The Myth of Early Moats in Startups (And What To Do Instead)

The obsession with early moats distracts startups from the real work of building lasting value.

“You can have the greatest moats in the world (on paper) - but it’s useless if customers don’t have a need for your product.” 

- Nikunj Kothari (Investor, Head of Growth @ Opendoor)

Moats & Funding

Moats are an attractive idea. In some shape or other they are some kind of:

●      Competitive Advantage: A moat is a sustainable competitive advantage that a company possesses, which protects it from competitors and maintains its market share and profitability over time.

●      Barriers to Entry: A moat can be defined as barriers to entry for other firms, such as patents, brand recognition, or high capital requirements, making it difficult for newcomers to compete in the market.

●      Unique Resources: A company's unique resources, such as proprietary technology, exclusive access to the best raw materials, or a superior distribution network, act as a moat by creating a protective barrier around the company's profits and market position.

Founders are compelled to think in these terms from the start. The moment you try to raise funds, the questions you get asked make it impossible to avoid thinking about the moat.

It’s understandable that investors want to know how we’re positioned to win.

The worst horror of all is if your venture-backed startup gets killed by Google. But this fear is often over-emphasized and seldom materializes.

In the meantime, optimizing for “having a moat” ends up being a “yacht problem” — a nice problem to have, but “premature optimization”.

No strategy, including moats, is set in stone or works immediately when conceived. It’s a designed hypothesis — effective only when it becomes reality.

Established companies often tout moats as their survival mechanism. Yet, few startups are built on moats, or they cease to really be startups shortly thereafter.

OpenAI Example

Does OpenAI have a moat?

You might say it’s that they have smart people or they partnered with Microsoft.

But there are a lot of smart people out there. And while Microsoft is special, it’s not unique, especially when it comes to being a company with deep pockets. So far, in my opinion, OpenAI’s moat is their speed of execution. Think about that: your shipping velocity can be a moat.

Other potential moats include:

●      A product experience that’s five times better, leading to high retention

●      Untapped distribution channels

●      Vertical integration against an incumbent

●      Being significantly cheaper than the competition

All these factors point to the need for a solid market, a well-distributed product, and identifiable competitors.

And what has to be true for those things to be true?

Product/market fit.

Do You Have Product/Market Fit?

Jason Cohen, the founder of WP Engine, wrote a great post on PM/F.

A few things that would tell you if you have product/market fit:

1. If you're questioning whether you have Product/Market Fit, you don't.

2. Product/Market Fit is the shift from struggling for each customer to an overwhelming influx of demand.

3. An increase in demand often brings a surge in complaints and operational challenges.

4. Sudden and sustained increase in growth rate indicates Product/Market Fit.

5. Cancellation rates should be under 3% for B2B and 5% for B2C to affirm Product/Market Fit.

   
   

It goes from push to pull on the sales/marketing side, and the cancellations don’t drag your Customer Acquisition Cost (CAC) down.

Now you have a castle to defend, and you can start to think about defensibility.

But I Really Want a Moat

I know it might feel like you’re doing things in reverse. That’s because, as a founder, you’ll tend to be overly optimistic about the prospects of your baby before everyone loves it.

So why would you defer thinking about the moat if you know you’ve got a hit on your hands?

What if I told you that you could actually kill your startup if you try to give it a moat prematurely?

Let’s say you’ve built something, and the sales are slow. Maybe you start to see similar solutions pop up on the market. You feel like you need to protect the product, differentiate it, and make it special so that you look different and people buy you more.

What if your customers don’t even think about those alternatives?

You thought the market was here, but it’s there, or it’s nowhere at all.

Now, you went ahead and fortified your position in a non-existent or wrong market. You spent resources and time on something that was not necessary.

Nothing is Guaranteed in Business

But what if you lose market share after an initial influx?

What if you get so hot that competitors rush in, and you fail to ever define the moat before it’s too late?

It’s possible. It's business; anything is possible. There are no guarantees.

Let’s go back to OpenAI. There are a lot of startups today that are building products on top of the OpenAI APIs.

Recently, OpenAI announced that they will be adding the ability to upload a PDF to have a conversation with it.

This was also the promise of several “chat with PDF” AI startups. The folks on Twitter were quick to celebrate their death.

While we haven’t seen their death yet (the world is dynamic, and those builders are not NPCs - some will figure out a path forward), the threat remains.

So if (and it’s a big if) you’ve hit PM/F, you have my permission to think about the market you’re in, who you’re competing with, and how.

Further Reading

Strategy development is a never-ending task. Before PM/F, all your efforts go towards that.

After it, you’re protecting it. Some strategies can take years to play out. Some fall through. So, it’s important not to think of it as a binary exercise. You never really have a moat; you just protect the business slightly better or worse.

If you really want to consider what moat to have, I can highly recommend two books:

●      7 Powers by Hamilton Helmer

●      Competitive Strategy by Michael Porter

You should also check out:

●      Blue Ocean Strategy

●      Good Strategy/Bad Strategy & The Crux

●      Playing To Win