How To: Protect Your Profits
Russ Wilcox
Partner at Pillar VC
Let’s assume your business grows exactly as intended, but then everyone sees what you are selling and how much profit you are making. What stops someone else from eating your lunch?
Imagine you launch a great product and start to grow quickly. What happens next? Life gets TOUGHER, because you will attract hostile attention from the incumbents who are losing business, and at the same time, a host of fast followers emerge to steal a piece of your success.
When asked about these dynamics, most founders grow impatient or a bit uneasy. It seems hard enough right now just to build a good product; they want to worry about the rest later. However, they can end up wasting years of their lives, if they don’t anticipate how to deal with competitors well in advance.
Incumbents have grown adept at squashing competitors. They have an automatic allergic response to start-ups. Come up with a new flavor of soda and start to gain sales? You can bet Coke or Pepsi will introduce a similar flavor, and kill your business. Or they will simply pay higher slotting fees, and your product will be on the bottom shelf. Think of how FaceBook added stories to Instagram as a way to defuse Snap. Create a new interface for tracking tweets? Twitter comes along and shuts you down because they want to control the use experience. Start selling a tool for managing salespeople that takes off? Suddenly Salesforce, Oracle, Microsoft, and IBM start offering a similar tool to the accounts they already own and you have nowhere to sell.
What stops someone else from eating your lunch? Peter Thiel calls this the need for a moat.
If you do have a good answer for fending off the incumbent response, next think about copycats. Let’s assume your business grows exactly as intended, but then everyone sees what you are selling and how much profit you are making. What stops someone else from eating your lunch? Peter Thiel calls this the need for a moat.
There are graveyards full of startup ideas that die at that question, so it is worth exploring a variety of ways that start-ups can use to protect their hard-won profits.
First-Mover Moats
The best answers are when there is something about the business that creates a first-mover moat. If the start-up can break out and capture the lead, then it can gain from speed or scale or experience in a way that snowballs and makes it a permanent leader. Here are some examples:
Network effects grow with time and are highly attractive because they grow exponentially fast. Here is a network effect: when Bell Labs has 2 phone subscribers on the first day, there is only 1 potential conversation. But with 10 phone subscribers, there are 9×10/2 = 45 potential conversations, and this grows exponentially (Metcalfe’s Law). When Facebook adds one person, that person not only receives benefit for themselves, they also create benefit (by adding content) for everybody else. The basis of a network effect is interoperability – anyone on the network can interact with everyone on the network.
Two-sided marketplaces have a network effect. If the most buyers for rare stamps are on eBay, then everyone selling a rare stamp will go to eBay, and this attracts even more buyers. The most drivers are on Uber and Lyft. The most apartments on AirBnB, the most travel reviews on TripAdvisor, the most sports gamers on DraftKings, the most furniture on Wayfair. Once a clear winner in each of these marketplaces emerges, they have an enormous edge over smaller sites.
Setting the standard is another type of first-mover moat. Once a leading standard emerges, such as Linux, then more support and more effort and services are offered for that standard and it becomes unbeatable. Because of the power of this effect, engineers try to build their products using standards that are open-source and controlled by a committee rather than one company. However, there is a chance that a market-leader in each “layer of the stack” (meaning each of the layers of hardware, network, operating system, development tools, analytics, and applications) will obtain such high share that everyone will adopt them, and then they can achieve a privately-owned standard. Intel and Microsoft did this in the PC era and earned many billions as a result.
Economies of scale occur when size drives a cost advantage over smaller rivals. This sounds like a manufacturing effect but it is also key in software – once you write the software, there is no cost to making copies. So whichever software company is bigger will earn a higher profit, which they can then reinvest to grow even bigger.
Economies of scope refer to cost reductions you can achieve by combining different products. For example, if you are selling someone a movie ticket, you get to sell them drinks and popcorn. The biggest exploiter of this effect that I know is Amazon – come there for anything and they will cross-sell you every accessory, plus nearly anything else you can think of, all in one order.
Other Respectable Moats
If a business cannot access these powerful, self-reinforcing first-mover moats, then there are still some other strategies available to create a less powerful but still respectable moat.
One example is territorial dominance. Once WalMart expanded into smaller cities and soaked up each local pool of demand, there was no room for a rival to also enter profitably. Our portfolio company Soofa places digital signs on city streets; once there is a Soofa sign on a certain corner, it is doubtful that the city will approve a similar sign from a competitor on the same corner. If a chain like Dunkin’ Donuts or Pizza Hut can deeply penetrate a city, they can spread costs of citywide radio, TV and newspaper ads across many storefronts for an unbeatable edge on ad costs. These businesses may not be monopolies on a national scale, but they are on a local level. If this is the dynamic then people call it a “land grab” market.
Captive channels can have similar benefits. Businesses that spend years patiently building up networks of distributors are creating a barrier to entry because competitors cannot easily sell through these channels without displacing the incumbent. Apple invested in stores so they could have captive relationships with customers. Netflix movies can be certain of distribution through Netflix. The Avon salesforce would be difficult for a competitor to poach.
Another example is mastering complexity. For example, few companies understand how to design software to handle airline reservations. Even if you wanted to enter the business and could see how the existing players operate, here’s just too much going on behind the scenes to easily imitate. In our world, E Ink had to understand chemistry AND optics AND coating AND device controllers. That technical complexity yielded substantial trade secrets but the complexity can be non-technical. Subway is known for having a franchise operating manual that is a masterpiece and helps ensure every store runs tightly. Construction companies who know how to manage massive projects are able to bid on major public works when their smaller competitors could not.
Another moat can come from patents. That’s good, but not as appealing as a network effect, because it costs money to enforce a patent, while scale economics enforce themselves. On the other hand, patents are moats that even individual inventors can use for protection.
Another medium-strength moat is regulation by the FDA. Although it can cost hundreds of millions or even several billion dollars to develop a new drug, once you are approved then the FDA will typically only approve one of your competitors if their product is the same or better than yours. You get to set the “standard of care.” Once products hit the market, there is no room for knock-offs until they go off-patent. Prescription drugs are heavily restricted – only doctors can prescribe, only pharmacies provide. And if a clone drug could somehow get onto the market, the infringement of your patent will be immediately obvious because chemical compositions of drugs are easily tested. The reason that VCs can bet so heavily on drug development is because there are strong barriers to entry.
Since these barriers are purely legal, they are not completely reliable. The government of India often forces drug makers to license their patents for cheap local production. Companies that find a new use for an old drug may receive a patent on the use, but they cannot easily stop doctors from prescribing the old drug off label for the new purpose.
Be careful of betting on regulatory edges that can be changed on a whim by politicians. One CEO in our Forum spent millions of dollars to develop software to help hospitals meet a new requirement created by Obamacare. By betting early, he expected to be the only software provider available to hospitals ready with a solution before the requirement took effect. However, when the deadline approached the hospitals just all complained to the government that they were unprepared. The government agreed to push back the deadline by several years, and his market evaporated.
Customer switching costs are another moat that can be strong. Once you buy a home alarm system, you may be required to use the manufacturer’s proprietary monitoring service until you are willing to rip it out and buy a different system. Training and habits can also become switching costs – after graphic artists devoted years of effort to learning Photoshop, they were not eager to switch to a new tool.
How else can I protect my profits?
If there is no strong moat, I commonly hear these kinds of answers: “we have a built-in cost or sales or marketing advantage due to a relationship with (some large company like IBM or AARP)”, “we will build a consumer brand”, “we all personally come from this market and we uniquely understand what the customer wants so we will have the best design”, or “our culture will emphasize (innovation, cost, customer service)”. These are all examples of how normal businesses compete and pretty shallow as moats go. If you start this type of business, you must expect to live on thin margins and spend a lot of time hustling to beat competitors. You should probably try to think of a better idea.
Here is an example of where the moat discussion killed an idea. I spoke with a start-up team who was interested in helping restaurants take more mobile orders for carry-out. They could show restaurants loved the idea, they knew how to deliver the product at a profit, and they could list many small chains who might buy. So that was a green light on the first three questions, but we had a problem when it came to competition. They said none of the larger players selling restaurant software had yet added this feature except for one. That competitor was targeting restaurant chains of 15 or more units. So the founders said they would focus just on chains with 5-10 units and it would be a land grab situation.
The problem we then discussed was that if they started to succeed, would it attract attention? The existing competitor could easily target 5-10 unit chains. The other large players also could easily add mobile orders to their software if they saw the start-up gaining steam with this feature. Then mobile ordering would become a commodity feature. So, we did not invest.
If your profit barrier will be weak, what should you do? Face the facts and change your approach while you still can! If you waste your career building a company that cannot protect its profits, your investors will earn a disappointing return, but it is you who will never get back your time.
If your profit barrier will be weak, what should you do? Face the facts and change your approach while you still can! If you waste your career building a company that cannot protect its profits, your investors will earn a disappointing return, but it is you who will never get back your time.
