"As we wrote about in “What is a “Moat” and why does it matter?”, we define moats as “Proven, perpetuating and permanent unit economic advantages from peers within a competitive set”."

"As early stage investors, we don’t evaluate the company’s current moat, but rather its path to a “moat trajectory” (highly recommend listening to this podcast from Mike Tian of WCM for more on this concept)."

"Even with that, companies must first build (what we refer to as) “capabilities” before they can establish a moat or even a moat trajectory."

"Customer oriented organizational design generally revolves around behavioral psychology of customers, locking in a customer post-purchase. These organizations tend to front-load sales/marketing efforts and/or subsidize short-term pricing/profit to bring on customers with a long-term LTV in mind."

"Capabilities (referred to as “powers” by some, including Helmer’s immensely impactful book 7 Powers) are the intangible assets that you have developed as a business that enable you to operate more effectively and earn returns above others in the market."

"Ultimately these are the engines of your competitive advantage, determining the persistence and scope of your moat."

"While these may never appear on a balance sheet, they are the single most valuable asset of a company."

"Greenwald proclaimed that competitive advantages fell into two distinct camps, customer captivity and resource captivity, and that the strength of these advantages were a function of scale."

"Scale ultimately made it easier/cheaper to acquire and retain customers (customer captivity) or to produce your product (resource captivity)."

"We’ve chosen to expand upon this foundation by adding two additional parameters for success, network effects and organization design."

"Demand-side economies of scale: Increasing returns to scale making it cheaper / easier to acquire customers."

"Supply-side economies: Lower production costs achieved via higher asset utilization, lower cost of capital or the ability to purchase variable inputs at lower costs."

"Risk variance: Ability to aggregate and progressively manage risk as the cost of uncorrelated volatility minimizes with scale."

"Process Power — Complexity: Companies that pursue complex, challenging goals face fewer qualified competitors than those who chase easier goals. It also takes longer for copycats to catch up, which helps entrench the top dogs."

"Process Power — Speed: Not only must companies embrace change, but they need to embrace changing quickly. Speed is also relative."

"Process Power — Efficiency: Companies that become increasingly more efficient with their resources for every additional dollar that they put to work, enabling increasing returns on investment."

"Unlike scale, network effects tend to experience exponential returns to scale (whereas gains from additional scale can still be positive, but generally experience diminishing returns)."

"We seek to define different forms of network effects and the ways to stress-test them to ensure they are both 1) actually in-place and 2) impact the competitive positioning of the company."

"Compatibility, standards and protocols: Interoperability of technology that encourages incremental use and adoption of a service as it grows."

"Cults / Reflexivity: When belief in a company transcends fandom and borderlines on religion, rationality barely matters. Irrational pricing is what enables companies (like Tesla) to raise capital, tackle new ideas, and stir up exuberance again."

"Customer network effects: Marketplaces matching buyers and sellers."

"Endogenous data network effects: Data acquired and implemented from an application to an end client that makes the service increasingly valuable over time."

"Local network effects: Density and/or critical mass achieved in a local geography enabling increasing value to the user."

"User network effects: As an increasing number of users join the service, it becomes increasing valuable."

"Exogenous data network effects: User generated content that creates increasing utility of a service while capturing new demand."

"Platform Dynamics: Attracting others to develop and build upon your system to increase its attractiveness and utility to 3rd party users."

"System data network effects: Systems learning from increasing customer utilization that makes it increasingly powerful."

"Organizational design has been touched upon within strategy circles preceding the digital age, but has been amplified with availability of venture capital."

"In the past, businesses were often defined by the geographic territories they presided over, experiencing diminishing competitive advantages as they moved further away from their core centers of influence"

"This yielded numerous localized winners and a few major players who were able to consolidate territories and market share to amass behemoths (ex. Walmart). With costs of digital distribution being far cheaper and nearly limitless, however, winner-take-all dynamics are much more feasible."

"While competitors can often offer products of comparable quality, small advantages in LTV ultimately generate globalized advantages over competitors resulting in winner-take-all or winner-take-most dynamics"

"On the resource side, we generally see these capabilities as state granted resources, patents, IP and/or brand trademarks that the organization has exclusive control over."

"State granted: A government indirectly/directly protects a company from competition by protecting necessary resources (patents, IP, supply chain resources, etc.)."

"Brand: Consumer perception around a company that enables proven increase in WTP above comparable products."

"System of Record: High costs to multi-homing across multiple services."

"Financial — Sunk: Customer reluctance to switch due to high investment and costs already incurred."

"Procedural — Search: Customers are reluctant to switch due to high time and effort gathering and evaluating switching with limited benefit."

"Procedural — Uncertainty: Customers are reluctant to switch due to potential likelihood of low performance when switching."

"Procedural — Cognitive: Customers are reluctant to switch due to potential for high time and effort learning new procedures."

"As we work with early-stage teams, we ask them “which of these capabilities are you trying to build?”"

"If you are a business that yields customer advantages because you are the system of record, make sure you lock customer data in wherever possible. Owning as much customer data as possible is ALL THAT MATTERS"

"Either way, defining the capability(ies) you are creating is the core of competitive strategy."

"Why VC’s Obsession with Big TAM is a Big Mistake"

"Given all these uncertainties, a large market simply isn’t enough. It’s your positioning in the market that matters."

"Market share is one of the leading determinants of margin, so if you want to be a profitable company, it’s not about being in a high gross margin category like software, it’s about owning your market."

"Don Valentine once said “I like opportunities that are addressing markets so big that even the management team can’t get in its way.”"

"Don’s POV on market sizes and the importance of storytelling has informed much of the Silicon Valley “pitch” mindset of the last 3–4 decades, orienting founder <> investor behavior around grandiose pitches on “TAM (Total Addressable Market)” at the earliest stages."

"While many VCs value a company based on multiples, the core underpinning of a company’s value when it hits public markets is its future cash flows."

"The core competencies required for success have changed as well. Chasing a large TAM with a great story isn’t enough. If you don’t have the mechanisms to create a sustainable advantage that generates long-term cash flows, you’ll be sitting atop a melting ice cube."

"Many of these companies raised hundreds of millions (if not billions) to “win” their market, with the justification that the size of prize was worth the investment. Many are now struggling to find any path to profitability and sustainable earnings power."

"There is one sacred rule of business that is often not addressed — “Competition is bad for business.”"

"generally the less competition a business faces, the better its chances of generating earnings."

"While most monopolies are formed via network effects, economies of scale, or state-granted permission, there is another often overlooked form of monopoly power that we see every day but rarely apply to the tech industry: the structural monopolies of niche markets."

"Competition Demystified, which highlights geographic proximity and market size as two major parameters that contribute to monopoly-like returns."

"These markets are often too small to lend themselves to multiple winners, so once a competitive advantage is set, the dominant firm can generate significant profits from that position."

"The same could be said for retail and local services in rural markets, where you’ll see players take outsized margins knowing that consumers have limited options."

"This was core to Walmart’s success and is a wonderful case study in Competition Demystified, where Greenwald highlights Walmart’s ability to crowd-out local competition, leveraging their corporate economies of scale as competitive advantage against their localized competitions."

"But in the decades since Walmart established its dominance, new technologies made the geographic constraint less limiting, making TAM constraints one of the last bastions away from competition."

"Small markets = less competition = more profits"

"Market size constraints are a limiting factor to growth, but they also limit competition."

"This is because small or declining markets can’t accommodate multiple players capable of driving long-term profits."

"Clayton Christensen discusses this at length in The Innovator’s Dilemma, noting the persistent failure of forecasting and posing that organizations should build for optionality and agility given the uncertainty of market sizes and adoption rates."

"Once a company has dominated its market, it can use that foundation to expand their addressable market (or produce cash flow to return back to shareholders)."

"These vertical software businesses, generally spend far less on sales & marketing than their horizontal competitors, and produce nearly double the level of EBITDA."

"The unifying trend behind all these business strategies is that they are able to 1) develop early competitive advantage in a market, 2) dominate the market share of that market, 3) produce profits and/or cashflow from that position and 4) choose where to expand from there."

"Given the law of large numbers, it’s far more efficient to capture a dominant market position in a smaller market than it is in a larger one with lots of competition, which is why we think niche markets represent an underestimated beachhead for great companies."