Venture Capital Due Diligence: Building Product Moats

Due Diligence
April 28, 2021

This is part of GoingVC’s Research Series on Venture Capital Due Diligence

Introduction | The Screening Process | The Market Test | The Scorecard
The Management Test | The Management Team
Product KPIs | Building Product Moats
Accounting 101 | Financial Valuation
Technical Due Diligence

How to Build a Moat

Financially speaking, a company moat is a system of competitive advantages that help a company generate excess returns. In VC-speak, we can swap out excess returns for perhaps sustained growth. VCs should identify which and how many proprietary advantages a company has and how management intends to deploy such advantages. Generally, these moats are built around a technology, legal (i.e. via patents or trademarks), access (geographical, resource-based), or position (first-mover) advantage. Let’s dive in a bit deeper to better understand how a moat is built.

Real Product Differentiation

The simplest type of moat comes from having a better product. However, with simplicity in design comes a high degree of failure. Better products often require premium prices, which can hamper margins, prohibit extensive R&D spending, or create a sensitive brand (as customers will be quick to leave if quality deteriorates). Luxury brands are often characterized as low margin, incredibly competitive markets with extremely fickle dynamics – and these companies are constantly searching for additional competitive advantages. While first-movers often have an advantage, it can easily be wiped away as new entrants hit the market. For VCs vetting companies that are creating new markets, relying solely on a first-mover advantage or ignoring the possibility of future competition should be seen as a red flag. These companies should have a clear plan in place to develop a wider moat.

Let’s take a look at White Claw, everyone’s favorite Seltzer, an undisrupted market leader. While not the first Seltzer to hit the market, it can be argued it’s high profile launch and virality re-kicked off the interest in seltzer and placed it at the forefront, giving it a head-start over others. Of course, as previously mentioned, being first is no guarantee of continued success.

Perceived Product Differentiation

This moat is developed through the power of the brand. Why do people buy brand name things when many of us know private-labels are just as good? The perceived notion of superiority associated with the brand. Big brands do not just carry this as a symbolic advantage, they can be capitalized on the company balance sheet as an intangible asset (which can lead to lower borrowing costs, for example, and a higher valuation) – a very tangible benefit. Brands take time and serious amounts of capital to develop, so it’s unlikely to be seen as a foundation for a moat in early stage companies, but growth equity and late stage VCs should take stock of the brand and it’s sentiment within the marketplace when performing due diligence on a company and its products.

Swinging back to seltzers, White Claw took a questionable first-mover advantage and turned it into a real moat with it’s strength of brand that developed. We now have the makings of a product primed for rapid growth.

Low Cost Leadership

What happens when competitors wake up and want to get into the game? Often times this can be done by offering similar products at lower prices. This, when executed well, can be a successful way for incumbents to drive off competitors (through the use of scale to offer lower prices, such as WalMart) or create a terrifying race to the bottom. To be fair, the latter does not always end poorly as commodity-type businesses such as airlines have found ways to be profitable, for example – but they’re not envious business models! To be successful as the low-cost leader requires developing a better process (often through technology) or more efficiently operating at scale.

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The first hint of skunkiness for White Claw comes as major brands such as Budweiser rush to release seltzers on the strength of their brands and efficiency of their global supply chains. As Bud’s budget allows them to come to the market with deep sales and a massive marketing spend, White Claw will likely need to rely on their loyal customers, which is challenging in an industry where there is little product differentiation, to hold their market position.

High Switching Costs

How much would someone need to pay you to switch the brand of pen you write with? Probably next to nothing, if you even know what brand of pen you most recently used. Now, how about changing your bank account?

Ah, switching costs.

Companies that can ‘lock-in’ their customers by making it hard to switch have built a very respectable moat. Banks, asset managers, insurance companies, cell phone carriers, and the like benefit from the fact the effort for consumers in making the switch is not outweighed by the benefits gained. Ever wonder why every cell carrier is constantly advertising a free new iPhone if you switch? The cost of acquiring new customers is high, but the chance they leave is low – making the customer lifetime value relatively high. The downside is that it makes disrupting these markets very, very challenging…and very expensive. It is why most of these markets are oligopic in nature and most innovation comes from technology and tangential innovation.

If White Claw exited the seltzer market, what would happen? Nothing. Die-hard White Claw fans would most likely move onto the closest competitor and feel rejuvenated. Note high switching costs are not the same as brand loyalty. High switching costs imply it is not worth making the switch — if a new seltzer came to the market at half the price as White Claw it would be relatively easy for White Claw drinkers to make the switch —  the company does not benefit from high switching costs. (The degree to which fans choose the higher priced White Claw over the new bargain product can be attributed to brand loyalty, quality, or other.)

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High Barriers to Entry

If high switching costs are all about keeping customers locked in, barriers to entry are all about keeping competitors out. Firms often acquire this moat via it’s industry than through proprietary development, meaning firms that operate in industries that require substantial capital to start (manufacturing, utilities, for example), are highly regulated (casinos, airports), or are dependent or patents (Biotechnology, Big Pharma) rarely see this moat deteriorate once they’re able to launch successfully.

Starting a beverage company is extremely capital intensive. It requires not only years of expensive R&D, but physical assets, numerous distribution channels, and complex sales partners, among others. This plays well for first-movers who know competitors will have to spend substantial amounts of money to enter their market. This likely explains the lack of success of other small and medium size seltzers and the more recent launch by mega-brands in the space (who could let the market develop and use their larger balance sheets to their advantage).

Network Effects

A lot has been written about network effects in the last half-decade as marketplace platforms have grown. Network effects arise when the value of a platform increases as more users join – essentially when value is created from interactions among users. It is this endogenous value-creation that gives network effects a premier moat construction.

eBay is perhaps one of the finest examples (and first in many respects) of the benefits of network effects. The company has staved off competition from larger players throughout its history and basically operates as a monopoly because it was able to so efficiently capture both sides of the marketplace – as more buyers came, more sellers came, and so on. It is important to distinguish here between word of mouth virality and network effects. The former can certainly help establish, but does not define the latter. Network effects lead to higher growth, sustainable margins, and real value, they are the product of word of mouth growth, use of data, creative customer acquisition tactics, and customer interactions, not the source.

Can an undifferentiated consumer product such as White Claw generate network effects? Absolutely – but it’s really hard. It’s why brands today work so tirelessly to create communities. Admittedly, it’s hard to opine that White Claw benefits from real network effects as there is no more added value to me as more people drink White Claw.

For VCs, determining the presence and strength of a competitive moat is challenging. Most important is determining what unique competitive advantage exists. Harder yet is determining how long an advantage will last. This is why management should be aware of the competitive advantage(s) sought, how to assess their product’s positioning in this framework, and understand when an advantage may be at risk.

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