How to tell if a startup has a moat - by Dan Hockenmaier
Moats are more important than ever in the AI era. Anyone can create a product; they can do it faster than ever before, and everyone is building the same things.
perhaps because it seems harder to measure, people often skip one of the most important criteria: Does it have a moat?
A company can check all your boxes and look like a rocket ship. If it doesn’t have a moat, though, it’s going to stall out. It won’t be able to keep growing once competition gets fierce
Moats are more important than ever in the AI era. Anyone can create a product; they can do it faster than ever before, and everyone is building the same things. But only some of these products will win.
The framework has three steps:
Identify a compounding advantage
Gauge how strong that advantage could be
Measure if it’s working
In reality, only a small subset of what people call moats actually drive the vast majority of long-term value.
They’re what I’ll call compounding advantages: not just a temporary edge, but a self-reinforcing flywheel that gets stronger and stronger over time, ultimately making a company very hard to compete with.
How to identify the compounding advantage
Your job is to identify which kind of compounding advantage a startup has the potential to build. It won’t be in full force yet (it takes a long time to develop), but it should be pretty clear which path they are on. That’s because it’s not something you can “bolt on”; it’s not some clever competitive tactic or a tweak you can make to your business model.
A compounding advantage is the core loop at the center of the business through which you add more value for customers. Defensibility emerges as a byproduct of turning the flywheel over and over.
So as you evaluate a company, don’t focus on what they say they are or what their “strategy” is. Focus on what they’re actually doing. What is the team working on every day? What’s on their roadmap? Which teams are large and influential inside the company?
Mike Vernal recently wrote something of a manifesto for anyone building this kind of business today:
If you are building a venture-backed software company, I think the answer is once again “do it all.” Just build the whole thing—your moat is the totality of what you’ve built and completely owning the buying center.
The bigger cost is what I’ll call the “workflow tax”: all of the time the team spends learning a product and building it into how they work, and how disruptive it is to do that over again.
At the core of these companies is a machine to both deepen and broaden customer engagement. The roadmap is rich with efforts to better serve existing use cases or create ways to serve new ones. They’ll often be focused on integrations and working with other parts of their customers’ stack. The team should be heavily tilted toward product and engineering, with an emphasis on shipping rapidly.
Network-effect products are common in industries like social (LinkedIn), gaming (Roblox), and marketplaces (Amazon).
The emphasis of a network business is less on building out the surface area or feature set of the product, and more on growing the network and making it easier and easier for that network to interact.
3. Scale
Businesses with scale as their compounding advantage are all about making it possible to offer the same product at a lower cost or a higher-quality product at the same cost.
4. Data effects
These are businesses with data at the core. It’s the input that makes the product higher-quality, more efficient, or work for more use cases. And by using the product, customers generate even more data, which further compounds this effect.
In these companies, you’ll often see a large effort to collect and sanitize data, and to build algorithms and products on top of it. ML and data science are usually large and influential teams.