Defensibility, Switching Costs, Barriers to Entry…
We hear these terms often when discussing startups. It’s not only important to build something of value, but value that can be protected. Many in venture capital, refer to this as THE MOAT.
Renowned investor Terrance Yang was asked recently, “As an investor, if you could ask founders only one question before making a funding decision, what would it be?”
Terrance’s answer: “How are you building a unbreachable moat protecting a very valuable castle?”
There are different types of factors that can create a moat… some internal, others external. An external example is regulation. In a previous life, I dealt with regulatory agencies including the FAA, while working in aerospace and defense, and the EPA, while working in the water industry. In both cases, the regulations were so onerous that getting a product to market was a multi-year, process. We even employed lobbyists to work on our behalf. While this put a strain on our new product development efforts, it also created enormous barriers to entry; protecting the value of products in-market.
There are also internal factors that create moats. These are factors that reside at the company or product level. Union Square Ventures has a thesis to invest in companies with network effects. Big surprise, central to their thesis is a moat. Network effects drive more user value, raise entry barriers and increase switching costs.
The problem with external factors is they often do more to limit innovation, rather than promote it. External factors favor the incumbent, whereas internal factors favor the innovator. We can argue the merits of internal vs. external moats, but it’s certainly easier to exert control over those factors that are in-house. If the moat exists at the product level, you own the moat. If you’ve hired a band of brigands to build and manage your castle’s moat, you may own the customer; but the master of the moat owns you.
Now, as an investor, instead of looking for startups with a variety of different moats, what if your thesis had a built in moat? What if the very category of startup you invest in creates enormous barriers to entry, brand equity, and high switching costs? This is why I invest in smart hardware.
Today, Ben mentioned a quote from Brad Feld, “I don’t invest in hardware. I invest in software wrapped in plastic.” There’s a big difference between a dumb gadget that collects dust and a smart device that gets more useful over time. Shelfware is to SaaS as the Gadget is to Smart Hardware.
There are a number of reasons why I invest in Smart Hardware.
-I’ve developed a smart hardware product.
-I love the business model.
-I love the annuities.
-I love that there’s constant pressure to create more customer value.
-I love that a sale is the beginning of a customer relationship and not the end.
But the thing I love most is that the smart hardware moat is incredibly wide and enormously deep. Not only is it exponentially more difficult to do smart hardware than software alone, thus raising entry barriers; but the connection and brand equity for physical products far exceeds that of virtual products.
The reason for this is that smart hardware benefits from many principles of behavioral economics and human psychology. These principles serve to deepen their relationship with the customer.
A sampling of principles that are far more powerful for physical products, than virtual include:
All of these factors make the customer more likely to buy, to use, to promote and to convince themselves that they’ve made a great purchase.
Does a moat have to be hardware? Absolutely not. But should a moat be fundamental to startup strategy from day one? You know my position. And if founders must face this when designing their business, why shouldn’t investors when creating their thesis?