The benefits of creating a “competitive moat” around your business

And why new on-demand services such as Uber may not be the best role models

Warren Buffett said in his 2007 letter to Berkshire shareholders: “A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital.”

In software, a great way of creating such a moat is to build a network of users and many of the most successful tech companies from the last decade have done this; from social networks such as Facebook, LinkedIn and Twitter to platforms like Apple’s App Store which has powered the most profitable tech product of all time — the iPhone.

How does a network effect give you a competitive moat?

The network effect is a powerful moat because once you have all the users on your platform, then other products operating in the same sphere cannot lure those users away even if they have superior features or user experience. A great example of this is OpenTable.com. OpenTable was a fairly average restaurant reservation software company in California when it launched Opentable.com in 1999 which let users book tables in the restaurants using its software. Since then, it has completely dominated the online booking market in restaurants by having the largest network of people looking to book a table. Over the years, many superior, slicker and cheaper products have tried and failed to gain traction with restaurants. It is owning the best network of restaurant users that protects Opentable from new competitors and it is OpenTable’s reservation and ERP software running in the restaurant itself which protects it from competitors creating their own network.

Furthermore, these networks tend to have a winner takes all effect and Fred Wilson, one of the world’s better known VCs, has built his (hugely successful) investment thesis on this concept.

New mobile first and on demand services are scaling incredibly fast and appear to be building a network of users.

Powered by the mass adoption of smart phones there is now a new type of networked businesses that is scaling faster than any before it. On demand mobile app businesses are springing up everywhere — from taxis (Uber, Lyft, Hailo) to home cleaning (Homejoy, Handy) to Fast Food (Grubhub, JustEat) and more. Their goal is to build a network of users around specific use cases so that they will become the primary door into these vertical markets. We’ve seen huge amounts of capital raised in this space and very public competitive battles for users in the different segments in a race to create the defining network in each vertical.

But are they actually creating a defensible network?

The problem I see with this strategy is that as a service provider there is no limit to how many networks you can be on. For example, there is nothing to stop a taxi driver from being on Uber and Hailo, or a cleaner from being on Homejoy and Handy. This is in contrast to the previous generations of networks (let’s call them embedded networks), such as OpenTable or Hostelworld where, because the enterprise software part of the network had to be used in the running of the business, you could only offer your services on one network, hence the creation of a moat around those networks that still exists.

This apparent lack of a real competitive moat also explains why the margins of companies such as Uber and Hailo are already being driven down so early in their existence as they compete with each other for customers and drivers. If they were truly building a competitive moat, then they wouldn’t be under pressure to cut prices. It also explains why even though Hailo for example, had been the first company to build up a network of taxis in London which should have given it a defensible advantage, they have quickly been caught by Uber, and the same thing looks to be playing out in Dublin, Hailo’s most profitable market.

Ultimately I’m sure there will be some decent businesses created in this space. But the massive valuations these companies are commanding are based on the idea that the winners will be building a defensible network which will sustain high profit margins for long into the future. And so far there doesn't seem to be any evidence that such defensible networks are being built.