Comparative Advantage with Technology - How to Measure Moats

Recently, we’ve seen incredible interest in AI-enabled services. We’ve long been believers in technology’s potential to unleash value in service businesses (previous investments include companies like Vettery, Block Renovations and Leap), but we think it’s essential to determine the scope and sustainability of technology’s impact on a company’s economic performance to determine if the thesis makes sense. We refer to this as “measuring the moat”.

While digital solutions may have the ability to provide advantages over legacy incumbents, knowing the size of the moat is critical to determining if the advantages are sizable enough to create a meaningful difference from competitors. When markets have become too frothy, investors have fallen prey to this fallacy, investing in companies that were nothing more than a digital skin on top of legacy solutions. This happened during the initial dot com wave with a slew of ecommerce companies that raised capital, aggressively spent and ultimately yielded no advantage over legacy retailers, and again over the last decade with examples in insurance, freight brokerage and real estate. Service businesses can be incredibly valuable, but when you focus on digital lipstick > value creation, you are creating a recipe for destruction.

As we think of measuring moats, it's important to recognize that “disruptors” and “enablers” have different methods of establishing their economic leverage over the industry status quo. Companies that are “disruptors” attempt to replace existing industry players with a redefined cost structure. “Enablers”, on the other hand, create efficiencies in the existing value chain that result in higher profits and/or consumer/producer surplus for existing stakeholders. Much like most things in life, these distinctions aren’t black and white, but often subject to interpretation. For broker intensive industries such as the freight logistics world, is a digital solution like Uber Freight a “disruptor” of existing brokers or an “enabler” of shippers and carriers? There are valid arguments for either, which is why it’s incredibly important to 1) understand the competitive dynamics of the industry and 2) to understand the impact the startup has on those industry dynamics. If the company is likely to change the behavior of other stakeholders in the industry (as many platforms and marketplaces do), it’s likely an “enabler.” If market fragmentation is too high to consolidate stakeholders to a single platform, then you are likely “disrupting” a broker.

Once you’ve determined the relevant categorization of your company, you must determine the lever points for how your company changes the cost structure of the industry status quo. We use the framework below (from our initial post on moats) as a basis for those economic levers.

For “disruptors”, applying these levers may reduce COGS, CAC, OPEX or increase Willingness to Pay (WTP). It’s important to note that the startup’s initial state (i.e. where it is today) may indeed operate at a disadvantage to the status quo, as is often the case for companies attempting to achieve economies of scale. This is why we generally like to break out a New Co’s economic structure into two separate profiles: 1) the Initial State (i.e. their unit economics today) and 2) Post-Disruption (where they can be at scale). See below for an example. When the New Co can offer a service that customers are willing to pay more for, but do so at a lower cost than what incumbents offer today, this creates “consumer surplus”. When the New Co can do this at a price below the cost structure of the incumbent (i.e. where the incumbent would make zero in economic profit), then that is its moat. Theoretically, if the New Co offers their product at anywhere below that price point, competitors won’t be able to compete on price and they can gain 100% market share (NOTE: in reality, this is rarely the case as customers vary in preferences and there are non-uniform transaction / distribution costs).

For “enablers”, knowing the cost structures of competitors is incredibly important, but you must also understand the cost structures of other stakeholders in the transaction. With “enablers” you must ask, “Can I make everyone better off, and still find a way to make meaningful margin?” We can do this through what is called “value stick analysis”, showing the profits of various stakeholders in the value chain (please see below for an example). In this case, the innovator enters the industry, shuffling the cost structure of a transaction. In the diagram below, the gray boxes represent the total dollars flowing through each player, with the bright green portion representing their profits. Some players increase in spend, others decline, but each is better off, taking in a higher level of profit than what they did before. This example also highlights additional consumer surplus created by compressing the value chain, enabling customers to purchase the same (or better) product at lower cost. While it’s not necessary for all stakeholders in the value chain to benefit for an “enabler” to succeed, you’d need to determine the competitive response for those that are adversely impacted and how it impacts the remainder of the value chain, which gets much more complicated.

In either case, it’s incredibly important to be rigorous in determining how much the New Co can change cost structures. We recommend studying industry cost structures, testing initial pilot data or acquisition costs or building bottoms-up cost analyses to determine what a realistic cost structure could be like. As you outline these many factors, you’ll have to use your judgment to determine whether the assumptions are reasonable and achievable, as well as your margin for error in achieving a solid moat. 

While companies should be thinking about their defensibility from Day One, moats are rarely demonstrated in the earliest days of the business. In these cases, founders can evaluate the company’s path toward moat (what we refer to as a “moat trajectory”) and determine whether their aspirations for a true moat are achievable and meaningful. Even if the company is able to achieve advantage in a single lever (such as AI reducing OpEx), this can be the basis for a massive advantage over others if it is meaningful enough and they can eventually operate at parity on the others. At Equal, we refer to the first demonstration of advantage over a single lever as the “first point of moat”, which is generally the core hypothesis we attempt to prove with a business after establishing its wedge and flywheel. 

While this analysis may seem like a LOT of work for an early-stage startup, it’s essential, especially in services with real marginal costs. There have been tens of billions of dollars lost simply because founders / VCs failed to understand whether they had developed an actual company of value (one with an enduring and impactful moat) or a digital version of a legacy business. This analysis creates not only a framework for true value creation - building  companies with both meaningful AND sustainable moats.

NOTE - The basis for this framework comes from the work of Michael Mauboussin and his famed paper “Measuring the Moat: Assessing the Magnitude and Sustainability of Value Creation”, which we highly encourage for reading.