Dear Startup Investor,
Buck Jordan here to talk about a concept that’s widely discussed in the startup world and key to assessing a potential investment opportunity: defensibility.
So, what is defensibility?
Well, it describes the likelihood that a startup can preserve – and even compound – its competitive advantage and maintain its customer base over time.
Business is a competitive sport – it’s not for the faint-hearted. All startups face competition, and the best ones often face the most intense competition.
After all, a great idea is rarely proprietary.
For example, how many search engines existed before Google launched? More than ten – until Google came along and became the dominant player. It is almost an iron rule of entrepreneurship that great ideas inspire numerous entrepreneurs to build competitors.
The competitiveness of business and startups is why the concept of defensibility is so critical to investors. The key question to answer is: how durable will a startup’s business be over time in the face of competitors?
At its core, defensibility is driven by structural advantages a startup has that its opponents do not.
As investors, we typically refer to these structural advantages as “moats,” like the water-filled ditches built to surround and protect castles back in the Middle Ages. These moats (a.k.a. structural advantages) come in many forms, but here are four of the most common, tried-and-tested ones to look for.
Startup Advantage No. 1: The Network Effect
Throughout the past two decades, one of the most popular moats has been the “network effect.”
This refers to the phenomenon where the value of a product or service increases as more people use it.
What does that actually look like in practice? Let’s take the example of Linkedin.
If only a few hundred thousand people had Linkedin accounts, it wouldn’t be a very useful place to make business connections, prospect for sales, and recruit potential new employees. The network would be too small; it would lack the breadth and depth to really make it worth these pursuits.
But there are not a few hundred thousand people on Linkedin; there are nearly 800 million. This makes it an extremely useful place for any and all of the aforementioned activities. LinkedIn’s huge network is a big reason why Microsoft acquired it for a whopping $26 billion.
(If you want to get technical, a fancy way to talk about network effects is using something called Metcalfe’s Law, which states that the value of a communications network is proportional to the square of its number of users.)
A lot of the most iconic tech companies of the past few decades were startups whose primary moat was driven by the network effect. Companies like Facebook, Instagram, LinkedIn, Snapchat, Tik Tok and Amazon were all network-effect businesses in their own unique ways.
The network effect is very difficult to achieve, because building large userbases and retaining them is extremely hard. But, if a startup has the potential for network effects in its business model, it has a deep and sustainable moat.
Startup Advantage No. 2: Data
Another popular moat – especially for machine-learning and artificial-intelligence companies – is having bigger and richer datasets than anyone else.
These data moats are critical not only for training the best machine-learning algorithms, they also enable startups to better underwrite customers; offer personalized, meaningful recommendations; predict customer behavior and spending; and many more things. Building high-quality datasets is cumbersome, expensive, and takes a long time.
What’s an example of a data moat in practice? Well, think about credit bureaus like Experian and TransUnion.
These companies have huge data moats. Credit bureaus get dozens of reports from banks, credit card companies, fintechs, and numerous other data sources, all of which feed into their credit-scoring algorithms.
Each of these companies have their own unique data sources, but each of them has built up data moats that make it extremely difficult for any new startup to compete. Not only is data their moat, but it also drives revenue from their core product, the credit score.
When evaluating any startup, ask yourself, will this startup build a unique and valuable dataset that nobody else has? Will this dataset keep growing over time? Is this dataset difficult to replicate?
If the answer to these questions is yes, the startup has a strong advantage.
Startup Advantage No. 3: A Strong Brand
Branding, as a moat, predates most tech startups. They’ve been used for thousands of years to stand out from the crowd. We all have brands we’re loyal to.
Brands are used to distinguish one company’s products from another; building recognition of a brand and “mindshare” in consumers is the key goal. One of the greatest examples of a pure brand moat at play is Red Bull. Incredibly for an energy drink company, it doesn’t manufacture its own flagship drink.
Red Bull is purely a marketing company.
It outsources the production of its drink to third parties and focuses purely on maintaining and marketing the global Red Bull brand. The company uses a range of team-sport sponsorships (such as Formula 1), extreme-sport sponsorships and more to get coverage of its brand around the world and build global mindshare. This novel strategy has worked wonders; the company generates annual sales of more than $7 billion.
Startups that most benefit from strong and robust brands are consumer-facing startups like ecommerce companies. Even so, a strong brand is also very important for startups focused on selling to other businesses.
The best way (in my opinion) to evaluate the strength of a brand is to see what people say about it online (through reviews) and through in-person conversations with customers.
Nothing tells you more about a brand’s perception than speaking to its customers.
Startup Advantage No. 4: Intellectual Property and Trade Secrets
The last major moat that startups employ is intellectual property (IP) or trade secrets.
These advantages are most common in “deeptech” startups building cutting-edge products in manufacturing, aerospace and artificial intelligence and less common in companies building ecommerce and software products.
IP protections rely on the use of patents to give a company the sole right to use a technology it develops for a period of time. Patents come in many forms, and it is worth spending a little time learning about each one.
One of the best examples of the value of IP is Google’s PageRank Patent for the algorithm that helped power its search engine. This patent is what made Google’s search engine dramatically better than that of all of its competitors at the time.
The search experience Google offered allowed it to quickly draw users away from other search engines and become the dominant global search engine. This patent gave the owner a 20-year term for exclusive use of that specific method.
In 2018, this patent expired, and it is now in the public domain. But, Google’s 20-year period of exclusivity gave it the breathing room needed to continue research and development on its core algorithm. By then, it had developed newer and better technologies to power its search engine.
Patents, when properly used, can be a huge business advantage. However, most patents aren’t particularly useful on their own. Instead, patents are extremely useful when they protect a highly unique part of a company’s product and give it exclusive rights for years.
So you see, it’s not enough to invest in just a great team and a great market.
As investors, it’s important to seek out durable businesses that will both stand the test of time and be able to hold their own against other well-funded competitors with similarly great teams.
Great businesses have defensibility across one or more vectors.
These “moats” are critical structural advantages we must look for when assessing an investment opportunity. If a startup doesn’t have these moats, it’s hard to see how it will be a durable business over time.
On the other hand, a startup with a robust moat is far better positioned to build a highly valuable business through the years. Therefore, when you’re picking a startup to back, check the quality of its moats against the list I just gave you.
The more defensible its product or service is, the more distance it can place between itself and competitors en route to a high-multiple return on investment for you.
Simply put, companies with effective moats survive long enough to provide exit opportunities for angel investors.