A Playbook for Value Creation

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While the process for identifying great companies is never uniform, there are indeed best practices to follow in building scalable, defensible companies. At Equal Ventures, one of our core philosophies around identifying companies with breakout potential is evaluating opportunities for perpetual unit economic advantages, or as we like to call them, moats. 

We’ve discussed how we view moats in prior posts, but thought it would be helpful to address our methodology for building companies that optimize Time-To-Moat (TTM) and expand the economic impact of their moat(s) over time. Our process isn’t magical, but we’ve seen it work, especially for companies in legacy industries where digital moats largely remain up for grabs.

THE 4 STEPS TO BUILDING & SUSTAINING MOATS - WEDGE, FLYWHEEL, MOAT, EXPAND

Wedge: Moats almost never exist from Day One. With that, the first step to developing a moat is identifying a path to market that uniquely differentiates you from the pack, a foot-in-the-door so to speak. There are many ways to do this, but the key purpose of this phase is to identify an initial (more to come on this distinction later) subsidy to attract customers to your platform / service / marketplace and away from existing incumbent services. 

The methods of doing so are too various to mention, but one of the more popular (and successful) means we’ve seen has been offering free(mium) software services. This method generally offers the customer a highly functional tool/product at a freemium/reduced price point in exchange for access to the customer and/or their data. We’ve seen many companies use this tactic to steal wallet share from other business line items the customers may otherwise pay for, such as financial services. For the customer, this is a trade off between granting access and paying for the product. For the platform, while initial CAPEX is high (due to development cost of the product), variable acquisition costs are generally far lower than traditional methods. Many times, the best software-based wedges don’t feel like platforms, but rather like tools. They are simple, easy to use and drive high levels of engagement due to their simplicity. They lure customers in with an easy-to-understand value proposition that provides immediate benefit, without signaling long-term platform ambitions that might otherwise drive competitive responses. 

The key to the wedge is ensuring it facilitates capture of the flywheel assets (data, customers, users, etc.) necessary to ultimately establishing a moat. All too often, companies incorrectly assume that they can figure out monetization (let alone moats) based on initial usage /engagement, but we’ve seen this difficult and wasteful if not carefully thought through. Knowing what unique assets you’re accessing via the wedge and making sure these 4 steps work in unison is absolutely essential. A first-mover advantage alone is simply not enough.

Flywheel: As usage/engagement permeates the platform, it’s time to use the flywheel assets (i.e., what you have acquired from your initial wedge) to establish a recurring feedback loop for your service. Network effects are probably the most impactful and commonly attempted (albeit rarely realized) means of generating a flywheel, but there are other methods for generating this initial power of the user/market. It’s important that the service is designed to demonstrate incrementally more user value for each incremental session it performs. The biggest mistake that we see at this stage is founders building a company that drives high engagement, but ultimately little incremental value generated with each iterative session. This is INCREDIBLY important as the extent of your defensibility will largely be based on velocity of how your service improves, making it increasingly more difficult for others to replicate and/or compete. This is far and away the stage at which most companies fail. Achieving relevant flywheel effects is incredibly difficult, but signals that you are in the early days of creating something special that can yield above market returns to you and your investors. The ability to earn above market returns (i.e. your moat) represents what we call a “capability”. 

Moat: Once the flywheel is set in motion and you’ve created a unique capability for your company, it is imperative for companies to validate the presence and extent of moats in the business. While founders need not price products to market parity, it’s important to assess whether the juice will be worth the squeeze. We recommend founders create three states for their core market: 1) current state of economics for competitors/market, 2) current state of your economics, 3) future state of your economics. For some businesses (like tech-enabled services or marketplaces), the early moats are easy to calculate. For others (like social networks), the extent of the moat may be immediately known, but rarely calculable. Lastly, there will be businesses that demonstrate worse economics than legacy players at first (generally platform businesses). For these businesses, it’s essential they demonstrate a “moat trajectory” (i.e. path toward the moat) and can show their initial proof points of that moat. In these cases, the slope of their improvement is INCREDIBLY important and investors must use their best efforts to 1) determine when the long-term advantage will be achieved, 2) determine how much capital will be necessary to seize that advantage and 3) whether that advantage will be significant to warrant the scale of investment (these businesses are generally the most capital intensive, but can be incredibly lucrative if properly seized – ex. Amazon). 

Expand: For a moat to be a moat, it must generate a sustained advantage. The difference between whether your company has captured an initial advantage or one that is sustainable and scalable means EVERYTHING. Companies with only initial advantages (such as those reliant exclusively on economies of scale) are likely to face bitter competition that will lead to continued R&D spend, lower pricing power, higher churn / customer acquisition costs and, ultimately, lower margins. Those who have properly set moats should see profitability dramatically improve as market share consolidates. While this may seem like the time to coast, it’s the exact opposite. This is the time to double-down to seize greater captivity over your base and expand your service to further increase wallet share, margin and/or willingness-to-pay. Companies that are able to make this transition go from GOOD to GREAT as LTV per customer grows, enabling ever further operational leverage on CAC. Many are positing that moats are thinner than they’ve ever been (even for digital companies), so it’s more important than ever to double down on moat expansion if and when your company gets the chance. 

PULLING IT ALL TOGETHER

While there are countless ways to build great companies (and certainly many ways that do NOT fit this framework), we’ve found the steps above to be helpful in establishing some order from within the chaos of starting, building and scaling a company. As a firm that believes heavily in hypothesis-based investing, we like to see founders test/validate each of these through the various stages of their capital raising lifecycle and we generally find ourselves investing with visibility into a near-term flywheel and/or early signs of a potential moat. We often use this framework with founders to determine the key hypotheses they will need to prove out for their business at various stages. 

While there are indeed incredible companies that generate near-term visibility of economic moats before even launching a product (showing great thoughtfulness in product design, strategy and execution), more often see it requiring multiple, methodical steps to unlock moats. Proving/disproving these fundamental hypotheses requires immense focus and we try to align the Objectives and Key Results (OKRs) of the business to these hypotheses to ensure everyone in the company is squarely focused on their achievement.