May 2023 | 

Ready to Scale? Why You Need a Moat

Ready to Scale? Why You Need a Moat

Unless you’re in business school, or read a lot of books authored by business school professors, your definition of a moat probably comes from the Middle Ages, when castles, forts, and even whole villages created a first line of defense with a deep ditch. In business, Warren Buffet popularized the term as a barrier to competition that secures an organization’s market position. For startups, its importance is growing exponentially as uncertainty rocks VC markets and venture capitalists heighten their due diligence efforts — in this environment, a moat can be the factor that determines the kind and, critically, the amount of available funding.

When Wharton professor Gad Allon teaches scaling operations, whether in Wharton’s Scale School, to his MBA students, or to participants in the Scaling Business for Profitable Growth program, he tells his students that firms should usually accelerate their growth rate only if they can create a scale-based moat. “Are the general and competitive environment, business model, and operational reality favorable for growth?he asks. “The main question is whether you can create a scale-based moat, which usually translates into whether you feel the urgency to grow.”

Scale-Based Moats

As Allon describes in this post, there are three scale-based moat types, which strengthen alongside scale. He identifies them as:

  • Supply-Side Economies of Scale: This moat type is a massive investment in capacity that reduces average costs as the fixed or indirect cost becomes amortized over more units. Exemplified by firms like Intel, Amazon, Walmart, and Tesla, this is the most classical notion of economies of scale and the hallmark of the industrial revolution
  • Demand-Side Economies of Scale: With this type, the product or service value increases as value drivers on the demand side of the equation are activated. Typical in firms that rely on network effects (think Facebook and Snap), which create engagements between different users on the platform, willingness to pay increases as more users join (since each additional user is now connected to more users), and both the cost of acquiring customers and the churn rate   decrease.
  • Learning Curve: Gaining scale in industries where the advantage is based on the ability to train humans or algorithms in performing a task allows them to provide a better service (or lower cost) through more transactions or customers. This then allows them to accelerate the rate by which the humans or the algorithms are trained. While data itself may not be a moat, data plus an algorithm can become better and further improve with more data. This is typical in health care (e.g., cancer care), cyber security (the more attacks, the more you learn), and even manufacturing.

Other Types of Moats

Apart from scale-based moats, there are other ways for firms to protect themselves, and it is important to note that firms can have more than one moat. And while these other moats may enjoy scale, driving customer acquisition acceleration, they do not depend on or become better with scale. These include:

  • Intellectual Property (IP): Owning the rights to a certain patent, copyright, or trademark (or know-how, even if not patented) that allows a firm to offer a better solution than the existing technology does (e.g., a faster search engine, a more effective drug). This is very common in pharmaceutical and telecommunications companies.
  • State Granted: The state grants the firm exclusivity to customers or assets. For example, the state could grant the right to a specific spectrum of radio frequency or the right to mine a specific rare earth mineral.
  • System Rigidity: Otherwise referred to as switching cost. Customers are often reluctant to switch from one product or service to another because they don’t like discontinuity or because they already exert relationship-specific costs. When your favorite apps exist only on your iPhone, for example, you are less likely to switch. If a firm has invested in training its salespeople on Salesforce, it’s likely to continue that way. Some of these decisions are economic-based, but most are behavioral. Note that this is true only for existing customers and doesn’t translate into a competitive advantage for new clients.

Assessing Your Growth Tailwinds

Allon says an ability to create a scale-based moat is a critical growth capability, yet “when money is flowing and growth is rapid, significant pitfalls can be hidden. Everything looks great as long as you are growing. Then, the music stops and the lack of a real competitive advantage is exposed.”

“To stay ahead of all those who will start copying you and convince the unconvinced,” he warns, “you need to go deeper and build a moat — a true competitive advantage. And having more than one is even better.”