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Economic Moats - For Early Stage Startups and Early Stage Investors


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In order to grow into a company that endures, an early stage startup must protect itself from competition and strengthen its position within its market. Economic Moats make that possible. This presentation synthesizes a series of blog posts on that topic into a more user-friendly format. It is useful for startup founders, as well as early-stage investors in seed and series A technology startups.

1. Network Effects
2. Switching Costs
3. Intangibles
4. Cost Advantages
5. Efficient Scale

Published in: Technology
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Economic Moats - For Early Stage Startups and Early Stage Investors

  1. 1. Notes on ECONOMIC MOATSfor early stage technology startups BRIAN LAUNG AOAEH
  2. 2. 2  BA - Mathematics, Physics - Connecticut College  MBA – Specialization; Financial Instruments and Markets – NYU Leonard N. Stern School of Business Former employee; Watson Wyatt, UBS AG and Lehman Brothers Currently; Investment analyst, Partner - KEC Ventures, New York City WHAT DO I DO? I assess early stage technology startups for seed stage and series A venture capital investments BRIAN LAUNG AOAEH Let’s talk: @brianlaungaoaeh
  3. 3. Questions I ask myself daily when assessing startups Focus on early stage technology startups A summary of the economic moats those startups might build around themselves to sustainably fend off competition and mature into successful companies The observations of this document take into account my experience as of 2015/2016 3 SCOPE OF THIS DOCUMENT 2016
  5. 5. 5 1 DEFINITIONS
  6. 6. WHAT IS A STARTUP? A temporary organization built to search for the solution to a problem, and in the process to find a repeatable, scalable and profitable business model that is designed for incredibly fast growth #Experimentation #SteveBlank #PaulGraham 6 WHAT IS AN ECONOMIC MOAT? When specifically thinking of early stage technology startups: A structural feature of a startup’s business model that protects it from competition in the present but enhances its competitive position in the future WHAT ARE THE SOURCES OF ECONOMIC MOAT? NETWORK EFFECT SWITCHING COSTS INTANGIBLE ASSETS EFFICIENT SCALECOST ADVANTAGE
  8. 8. WHAT IS A NETWORK EFFECT (also known as Direct-benefit effect)? A network effect occurs when the value of a good or service increases for both new and existing users as more customers use that good or service. The network effect is a virtuous cycle that allows strong companies to become even stronger. 8  Need for some form of interaction or compatibility with others: the number of other people using the technology has a direct impact on how valuable that technology is to each individual user.  For Network effects to evolve positively for a startup, the users of the network need to derive both inherent value and network value from their use of the product.  Inherent value is value that an individual user derives because of that individual user’s consumption of the product or service.  Network value is value that an individual user derives because other people use the product or service. HOW DO THEY DEVELOP?
  9. 9. LOCAL NETWORK EFFECTS DIRECT NETWORK EFFECTS or one-sided network effects TWO-SIDED NETWORK EFFECTS INDIRECT NETWORK EFFECTS 9 4 TYPES OF DIRECT-BENEFIT EFFECTS When increased usage leads explicitly to increased welfare for the members of the network Fax machines, telephones, messaging apps When the proliferation of network members leads to the proliferation of complementary goods and services such that the welfare of the network’s members increases significantly iOS, Android, smartphones and apps When an increase in usage of the product by one group of network members increases the welfare of a separate and distinct group of other members of the same network. Marketplaces, platforms that combine hardware and software, and software pairings in which there’s a reader and writer When an individual network member’s welfare increases not because of an increase in the overall network user base, but as a result of growth in the users within a localized subset of the network’s membership. Whatsapp: welfare increases when people in your contacts’ list join, no matter the number of Whatsapp users
  10. 10. The Power of Network Effects (Image Credit: Ray Stern, former CMO of Intuit) 10 THE POWER OF NETWORK EFFECTS
  11. 11. 11 HOW MIGHT A STARTUP START TO EXPERIENCE NEGATIVE NETWORK EFFECTS? LOCK-IN OR SWITCHING COSTS  When a member of one network cannot switch from that network to another without suffering substantial costs.  The switching costs could be monetary and non-monetary. Often, the non-monetary switching costs far outweigh the monetary costs. Non-monetary costs might include the loss of massive amounts of information and data, business process disruptions, and so on and so forth.  Switching costs are not an issue as long as users perceive that they derive more value from being within the network than the inconvenience they suffer as a result of lock-in or switching costs. NETWORK CONGESTION CONFLICTS OF INTEREST
  12. 12. 12 HOW MIGHT A STARTUP START TO EXPERIENCE NEGATIVE NETWORK EFFECTS? LOCK-IN OR SWITCHING COSTS NETWORK CONGESTION CONFLICTS OF INTEREST  When the experience of each member of the network deteriorates as the network’s membership grows. In other words the network becomes less efficient from the users’ perspective.  As a result of this each member of the network derives decreasing inherent and network value from the network. Ex: A website, web or mobile app that is consistently unavailable because too many people are trying to access it simultaneously
  13. 13.  When a network operator behaves in ways that limit or restrict the ability of network members to freely form sub-networks.  Networks that support the construction of communicating groups create value that scales exponentially with network size, i.e. much more rapidly than Metcalfe’s square law.  When the operator of a network platform starts to compete with its platform partners it is engaging in behavior that will lead to the destruction of the network. Ex: I prefer to buy used books on Amazon if possible. This is possible because Amazon has allowed independent merchants to market such goods in its marketplace. If Amazon compelled me to purchase its own offering, or pay a penalty otherwise, what effect would that have on my behavior? On the behavior of the independent sellers? What if an Amazon competitor did not impose that penalty? How might that shift the competitive landscape? 13 HOW MIGHT A STARTUP START TO EXPERIENCE NEGATIVE NETWORK EFFECTS? LOCK-IN OR SWITCHING COSTS NETWORK CONGESTION CONFLICTS OF INTEREST
  14. 14. First mover adoption matters It can pay to subsidize adoption – by providing an in-network benefit of some sort Viral marketing matters Redefine the market Form alliances and partnerships Leverage distribution channels Seed the market Encourage the development of complementary goods Leverage backward compatibility Build-in compatibility with the market leader Close-off access to new entrants and existing rivals and innovate constantly Pre-announcements 14 WHAT STRATEGIES SHOULD A STARTUP THAT’S COMPETING IN A MARKET IN WHICH NETWORK EFFECTS MATTER EMPLOY IN ORDER TO WIN?
  15. 15.  Understanding networks effects and how they unfold for an early stage startup is critical  Markets with network effects are fiercely competitive  A bandwagon effect tends to take hold thanks to positive-feedback loops  A winner can emerge in remarkably short order and that winner typically garners a commanding market share lead over its competitors  Once a winner has been established it is extremely difficult for competitors to win users away from it 15 CONCLUSION ON NETWORK EFFECTS
  16. 16. 16 3 SWITCHING COSTS
  17. 17.  Switching costs refer to the expense in cash, time, convenience, risk, and process disruption that a customer of one product or service must incur if they change from one product from an incumbent Producer A to another product from Producer B.  Switching costs can be explicit or implicit.  It can confer the benefit of customer lock-in to incumbent suppliers if the customer perceives the cost of switching as outweighing the benefits that would be obtained by making the switch. 17 WHAT ARE SWITCHING COSTS?
  18. 18. 18 HOW DO SWITCHING COSTS DEVELOP?  When an incumbent product becomes “mission-critical” for the purpose for which the customer acquired the product in the first place.  An incumbent that combines network effects with high switching costs in the same product line is well positioned to build a durable moat around its business.  3 main assumptions about switching costs: They can be exogenous Switching costs are symmetricalThey can be endogenous When they evolve without any intentional influence from the incumbent producer Ex: From customers that adapt the product When they evolve through deliberate actions by the incumbent Ex: volume discounts , long-lived license agreements, incompatibility with competing products between all the producers competing within a given market
  19. 19. COMPATIBILITY REQUIREMENTS TRANSACTION COSTS COGNITIVE COSTS UNCERTAINTY LEARNING COSTS LOST-BENEFIT COSTS 19 WHAT ARE THE TYPES OF SWITHCHING COSTS THAT LEAD TO BUYER LOCK-IN? One might consider switching costs to exist along a continuum that is characterized most distinctly by how intertwined each of the categories identified by economists is tightly intertwined with nearly every other category below:  They make it difficult and expensive to switch between products.  It is an implicit cost that is borne by the customer. Ex: An individual or organization running MS Windows contemplating a decision to switch to Linux.
  20. 20. COMPATIBILITY REQUIREMENTS TRANSACTION COSTS COGNITIVE COSTS UNCERTAINTY LEARNING COSTS LOST-BENEFIT COSTS 20 WHAT ARE THE TYPES OF SWITHCHING COSTS THAT LEAD TO BUYER LOCK-IN? One might consider switching costs to exist along a continuum that is characterized most distinctly by how intertwined each of the categories identified by economists is tightly intertwined with nearly every other category below: They impose an explicit cost on customers who decide to switch from one product to another Ex: Cable-TV subscription agreements typically impose a high penalty on subscribers who decide to terminate their agreement before it has run its full course
  21. 21. COMPATIBILITY REQUIREMENTS TRANSACTION COSTS COGNITIVE COSTS UNCERTAINTY LEARNING COSTS LOST-BENEFIT COSTS 21 WHAT ARE THE TYPES OF SWITHCHING COSTS THAT LEAD TO BUYER LOCK-IN? One might consider switching costs to exist along a continuum that is characterized most distinctly by how intertwined each of the categories identified by economists is tightly intertwined with nearly every other category below: They are the perceived hurdles customers feel they will have to overcome when they switch from one product to another. Ex: The dichotomy between Mac and Windows lovers. Beyond the practical reasons for preferring one system over the other, discussions often turn to name-calling. That suggests there are significant psychological issues at play that have nothing to do with the reality one might face if one tried to switch products
  22. 22. COMPATIBILITY REQUIREMENTS TRANSACTION COSTS COGNITIVE COSTS UNCERTAINTY LEARNING COSTS LOST-BENEFIT COSTS 22 WHAT ARE THE TYPES OF SWITHCHING COSTS THAT LEAD TO BUYER LOCK-IN? One might consider switching costs to exist along a continuum that is characterized most distinctly by how intertwined each of the categories identified by economists is tightly intertwined with nearly every other category below:  The apprehension regarding the quality of the new product – it works for the incumbent when customers have very little information about the relative performance characteristics of the new product  Uncertainty is minimized only if the customer believes that, at a minimum, the new product will match the old product in quality. Ex: A small business considering migrating from MS Exchange Server to Google Apps for Business at a time when its license for the former is up for renewal.
  23. 23. COMPATIBILITY REQUIREMENTS TRANSACTION COSTS COGNITIVE COSTS UNCERTAINTY LEARNING COSTS LOST-BENEFIT COSTS 23 WHAT ARE THE TYPES OF SWITHCHING COSTS THAT LEAD TO BUYER LOCK-IN? One might consider switching costs to exist along a continuum that is characterized most distinctly by how intertwined each of the categories identified by economists is tightly intertwined with nearly every other category below:  They are the hurdles to overcome to attain a mastery of the new product that is at par with mastery of the incumbent product.  Learning costs need to be considered on their own, independent of other categories of switching costs.  High learning costs increase switching costs in favor of the incumbent and vice- versa.  The decision to switch products often depends on the consequences when things go wrong, whether it’s an inconvenience or a potential significant loss of revenue.
  24. 24. COMPATIBILITY REQUIREMENTS TRANSACTION COSTS COGNITIVE COSTS UNCERTAINTY LEARNING COSTS LOST-BENEFIT COSTS 24 WHAT ARE THE TYPES OF SWITHCHING COSTS THAT LEAD TO BUYER LOCK-IN? One might consider switching costs to exist along a continuum that is characterized most distinctly by how intertwined each of the categories identified by economists is tightly intertwined with nearly every other category below:  They are costs suffered by the customer because of certain non-transferable benefits that have been earned but not yet consumed as a result of its historical relationship with the incumbent.  The customer who decides to make a switch suffers a significant loss and must start to earn such benefits from scratch with the new provider. Ex: Loyalty programs such as airline travel points, or roll-over minutes for mobile phone subscriptions.
  25. 25. Maintaining high switching costs leads to sustaining innovation for the incumbent  Switching costs lock in high-margin customers (with high needs) for the incumbent. To keep meeting their requirements, the incumbent needs to sustain innovation. While it improves on already existing products, it focuses on squeezing more out of a large base of existing and a comparatively small base of new customers. Disruptive innovation by competitors is aimed first at new customers in the market  However, disruptive innovation seeks to satisfy non-consumption by developing products with features so simple and inexpensive in comparison to the status quo that a disproportionately large number of new customers enter the market. The key is that the customers that flock to the disruptive product are very unattractive to established incumbents. With time, the disruptive product becomes a substitute for the incumbent product  With time, the disruptive innovation matures to the extent that it becomes a viable substitute first for the incumbent’s low-margin customers (with “only moderate” needs), and then for its most profitable customers - at a price point that is extremely hard for them to resist.  It is at this tipping point that the incumbent’s fight for its survival begins. 25 HOW MIGHT SWITCHING COSTS BECOME A DISADVANTAGE?
  26. 26. It is important for early stage technology startups, and investors, to understand the dynamic that might evolve as they seek entry into a market characterized by an incumbent who benefits from customer lock-in. The incumbent sells to existing customers, rival new-entrant serves new buyers The incumbent excludes the new entrant New customers are won with bargains, then they are “ripped off” Customers are paid to switch A portfolio of products is bundled together in order to increase total switching costs 26 WHAT ARE THE COMPETITIVE STRATEGIES AT PLAY IN MARKETS IN WHICH SWITCHING COSTS MATTER? 1 2 3 4 5
  27. 27.  This happens in markets that are relatively mature.  The incumbent focuses its efforts on its existing customer base, with growth in revenues arising from endogenous growth within that customer base.  New entrants meanwhile utilize new technology to serve new customers, initially ignoring the incumbents existing customer base.  This is especially true in markets in which the incumbent producer has a high level of power relative to customers in that market – typified by dominant market share, giving it pricing power over its existing customer base. 27 WHAT ARE THE COMPETITIVE STRATEGIES AT PLAY IN MARKETS IN WHICH SWITCHING COSTS MATTER? The incumbent sells to existing customers, rival new-entrant serves new buyers1
  28. 28. 28 WHAT ARE THE COMPETITIVE STRATEGIES AT PLAY IN MARKETS IN WHICH SWITCHING COSTS MATTER? The incumbent excludes the new entrant2  This happens in markets when the incumbent’s fixed costs per customer are greater than the switching costs per customer.  The strategy works if the incumbent is in a position to set a price that makes it unattractive for any new entrant to enter the market.  Where this is not possible, the incumbent will choose to set a price that allows the market to be shared between the incumbent and the new entrant.  This is why freemium business models are so powerful, especially when a freemium business model is coupled with a product that embodies network effects and switching costs. Ex: Facebook – A cost-leadership strategy to compete with Facebook is ineffective, so competitors must seek an alternate path.
  29. 29. 29 WHAT ARE THE COMPETITIVE STRATEGIES AT PLAY IN MARKETS IN WHICH SWITCHING COSTS MATTER? New customers are won with bargains, then they are “ripped off”3  This happens when customers are offered low “introductory offers” in order to entice them to adopt a product. Prices increase once lock-in has been established.  A common example are products that are free up to a certain usage threshold but for which continued use beyond the set threshold requires customers to pay. Various mechanisms might be used to ensure the onset of customer lock-in, and improvements in the product’s features and capabilities are designed to nudge users over the threshold beyond which they have to become paying customers.  This tactic is common among cable TV and satellite TV providers, and also among internet service providers.
  30. 30. 30 WHAT ARE THE COMPETITIVE STRATEGIES AT PLAY IN MARKETS IN WHICH SWITCHING COSTS MATTER? Customers are paid to switch4  Consider three segments of an incumbent producer’s customers:  Existing locked-in customers,  Unattached or new customers,  Customers locked into a rival.  In this situation, rival producers will implement price discrimination:  Existing locked-in customers get one set of prices,  New or unattached customers get another set of prices,  Customers locked into rivals are paid to switch.  This tactic is common with cellular phone service providers and credit card issuers.
  31. 31. 31 WHAT ARE THE COMPETITIVE STRATEGIES AT PLAY IN MARKETS IN WHICH SWITCHING COSTS MATTER? A portfolio of products is bundled together in order to increase total switching costs5  In order to make a switch, the customer must deal with nearly all the switching costs we have previously considered at the same time.  It works especially when the incumbent producer offers a product line that is so broad that most customers simply deal with the incumbent as their single supplier for the entire line of products that they use. Ex: Microsoft’s strategy of giving away Internet Explorer in a bundle with Microsoft Windows reportedly led to the demise of Netscape Navigator. I would guess that beyond merely bundling Explorer with Windows, Microsoft built-in a number of features that made Navigator less compatible with the Windows operating system than Explorer.
  32. 32.  Switching costs play an important role in retaining customers, and motivating repeat purchases in the future.  Early stage startups must spend some time understanding the features that create value for the customer while building customer lock-in early in their product design process.  The existence, or lack thereof, of switching costs amongst the incumbent’s customers will play an important role in determining its competitive response:  In a market with low switching costs, one might expect vicious price wars to ensue. Generally, such price wars will always favor the presumably better capitalized incumbent. Moreover, price wars are a bad idea for the incumbent as well as the new entrants.  In a market where the incumbent enjoys significant customer lock-in with ensuing monopoly profits, one generally expects new entrants to find a foothold from which they can eventually migrate up-market 32 CONCLUSION ON SWITCHING COSTS
  33. 33. 33 4 INTANGIBLE ASSETS
  34. 34.  An asset is a resource that is owned by a startup with the expectation that it will provide an economic benefit to the startup in the future.  Intangible Assets are assets that are not physical in nature. 34 WHAT ARE INTANGIBLE ASSETS? Intangible assets—a skilled workforce, patents and know-how, software, strong customer relationships, brands, unique organizational designs and processes, and the like—generate most of corporate growth and shareholder value. They account for well over half the market capitalization of public companies. They absorb a trillion dollars of corporate investment funds every year. In fact, these “soft” assets are what give today’s companies their hard competitive edge. Baruch Lev, Sharpening The Intangibles Edge, Harvard Business Review June 2004 Issue “
  36. 36. As far as early stage technology startups are concerned I am mostly interested in: “ Copyrights Trademarks Patents Trade secrets 36 INTELLECTUAL PROPERTY - overview Intellectual property (IP) refers to creations of the mind, such as inventions; literary and artistic works; designs; and symbols, names and images used in commerce. World Intellectual Property Organization
  37. 37. A copyright protects the original author’s work - that can be stored in some form of fixed media - from indiscriminate copying by other people.  Original author’s work: computer software, computer programs, blog posts, advertisements, marketing materials, videos, pictures, etc.  Some form of fixed media: Creating the work in my mind is not enough, but the moment I commit it to software or document it some other tangible way (even a notebook), the copyright comes into existence.  Protects: - Copyright registration: not necessary but in the US, a copyright holder can not file a lawsuit for infringement if the copyright is not registered with the United States Copyright Office. - For an individual, for the life of the original author + 70 years beyond his death - For a startup, for 120 years from the date of creation or 95 years from the date of publication. 37 INTELLECTUAL PROPERTY Copyrights 1/2
  38. 38. Note on copyrights for early stage startup: “WORK FOR HIRE DOCTRINE” “ 38 INTELLECTUAL PROPERTY Copyrights 2/2 In early stage startups, the parameters for determining who is an employee is not very straightforward. Thus, I believe founders should make it a practice to protect some of the work done by contractors and vendors with work for hire agreements, that will state unambiguously that the work product covered by the agreement between the startup and the contractor is a work for hire to the benefit of the startup. If a work is made for hire, an employer is considered the author even if an employee actually created the work. The employer can be a firm, an organization, or an individual United States Copyright Office
  39. 39. A trademark is a brand name. A trademark or service mark includes any word, name, symbol, device, or any combination, used or intended to be used to identify and distinguish the goods/services of one seller or provider from those of others, and to indicate the source of the goods/services. US Patent and Trademark Office “ 39 INTELLECTUAL PROPERTY Trademarks 1/2 Similar to copyright protection, merely using the mark in the course of doing business establishes the trademark right for the startup that owns the mark. A startup founder seeking trademark protection should seek the advice of an IP attorney since this is a more complicated topic than copyright protection.
  40. 40. According to the International Trademark Association trademarks are:  Fanciful Marks – coined (made-up) words that have no relation to the goods being described (e.g., EXXON for petroleum products).  Arbitrary Marks – existing words that contribute no meaning to the goods being described (e.g., APPLE for computers).  Suggestive Marks – words that suggest meaning or relation but that do not describe the goods themselves (e.g., COPPERTONE for suntan lotion).  Descriptive Marks – marks that describe either the goods or a characteristic of the goods. Often it is very difficult to enforce trademark rights in a descriptive mark unless the mark has acquired a secondary meaning (e.g., SHOELAND for a shoe store).  Generic Terms – words that are the accepted and recognized description of a class of goods or services (e.g., computer software, facial tissue). A fanciful mark has the strongest trademark protection. A generic mark has the weakest protection. Over time, the protection afforded a fanciful mark can wane if that term becomes a generic term that is used to describe a category. 40 INTELLECTUAL PROPERTY Trademarks 2/2
  41. 41. WHAT IS A PATENT?  A patent is an exclusive right granted for an invention; a product or a process that generally provides a new way of doing something, or offers a new technical solution to a problem.  Patent protection means that the invention cannot be commercially made, used, distributed, imported, or sold by others without the patent owner’s consent.  During the period in which the invention is protected, the patent owner can:  give permission to (license) other parties to use the invention on mutually agreed terms  sell the right to the invention to someone else, who will then become the new owner of the patent.  Once a patent expires, the protection ends, and an invention enters the public domain: anyone can commercially exploit the invention without infringing the patent. 41 INTELLECTUAL PROPERTY Patents 1/7
  42. 42. 42 INTELLECTUAL PROPERTY Patents 2/7 TYPES OF PATENTS  There are design patents and utility patents.  Design patents are used to protect the appearance of an invention.  Utility patents comprise most of the patent applications made to the US Patent and Trademark Office and are used to protect the functional features of an invention. They generally provide broader protection than design patents, also it is easier to avoid infringing on a design patent. They are also more expensive and take longer to obtain.
  43. 43. CONTENT OF PATENT APPLICATIONS To get a patent, technical information about the invention must be disclosed to the public in a patent application, that must be:  Patentable  New, or novel  Useful: a theory will not receive patent protection, in and of itself if it is not useful in a practical application.  Non-obvious: “someone of ordinary skill in the arts” would not necessarily have reached the deductions made by the inventor on the basis of prior art in that technical field  Adequately described: “someone of ordinary skill in the arts” should be able to replicate the invention using nothing but prior background in that technical field along with the inventor’s description in the patent application Software and business process patent applications will also likely be subjected to a “machine or transformation test.”  The machine test means that software or business processes can not be patented unless they are combined with a machine of some sort – a computer.  The transformation test means that software or business processes cannot be patented unless they transform one thing into another, different thing, or into a different state. 43 INTELLECTUAL PROPERTY Patents 3/7
  44. 44. FILING A PATENT APPLICATION There are two main patent award systems:  first to invent jurisdictions (like the US)  first to file jurisdictions Public disclosure causes the invention to become part of the “prior art” in the field of the invention. In the US: From the first disclosure to the public, the inventor has 1 year within which to file a patent application. If he doesn’t, he either forfeits patent protection for that embodiment of the invention or he can file for a provisional patent application with the USPTO to preserve a filing date. A final, or utility application has to be filed within 12 months, and will be examined by the USPTO to determine the merit of the inventors appeal for patent protection. Outside the US: Inventors do not have the benefit of a grace period. As a result any international patent applications must be made as soon as possible, in order to preclude public disclosure by the inventor. 44 INTELLECTUAL PROPERTY Patents 4/7
  45. 45. WORKING WITH PATENT ATTORNEYS OR PATENT AGENTS  They are unlikely to be experts in the technical field of an invention even if they specialize in the legalities of obtaining a patent in that field.  It is the inventor’s responsibility to transfer as much background knowledge as possible about the technical field of the invention and specific nuances of the invention itself to the patent agent/attorney.  This will help the attorney perform a more complete and comprehensive patentability search.  It will ensure that the patent application is drafted correctly from the outset. That has the benefit of minimizing rework.  It will also help the attorney answer questions and respond to objections during the period when the patent is being examined by patent examiners 45 INTELLECTUAL PROPERTY Patents 5/7
  46. 46. ADDITIONAL SUGGESTIONS – Part 1  Maintain “excruciatingly detailed” notes about the invention. You should describe the invention such that someone of considerably less expertise than you can understand the description. Keep pictures, drawings, figures, and any data that you create as you go through the invention process. You can maintain a “lab-book” with numbered pages, dates, and handwritten notes about how you have tested your invention using theory, as well as the steps you have taken to test the output of what you have created. These can be supplemented by electronic notes created with MS Word, and also saved as PDF files as well as spreadsheets you have developed to test the idea further.  Describe prior attempts to do what your invention does, and keep notes about why those prior attempts did not work.  Keep notes about the alternatives to your invention, and descriptions about how your invention is unique. You should describe the advantages of your invention over the prior art and alternative approaches.  Keep records about any discussions you have had about the invention with people outside of the immediate team working on your startup’s product. 46 INTELLECTUAL PROPERTY Patents 6/7
  47. 47. ADDITIONAL SUGGESTIONS – Part 2  Discuss the possibility of obtaining international patent protection with your IP attorney.  In certain instances it is possible to speed up a patent application in the founders’ home jurisdiction by first obtaining a patent abroad.  The Patent Cooperation Treaty (PCT) between different jurisdictions states that patent offices can fast track the examination of an applicant that has received a final ruling from a first patent office (which allowed at least one claim), through the Patent Prosecution Highway (PPH).  This is particularly useful when foreign patent offices can grant patents in a much shorter time than the USPTO does. Ex: a startup applying for a patent (examination times can of course vary)  In the US, it will take 5 years or more  In the UK, it will take 18 months + 6 months fast track examination in the US through the PPH = 24 months to get the patent granted 47 INTELLECTUAL PROPERTY Patents 7/7
  48. 48.  A trade secret is any confidential and non-public information that confers a competitive advantage to the owner of that information because it is not known to the public, and especially because it is not known to competitors in that market.  The owner of the information must make demonstrable effort to keep the information secret.  Trade secrecy can be lost by legitimate means, such as reverse-engineering by a competitor. It lasts for as long as the information remains confidential and undisclosed to the public. Any kind of information can be designated as a trade secret by its owner.  The key to maintaining trade secrecy is the creation of internal practices and procedures that are designed to protect the information designated as “trade secrets” from being divulged to the public. Ex: The mystique behind the formula for Coca Cola is one famous example of a trade secret. 48 INTELLECTUAL PROPERTY Trade secrets 1/2
  49. 49. ADVANTAGES  It is cheaper than going through the process of obtaining a patent.  It can cover subject matter that would not qualify for patent protection.  It comes into effect almost instantaneously, and that protection can last indefinitely if appropriate processes, procedures and practices are put in place. DISADVANTAGES  Once trade secrecy is lost, it is lost forever.  They can be reverse engineered by others.  Information protected by one party (A) could legitimately be “independently invented” by another party (B), who would patent it, resulting in a violation of B’s patent by the first inventor A  speak with an attorney for more details  It provides a significantly lower degree of protection than protection obtained from holding a patent. 49 INTELLECTUAL PROPERTY Trade secrets 2/2
  51. 51. WHAT IS A BRAND? Austin McGhie emphasizes throughout his book Brand is A Four Letter Word that a company’s brand embodies the market’s response to:  The company’s product,  The customer/user’s experience when they use the product, and  The company’s marketing strategy, which should lead to a differentiated and valuable positioning of the company and its products relative to its competitors.  It is an “emotional shorthand for a wealth of accumulated or assumed information”, which can be positive or negative.  It develops over time, as users and customers build an accumulation of experiences with the product or service.  Positive feelings should be reinforced continually and consistently by the company through its PR and marketing. 51 BRAND 1/3
  52. 52. “ “ 52 BRAND 2/3 HOW A STRONG BRAND CAN BE AN ECONOMIC MOAT A brand creates an economic moat around a company’s profits if it increases the customer’s willingness to pay or increases customer captivity. A moat worthy brand manifests itself as pricing power or repeat business that translates into sustainable economic profits. Why Moats Matter A brand is present when the value of what a product, service, or personality means to its audience is greater than the value of what it does for that audience. Brand is a Four Letter Word
  53. 53. 53 BRAND 3/3 EARLY STAGE TECHNOLOGY STARTUPS TOO OFTEN NEGLECT THEIR BRAND  A common reasoning is that there is no capital to devote to marketing.  However, the first step has already been done by the company when building its product: getting an intimate knowledge of its customers/users. Marketing is multifaceted and doesn’t have to be expensive: use social media to build the hype, have the founders embody the brand, etc. Trademarks, copyrights, design, iconography, and trade secrets (as a source of implicit brand affinity and loyalty) should also all reinforce the positive emotions that the startup has already been accumulating. In a few words, implement a simple strategy to communicate on 3 levels to customers:  WHAT – What problem does the startup’s product solve for them?  HOW – How is this better than the current alternative?  WHY – Why should they accept the risk that comes with trying a product from an early-stage startup? Why will they gain more than they stand to lose?
  55. 55. 55 RESEARCH AND DEVELOPMENT 1/2 WHAT IS R&D? R&D is the set of systematic, investigative, and exploratory activities that a business chooses to conduct with the intention of making a discovery that can either lead to the development of new products or procedures, or that can lead to an improvement of existing products or procedures, and in the process develop better ways of solving customers’ problems, creating new profit opportunities for the business.  It is systematic, investigative, and exploratory – it seeks to expand the boundaries of organizational knowhow and organizational capacity.  It seeks to solve customers’ problems in a better way than the status quo.  It seeks to create new opportunities for the startup to make profits. For those reasons, ongoing R&D is one important means by which any organization that operates in a competitive market can create an enduring competitive advantage for itself.
  56. 56. 56 RESEARCH AND DEVELOPMENT 2/2 R&D IS A GOOD INDICATOR OF FUTURE PROFITABILITY  Studies have shown that R&D intensive firms have sustained future profitability.  So what does this mean for early stage investors? All else equal, invest in startup founders who show indications of being capable of building organizations that will become R&D leaders in the markets in which they have to compete.  How might one go about assessing this? How often in the past have the founders’ started with the same information as everyone one else, but examined it in a way that led to unexpected results that proved to be correct and so enabled them to exploit an opportunity others ignored or did not know existed? For early stage technology startups, R&D should purposely seek to strengthen both the startup’s ability to win and retain customers, and increase profitability.
  58. 58. 58 CULTURE & MANAGEMENT 1/5 INVESTING IS MAKING A BET ON THE FOUNDERS’ DECISION-MAKING ABILITIES  Seed-stage investors are really taking a bet on the founders’ decision-making skill as managers of entrepreneurial risk, and the assumptions that drive those decisions.  It is very hard to differentiate between skill and luck at that stage because the financial ratios and metrics that one could use to make that determination do not yet exist. Managerial decision making skill only reveals itself over time.  What kinds of decisions will founders make, and make correctly on a consistent enough basis to yield a return on the investors’ capital?  The qualities of a good entrepreneur are multifaceted and not so easily visible in early stage technology startups.
  59. 59. THE ENTREPRENEURIAL STATE OF MIND In some cases, including the entrepreneurial context, uncertainty includes not only uncertainty about others’ actions, but also uncertainty regarding the courage and willingness of others to act. Ross B. Emmet, Frank H. Knight on the “Entrepreneur Function” in Modern Enterprise (PDF)  Jean-Baptiste Say – 1800 // An entrepreneur shifts resources out of an area of lower productivity and into another area of higher productivity and return.  Frank H. Knight – 1921 // An entrepreneur is someone who confronts a business challenge and is confident enough to risk financial loss in order to overcome that challenge.  Joseph Schumpeter – 1965 // An entrepreneur is someone who exploits market opportunities through technical and organizational innovation.  Peter Drucker – 1970 // An entrepreneur is someone who always searches for change, responds to it and exploits it as a business opportunity.  Robert Hisrich – 1990 // An entrepreneur is someone who takes the initiative to organize social and economic factors of production in order to create something unique that is of value to society, and accepts financial and social risk in the process. 59 CULTURE & MANAGEMENT 2/5
  60. 60. 60 CULTURE & MANAGEMENT 3/5 HOW TO DISCERN POTENTIALLY GREAT MANAGERS  Study the founders’ past accomplishments and try to determine which aspects of that track record result from decision-making skill and which ones result from luck. Weigh those two things during the assessment of what that means for the startup.  Take sufficient time to observe founders’ decision-making skills and abilities – individual skill matters just as much as collective skill.  Look at the role each co-founder plays in the final outcome.  The early stage startup founders who excite me the most have convinced me that they know how to build an organization that will become exceedingly more valuable than the sum of its parts. They must inspire excellence from their co-founders, from other early team members they recruit to join the startup, and they must inspire devotion from their early customers.
  61. 61. DECISION-MAKING PITFALLS  Insufficient focus on the customer, too much focus on the technological innovation.  Sub-par outcomes regarding recruiting great people, and empowering them to bring the founders’ vision into reality.  Inability to think creatively about new organizational designs and structures that will yield better insights about shifts in the expectations of existing customers, the hidden pockets of potential new customers, and opportunities that might be going unrecognized by competitors.  Incongruities between what the startup needs to accomplish in order to satisfy its customers and achieve product-market fit, and the choices that the founders make. There are many others. 61 CULTURE & MANAGEMENT 4/5
  62. 62. CULTURE EMERGES FROM THE START The culture of a startup is determined predominantly by the attitude, behavior, and personality of the founders. Look out for these elements:  Founders are self-aware, and understand how their behavior affects the startup through the response it elicits from members of their team, from their early customers/users, and from their early investors.  The way the founders talk about themselves and the organization they are building is distinctive, it illuminates the founders’ beliefs about the world, and about the reality they will create as a result of those beliefs.  They understand what they need to do to build a winning team. They also know why they need to do those things if they want their team to succeed.  They understand that culture is not something they can ignore until things are falling apart, rather it has to be tended continually. Culture matters just as much as other organizational functions that are much easier to measure and manage. 62 CULTURE & MANAGEMENT 5/5
  64. 64. WHAT IS IT AND HOW DOES IT WORK?  The regulatory environment is the framework of rules, laws, and regulations that the startup and its competitors have to adhere to as they go about their operations.  The benefits of this asset accrue to every entity that decides to enter that market after rules have been established by regulatory bodies:  First-movers usually bear all the social, political, and financial risks of putting the regulatory environment in place.  Fast-followers get a free-ride after a regulatory framework has been established  In the United States there are many examples of regulators requesting comment from participants in an industry during the period when rules, laws, regulations are being crafted to govern the activities of organizations within a given market. 64 REGULATORY ENVIRONMENT 1/2
  65. 65. WHAT ABOUT ASSESSING EARLY STAGE STARTUPS?  Startup founders who can play a role in shaping the regulatory environment that is developed to govern their activities have a better chance of influencing events in their favor than founders who demonstrate an inability to influence legislation.  If it is appropriate I want to see some evidence that founders have an understanding of the role that regulations might play; will they be a catalyst or an impediment? What can the startup do to make regulations work in favor of the business model that the startup has set out to create?  This is one of the most difficult intangibles for me discuss:  I have relatively less experience on this subject than on the preceding ones.  It is so specialized, it will largely be outsourced to a lobbyist, at least in the US.  This is unlikely to be something a startup needs to worry about until it has grown considerably, which is likely to happen well beyond the seed stage. 65 REGULATORY ENVIRONMENT 2/2
  66. 66.  Assessing intangibles and their potential impact on the future of an early stage startup is hard work that can seem to rely on information that is even more qualitative and less data driven than other aspects of early-stage startup investment analysis.  Nonetheless, it is important to think through the issues carefully since that work can lead to important conclusions that highlight potential risks and uncertainties, point to future areas of possible opportunity, and yield better decisions about when and where the investor should deploy scarce capital.  Collectively, intangibles are important because once a startup establishes them as an asset, it is impossible for that asset to be replicated in exactly the same way by a competitor. 66 CONCLUSION ON INTANGIBLE ASSETS
  67. 67. 67 5 COST ADVANTAGES
  68. 68.  A cost advantage arises when a company can sustainably lower its costs of doing business relative to its competitors.  Such a reduction in costs can be due to process advantages, superior location, economies of scale, or access to a unique asset. In other words: Definition: A cost advantage is a structural feature of a startup’s business model that enables it to maintain sustainably lower overall costs of doing business than its competitors while earning equal or higher margins over time. 68 WHAT IS A COST ADVANTAGE?
  69. 69. For early stage technology startups, these are the most important sources from which a cost advantage may be derived. 69 SOURCES OF COST ADVANTAGE PEOPLE & CULTURE SYSTEMS & PROCESSES FACILITIES CAPITAL  When a startup develops a unique organizational culture, it creates management processes, and organizational structures that enable and empower members of the team to consistently generate significantly better results than the results of its direct competitors and that beat the adjusted-performance of more well-established incumbents in that market.  This source of cost advantage is intimately connected to the intangibles of Management and Culture, and Research and Development.
  70. 70. For early stage technology startups, these are the most important sources from which a cost advantage may be derived. 70 SOURCES OF COST ADVANTAGE PEOPLE & CULTURE SYSTEMS & PROCESSES FACILITIES CAPITAL  When a startup develops unique organizational processes that enable it to consistently generate comparatively superior results. Key categories are:  Marketing and Sales Processes: how to create demand and satisfy it through delivery.  Operational Processes: how tangible and intangible inputs are turned into something the market is willing to pay for.  Distribution Processes: channels of delivery. A choice must be made between direct distribution and indirect distribution channels, and how it will affect the ability to maintain an overall cost advantage.  Support Processes: activities that make everything else that the startup does possible – ex: HR.  Systems & Processes are intimately tied to People & Culture to create an environment in which unique tangible and intangible assets are developed consistently over time to increase the competitive advantage over competitors.
  71. 71. For early stage technology startups, these are the most important sources from which a cost advantage may be derived. 71 SOURCES OF COST ADVANTAGE PEOPLE & CULTURE SYSTEMS & PROCESSES FACILITIES CAPITAL  This cost advantage is derived from the physical infrastructure that a startup needs in order to operate.  For early stage tech startups, hard decisions begin to be necessary when the startup has scaled to a point at which off-the-shelf hardware products are no longer good enough for what the startup seeks to accomplish.  This is often the point at which startups must consider the advantages or disadvantages they may derive from building custom hardware instead of relying on what’s available from outside vendors or partners.  It can also be tied to a geographic location which gives the startup unfair access to an input that is critical for what it does.
  72. 72. For early stage technology startups, these are the most important sources from which a cost advantage may be derived. 72 SOURCES OF COST ADVANTAGE PEOPLE & CULTURE SYSTEMS & PROCESSES FACILITIES CAPITAL  This cost advantage is determined by the startup management team’s ability to allocate capital in such a way that the startup successfully navigates the path it must travel between being a startup and becoming a company.  Cost advantages due to capital are determined by:  External sources of capital – potential outside investors and sources of trade credit,  Internal sources of capital – existing capital raised from investors, financial management of money the startup expects from its users or customers and money it owes to the vendors and business partners with whom it has a working relationship.
  73. 73. 73 6 EFFICIENT SCALE
  74. 74. “ Efficient scale describes a dynamic in which a market of limited size is effectively served by one company or a small handful of companies. The incumbents generate economic profits, but a potential competitor is discouraged from entering because doing so would cause returns in the market to fall well below the cost of capital. Why Moats Matter 74 WHAT IS EFFICIENT SCALE? In other words, from my perspective as an early stage investor: A startup can scale efficiently if doing so does not drive its customer or user acquisition costs to unsustainable levels over time, and if the startup’s decision to enter that market does not drive returns in the market to levels that are below the cost of capital for incumbent companies in that market over the short term.
  75. 75. Product-market fit milestone: when demand for a product at a price that is profitable for the startup’s business model begins to outstrip the demand that could have been explained by its marketing, sales, advertising, and PR efforts. Before Product-Market Fit (BPMF) Everything takes a lot of effort. Every sale is tough, everything that can go wrong will go wrong, and most of the sales deals will fall apart. After Product-Market Fit (APMF)  Demand for the startup’s product threatens to outstrip the startup’s ability to meet that demand. This is when a startup must scale, and scale fast and efficiently. 75 BEFORE AND AFTER THE PRODUCT-MARKET FIT  There are two reasons to scale at this point:  There is demand for the startup’s product from its users or customers that should be met  APMF is the point at which copy-cat competition starts to materialize from new entrants, and possibly from incumbents too.
  76. 76.  Efficient scale means different things at different points in the startup’s lifecycle: A team of 2 co-founders scales differently than when the team has grown to 20 people. In other words the way to pursue scale BPMF differs markedly from the way to pursue scale APMF.  Premature scaling seems great initially, until it leads to startup failure and death  The cadence of hiring is important:  BPMF hiring should be slow, deliberate and methodical  APMF the challenge is to hire the right people for the startup as quickly as is necessary to keep up with demand, and cope with competition. For this reason building sound and cost-advantageous systems & processes, and modifying them as the startup grows is important.  Technology-enabled scaling wins:  Tools to promote communication and collaboration once the teams grow  Tools to make salespeople as effective as they can be  Operations should seamlessly transition from one order of magnitude of scale to another without a deterioration in customer or user satisfaction  Customer or user acquisition should not be slowed unnecessarily by a failure to account for what customers are willing to do in order to get the product.  Culture makes a difference: Startups with a strong culture will scale more successfully than startups with a weak culture.  Eventually, most founders must also become managers and coaches: Not every founder is cut out for this and some may want to remain as close to building the product as possible – they need to be self-aware about this. 76 KEY CONSIDERATIONS FOR EFFICIENT SCALE
  77. 77. 77 7 CONNECTING THE DOTS
  78. 78. Founders’ willingness to conceptualize and build such moats should be self-evident. It should not be a secret that is hidden from investors. An economic moat is not the same thing as a competitive advantage. A competitive advantage is temporary. A durable economic moat is unique, and typically can not be duplicated. Startups need an economic moat that is derived from more than one source. In relation to Internet and other software technology business models, indirect network effects can prove to be as important as direct network effects. Intangibles often offer some of the strongest foundations on which to build an economic moat. Management & Culture, and R&D stand out to me because everything else emanates from those two. Cognitive costs are a real barrier to entry - especially for startups building products for sale to other businesses - and are nearly impossible to articulate or measure. A seed stage startup must find that niche of potential customers for whom the sum of cognitive costs and uncertainty is a minimum. To last, a cost advantage should yield increased value for users and customers. Finding product market fit does not automatically lead to conditions that favor efficient scale. Extended unprofitable growth is one sign that a market might not have the characteristics to support efficient scale, or that the startup has not thought its business model through enough. 78 SOME FINAL OBSERVATIONS when assessing early stage technology startups and their potential economic moats
  79. 79. CONTACT ME 79 Twitter: @brianlaungaoaeh Blog: THANK YOU! For more detailed discussion, the content of this presentation is available on my blog Design credits: Chloe Lolicart – // Send Chloe a request for your next presentation!