(2019-09-19) A Taxonomy Of Moats

A Taxonomy of Moats. There are many different moats but they have at their root only a few different principles. This post is an attempt at categorizing the best-known moats by those principles in order to evaluate them systematically in the context of starting a company. (startup)

I am going to try to be focus on only the barriers that seem to have structural causes. This excludes things like management talent, founder vision, company culture, and the like

Every business strategist seems to have a list of moats–Porter, Rumelt, Helmer, Greenwald, Mauboussin, etc. all the way back to Adam Smith. This post is less interested in the catalog of moats or the advantage a particular moat confers; it is more interested in attempting to isolate the underlying mechanisms that moats have in common to determine the difficulty a startup might have in establishing a barrier against competition.

One of the strategic tasks of an innovator is to deter imitation for as long as possible.

This applies not just to companies in established markets, but to startups that are creating new markets.

An innovation is a type of competitive advantage (though not all competitive advantages are innovations) and the strategic job is to make that competitive advantage sustainable over time

Mechanisms to deter or slow imitation are called, colloquially, moats.

Moats draw their power to prevent imitation from one of four basic sources:
The state,
Special know-how,
Scale, or
System rigidity.

Below is a taxonomy of the most common moats, organized by these sources.

in most cases a sustainable competitive advantage must be built up over time

State Granted Advantages

government is, directly or indirectly, protecting a company from competition.

Special Know-How

Having knowledge that no one else has is an excellent way to prevent imitation. It restricts access to a scarce but needed resource.

Exclusive access to something is only possible when you have the power to control that access.

Companies can keep some knowledge protected by keeping it closely-held: Kentucky Fried Chicken’s secret spice recipe,

A better example are the trading algorithms hedge funds like Renaissance have employed to earn market beating returns

In the 1700s the British government tried to maintain a national monopoly on technologically sophisticated cotton mills by prohibiting the export of their designs

One study of knowledge diffusion of new industrial technology found that “information concerning the detailed nature and operations of a new product or process generally leaks out within about a year.”

A more enduring advantage is tacitly held knowledge. Tacit knowledge is knowledge that can’t be easily communicated

Any field of which it can be said “there is more art than science” is probably one where tacit knowledge is important.

Individual tacit knowledge, while always valuable, is a weak competitive advantage as an organization gets larger because it is hard to scale. It is also only sustainable until a competitor hires the individual who has it.

Some tacit knowledge is not contained within the head or hands of individuals but embodied in an organization.

While individual tacit knowledge goes down the elevator every day, collective tacit knowledge is more durable and harder for competitors to obtain or imitate.

Returns to Scale

Economies of scope come from the same place.

scale can also increase the value of a product. This is often called network effects

Two-sided marketplaces and platforms are often lumped into network effects, though they don’t really create networks

Advantages to scale are also caused by the reduction in outcome variance when risky endeavors are bundled together.

Facebook was not the last social network to succeed. Instagram, WhatsApp, and others became valuable because they picked other qualities users desired and made themselves best at those. Scale advantages are only durable to the extent they inhibit direct competition.

System Rigidity

If changing from one product to another also requires changing other things—other products, routines, skills, etc.—the total cost of the change may outweigh the benefits so the product already embedded in the system can maintain an advantage over similar entrant products that are not (or not yet) interconnected

This tight network is not always imposed by a company, it also arises naturally through industry dynamics

If a startup is to become a valuable self-sustaining company it must eventually have a moat. Building one must be part of their strategy.

uncertainty is not just a nuisance startup founders can’t avoid, it is an integral part of what allows startups to be successful. Startups that aim to create value can’t have a moat when they begin, uncertainty is what protects them from competition until a proper moat can be built. Uncertainty becomes their moat.