How to Think About Economic Moats When Starting a Business
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Warren Buffett, the investment oracle from Omaha, famously looks for businesses with "moats" that can all but guarantee returns over time. As investors’ returns are taken from a firm’s profits, finding and establishing a moat would appear to be universally good advice in business. So can entrepreneurs gain from thinking about moats for their startups?
A moat, according to Investopedia, is a “business’ ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms.” Indeed, an economic moat, just like the medieval fortress original, keeps competitors out by raising barriers that lessen threats and make take-overs more difficult. A moat is a defensive measure that allows a firm to retain a leadership position and increase margins.
Profits and inefficiency
Economists refer to such margins as “monopoly profits,” since they are earned because of competitive imperfections. They would disappear in perfectly competitive markets, so economic efficiency is largely synonymous with zero economic profits.
That cannot be a goal for the individual firm, however. While zero profit means the business breaks even, this is no incentive for investing or going through the trouble of starting and running a business. Instead, as Michael Porter recognized, firms formulate strategies to set themselves apart and earn profits. Consequently, they earn profits from creating and exploiting economic inefficiencies.
A moat, simply put, is the firm’s achieved ability to protect that economic inefficiency that allows it to generate and earn profits. A firm that doesn’t have one should consider whether and how to create one.
In this sense, moats should perhaps be also on the entrepreneur’s radar. They should not be an afterthought in any business, but should also not be a first priority in the startup. After all, one cannot defend what does not yet exist. So unless you already have a fortress, a moat will do you no good. Yet if you build a fortress, it makes sense to build it where you can also create a moat. As Buffett’s investment strategy shows, a fortress without a moat is harder to defend.
Creating value can be your economic moat
For the startup, it should not be a choice whether to build a fortress or the moat. Rather, the fortress and moat should both be in the blueprint -- and the former should generate the latter. Successful entrepreneurship is, in a sense, about building a fortress in a shallow lake, thus creating a moat as a result of building the fortress.
Entrepreneurs should focus on creating new value through their startups, meaning they offer consumers something they have not been offered before. While this introduces economic inefficiency, at least to economists, it is not an inefficiency in your own business. Instead, by creating new value, your startup reveals to consumers the relative inefficiency of competitors.
Here are three ways to think about creating value in your startup:
1. Make value your strategy. Real value is in the eyes of your customers, so think of them first. If your startup can do a better job providing customers with value than competitors, then asking them to pay a premium should not be an issue. That is your moat: you can charge higher prices for even higher value.
2. Create your competitors’ inefficiency. This does not mean sabotaging your competitors. Your startup should aim to outdo them by doing things differently or doing different things -- or for different customers. The difference between the new value you create and the ‘old’ value offered by competitors is your source of profits as well as your advantage.
3. Staying ahead requires no defense. If you can score more effectively than your opponent, winning doesn’t depend on playing defense. This is is true in sports as well as in your startup. But it is also true that the best defense in the world will not win any games unless you can also score. So think offense first. If you do it well enough, your ability to create more value than competitors is your moat.
While Warren Buffett is right to look for investment opportunities with moats, this applies to businesses in existing competitive markets. Leaders in "red ocean" markets will see their profits fall to the industry standard or even zero unless they can protect themselves from the competition. For stagnated industries, this is defensive game -- it is about erecting barriers and digging moats.
But for industries that are not stagnant, where there is progress and innovation, what matters more is offense: to create new value. Without the ability to create value, no moat in the world can save your business. Entrepreneurs are better off playing offense and learning to do it well.