By Vic Singh, Founding General Partner at Eniac Ventures
At Eniac, our criteria for evaluating investments in seed stage startups has evolved over the years. While the founding team remains the most important criteria, we also consider large markets, traction and potential to build large moats as important criteria.
In this post, we wanted to share our thinking on one of the core criteria — the moat — and help founders demystify this a bit more. How we think about moats is likely different from other investors so we are hopeful that our thinking here will help founders understand how we look at opportunities and maybe spark some thinking about your own startup trajectory. We seek to invest in opportunities where enduring moats can be built and sustained over time to create transformational companies.
Broadly defined and coined by Warren Buffet, an economic moat is a company’s ability to maintain a competitive advantage over its rivals and protect its long-term profitability and market share. The term is derived from physical moats built for medieval castles to protect them from invasion.
The graph below outlines our conceptual framework for evaluating moats. We will unpack each of these and discuss how they can be compounded over time to create enduring value.
Innovation — We believe that a unique technology or business model innovation is sufficient to give a startup a head start on their way to building an enduring moat. Tech and business model innovation are short term moats that give you a head start. Innovation can be a powerful short term moat but startups must exploit this critical head start advantage period and execute to create long terms moats through compounding effects over time as outlined below. We assume the technology will become commoditized or the business model innovation will be copied but the initial uniqueness should be strong enough to give startups a head start. It is during this critical period that a startup must exploit its unique advantage and execute to take market share leading to their next moat.
Examples of early technical moats include autonomy in transport that gave Waymo a head start, or in business model innovations like Foursquare’s badges that drove usage through rewards, our company Zero’s insight around rewarding users for debit card usage or Salesforce’s creation of SaaS as a business model. In many of these cases, the company had a big unique advantage and early head start although its unique technology or business model innovation became replicated.
Lock in — Once a startup creates unique technology or a business model innovation to get a head start, they can exploit this to lock in users and customers. We see lock-in (or high switching costs) a lot with technical infrastructure companies or enterprise SaaS companies.
It’s very difficult to pull out an analytics solution like our company Localytics offers, or an ERP system like SAP without suffering heartache and pain from a cost and resources perspective. In his book 7 Powers, Hamilton Helmer cites that HP’s failed migration to SAP cost the company over $160M despite numerous safeguards and ample resources dedicated to the effort.
A product must be sustainably good to keep users locked in and the high switching costs can be generated through continued usage as the more it’s used the more difficult it is to switch. Lock-in is a more sustainable moat than unique innovation (discussed above). If executed well, the lock-in can also reinforce the unique technology or business model innovation making the product offering even more differentiated over time. Our company Localytics’ product offering grew over time as they locked in services starting from mobile analytics to a full-fledged re-targeting and marketing platform. Lock-in is a strong way to retain existing customers but may not necessarily be a real market moat to acquire new customers.
Standard — The combination of innovation and lock-in can be compounded to create an even more powerful moat — a standard. Our company Ready Robotics started as a software platform that enables factory workers to easily re-program robots to perform different tasks using the same robot. This was and continues to be a unique technology advantage which has been reinforced by locking in customers. Once deployed in manufacturing environments, it is very difficult for customers to pull out the system as their operations would be left inefficient and workers would complain given the product benefits, enabling Ready to begin to create lock-in. Over time, the fragmentation of the robotics OEM ecosystem led customers to mandate the various OEM’s to build to the Ready standard so all their various robots from different OEMs could talk to one another through one standard. Ready’s moat is now creating an industry standard by compounding and reinforcing its lock-in while making its unique technology even better over time allowing the company to have a lasting moat.
Network effects — This is one of the most valuable moats. The classic construct that the value of the product increases with each additional user is a pursuit of many startups. Obvious examples in the consumer space are Facebook, Twitter, Pinterest, Snap, Slack, etc. Consumer social platforms naturally lend themselves to network effects but for every FB, there are thousands that never got true network effects going. We think this goes back to not being a strong enough valuable differentiated product that created lock-in and led to a standard which the aforementioned services were able to do by compounding their early moats. Marketplaces like Uber and Airbnb were able to generate meaningful network effects by offering a unique business model innovation that led to lock in and created a standard. On the B2B side, API businesses like Plaid, developer platforms like our company Fritz.ai and enterprise productivity services like Docusign all exhibit network effects that make the platforms more valuable with each new user. Network effects don’t happen on their own and we believe they often require stacking of innovation, lock-in, and standard to generate meaningful value at scale. This can happen sequentially or in parallel. Once again the network effect will reinforce the other moats — uniqueness, lock-in, and standard — if the team executes well creating a powerful enduring long term business.
Data — In the age of AI and data, we like companies that have a path to a long term data network effects. To get there, the company will likely exhibit a combination of the aforementioned moats leading to its data network effect. A start-up may encounter unique challenges when deciding whether to go horizontal or vertical in its approach. Data moats enable companies to derive meaningful insights they can then use to serve their customers better, enhance their product offering, create even more lock-in, build the ultimate defensible standard all while generating network effects to create massive value. One key factor to building a data moat is it’s insufficient for a startup to simply generate data — they must be able to extract insights from that data that can reinforce their position and enhance their moat.
Google is probably the best example of a company that has generated massive data network effects across its various business lines that feed into the value of the company and reinforces its position as market leaders. Vertical companies such as Saildrone and Xwing (an Eniac company) are generating tons of data and making that data actionable through insights that it’s almost impossible to catch up as they gain more traction and strengthen their moat and ultimate position in the ecosystem. Horizontal machine learning companies like UIPath and FortressIQ (an Eniac-seeded company) in the RPA space have massive data sets around use cases that stretch across different organization types creating data moats and network effects that build on top of all their moats and strengthen their position with each new user.
In sum, if you’re a founder just getting started or a large company looking to build enduring value, we hope this framework for thinking about business value in terms of stacking and reinforcing moats to create enduring value is a perspective you will consider and build towards idiosyncratically for the type of company you are building and the customers you are serving.
Offensive and defensive — The moat concept lends itself to a defensive stance as it’s meant to protect a market position. Our paradigm incorporates stackable moats that can lead to new customer acquisition, not solely the protection of existing market positions.
Brand — We are impressed with the plethora of vertical commerce brands that have built moats around their brands such as Warby Parker, dollar shave club, away and many more but we believe the lock-in that’s generated by the initial product uniqueness may or may not be sufficient to build the type of stackable enduring moats we look for at Eniac. Those companies can drive big outcomes but we generally are not very good at evaluating brand moats.
IP — The compounding moat paradigm does not generally apply to biotech companies developing new drugs where the technical moat IS the value of the company once they get approval and before the patent phase. However, it can broadly apply to companies in spaces like quantum computing where the IP itself can be a sustainable moat but can be compounded by creating a standard over time. In software, we generally shy away from IP as the moat.
Economies of scale — Given we are investing in early-stage startups, economies of scale is something we evaluate. However, given the level of scale you would need (as Amazon has exhibited), we focus our paradigm on the aforementioned moats that generate a compounding effect.