of WCM for more on this concept). Even with that, companies must first build (what we refer to as) “capabilities” before they can establish a moat or even a moat trajectory.

Capabilities (referred to as “powers” by some, including Helmer’s immensely impactful book 7 Powers) are the intangible assets that you have developed as a business that enable you to operate more effectively and earn returns above others in the market. Ultimately these are the engines of your competitive advantage, determining the persistence and scope of your moat. While these may never appear on a balance sheet, they are the single most valuable asset of a company. Identifying how to build that intangible asset is core to a company’s business model and requires deliberate planning to unlock.

While others refer to capabilities with different terminology, we’ve sought to unify these topics into a single framework that expands upon Bruce Greenwald’s manifesto “Competition Demystified”. Greenwald proclaimed that competitive advantages fell into two distinct camps, customer captivity and resource captivity, and that the strength of these advantages were a function of scale. We expand upon Greenwald’s emphasis on scale with the belief network effects and organizational design can establish captivity and have established what we believe to be a simplified, but exhaustive list of “capabilities” below.

Scale Capabilities

Scale ultimately made it easier/cheaper to acquire and retain customers (customer captivity) or to produce your product (resource captivity). While we think this is one of the most powerful and concise frameworks for competitive strategy ever imagined, we do think that the digital age requires expansion for advantages not previously addressable in the analog age. We’ve chosen to expand upon this foundation by adding two additional parameters for success, network effects and organization design. Before expanding upon these two parameters, we’ve included a list of scale capabilities that we’ve identified along with links for further reading.

• Demand-side economies of scale: Increasing returns to scale making it cheaper / easier to acquire customers. Examples include national ad campaigns, “container principle” (increased surface area enabling broader customer offering / access) and capital float. Example: Bank of America
• Supply-side economies: Lower production costs achieved via higher asset utilization, lower cost of capital or the ability to purchase variable inputs at lower costs. Example: General Mills
• Risk variance: Ability to aggregate and progressively manage risk as the cost of uncorrelated volatility minimizes with scale. Example: AIG
• Process Power — Complexity: Companies that pursue complex, challenging goals face fewer qualified competitors than those who chase easier goals. It also takes longer for copycats to catch up, which helps entrench the top dogs. Example: SpaceX
• Process Power — Speed: Not only must companies embrace change, but they need to embrace changing quickly. Speed is also relative. Admire companies who make their competitors look slow. Example: Rocket Internet
• Process Power — Efficiency: Companies that become increasingly more efficient with their resources for every additional dollar that they put to work, enabling increasing returns on investment. Example: Ford

Network Effects Capabilities

Unlike scale, network effects tend to experience exponential returns to scale (whereas gains from additional scale can still be positive, but generally experience diminishing returns). Network effects take many ways, shapes and forms and are well-known in startup circles, but the concept is often overused and under-realized. We seek to define different forms of network effects and the ways to stress-test them to ensure they are both 1) actually in-place and 2) impact the competitive positioning of the company. Below are network effects capabilities that we’ve identified along with links for further reading.

• Compatibility, standards and protocols: Interoperability of technology that encourages incremental use and adoption of a service as it grows. Example: Android
• Cults / Reflexivity: When belief in a company transcends fandom and borderlines on religion, rationality barely matters. Irrational pricing is what enables companies (like Tesla) to raise capital, tackle new ideas, and stir up exuberance again. Rinse, repeat. Example: Bitcoin
• Customer network effects: Marketplaces matching buyers and sellers. Example: eBay
• Endogenous data network effects: Data acquired and implemented from an application to an end client that makes the service increasingly valuable over time. Often referred to as “stickiness.” Example: Pendo / Gainsight
• Local network effects: Density and/or critical mass achieved in a local geography enabling increasing value to the user. Example: Uber
• User network effects: As an increasing number of users join the service, it becomes increasing valuable. Example: Facebook
• Exogenous data network effects: User generated content that creates increasing utility of a service while capturing new demand. Example: Yelp
• Platform Dynamics: Attracting others to develop and build upon your system to increase its attractiveness and utility to 3rd party users. Example: Shopify
• System data network effects: Systems learning from increasing customer utilization that makes it increasingly powerful. Example: Google

Organizational Design Capabilities

Organizational design has been touched upon within strategy circles preceding the digital age, but has been amplified with availability of venture capital. Venture capital has enabled new entrants to compete with fundamentally different business models that require low degrees of monetization / profit in the early years in the hopes of achieving a strategic advantage in the long-run. While examples of this existed in the analog world, the attractiveness of this approach has expanded in the digital age where geographic expansion is much more economical. In the past, businesses were often defined by the geographic territories they presided over, experiencing diminishing competitive advantages as they moved further away from their core centers of influence (ex. the Berkshire Hathaway case study of See’s Candies). This yielded numerous localized winners and a few major players who were able to consolidate territories and market share to amass behemoths (ex. Walmart). With costs of digital distribution being far cheaper and nearly limitless, however, winner-take-all dynamics are much more feasible. Much like the two previous parameters, organization design capabilities are bifurcated to two camps, those related to customer captivity and those related to resource captivity.

Customer oriented organizational design generally revolves around behavioral psychology of customers, locking in a customer post-purchase. These organizations tend to front-load sales/marketing efforts and/or subsidize short-term pricing/profit to bring on customers with a long-term LTV in mind. While competitors can often offer products of comparable quality, small advantages in LTV ultimately generate globalized advantages over competitors resulting in winner-take-all or winner-take-most dynamics.

On the resource side, we generally see these capabilities as state granted resources, patents, IP and/or brand trademarks that the organization has exclusive control over. These, by definition, are resource monopolies by design. While some of these capabilities are more powerful than others, we’ve highlighted a brief list of organizational design methods below.

• State granted: A government indirectly/directly protects a company from competition by protecting necessary resources (patents, IP, supply chain resources, etc.). This is done through patents, IP laws, tariffs, licensing, regulation, or contracts/state-granted ownership of resources. In these cases, governments can create monopolies or oligopolies, in return for political loyalty or the creation of economic/financial benefit. Example: Utilities
• Brand: Consumer perception around a company that enables proven increase in WTP above comparable products. Example: Allbirds
• System of Record: High costs to multi-homing across multiple services. Example: Salesforce
• Patents / IP: Regulatory protection of innovation. Example: Pharma
• Financial — Sunk: Customer reluctance to switch due to high investment and costs already incurred. Example: Peloton
• Procedural — Search: Customers are reluctant to switch due to high time and effort gathering and evaluating switching with limited benefit. Example: Geico
• Procedural — Uncertainty: Customers are reluctant to switch due to potential likelihood of low performance when switching. Example: Legacy Venture Capital Funds
• Procedural — Cognitive: Customers are reluctant to switch due to potential for high time and effort learning new procedures. Example: SAP / Oracle

When developing the strategy for a company, it’s incredibly important to know your “north star”. As we work with early-stage teams, we ask them “which of these capabilities are you trying to build?” More often than not, founders have never thought about this beforehand, but recognize a path to one of these methods upon further reflection (hence the purpose of the exercise). We encourage them to use the capabilities that they seek to build as their “north star” and orient everything in the company to that objective.

If you are a business that yields customer advantages because of localized economies of scale, make sure you dominate every market you are in, don’t dilute yourself across too many. Getting density is ALL THAT MATTERS.

If you are a business that yields resource advantages because of platform dynamics, make sure you make your platform the most accommodating to 3rd party developers. Being the “go to” platform is ALL THAT MATTERS

If you are a business that yields customer advantages because you are the system of record, make sure you lock customer data in wherever possible. Owning as much customer data as possible is ALL THAT MATTERS

At times, companies can benefit from multiple capabilities (Amazon is a terrific example), making this exercise more complex, but not impossible. Similarly, some of these capabilities are stronger than others. Either way, defining the capability(ies) you are creating is the core of competitive strategy. This is ultimately your roadmap to establishing competitive advantage and proving the first instances to these capabilities is proving the first instances of your moat (or at very least, your moat trajectory). If you aren’t building toward one of these capabilities, I would strongly reconsider your long-term competitive advantage, since nothing is worse than spending a decade working on a company, only to see it fade away due to competition.