economic moats - for early stage startups and early stage investors

Notes on

ECONOMIC MOATSfor early stage

technology startups

BRIAN LAUNG AOAEH

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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

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

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SCOPE OF THIS DOCUMENT

2016

4

DEFINITIONS1

3 SWITCHING COSTS

2 NETWORK EFFECTS

4 INTANGIBLES

7 CONNECTING THE DOTS

5 COST ADVANTAGES

6 EFFICIENT SCALE

SUMMARY

5

1DEFINITIONS

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

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2NETWORK EFFECTS

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.

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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?

LOCAL NETWORK EFFECTS

DIRECT NETWORK EFFECTSor one-sided network effects

TWO-SIDED NETWORK EFFECTS

INDIRECT NETWORK EFFECTS

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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

The Power of Network Effects (Image Credit: Ray Stern, former CMO of Intuit) 10

THE POWER OF NETWORK EFFECTS

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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

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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

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?

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LOCK-IN OR SWITCHING COSTS NETWORK CONGESTION CONFLICTS OF INTEREST

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

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WHAT STRATEGIES SHOULD A STARTUP THAT’S COMPETING IN A MARKET IN

WHICH NETWORK EFFECTS MATTER EMPLOY IN ORDER TO WIN?

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

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CONCLUSION ON NETWORK EFFECTS

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3SWITCHING COSTS

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.

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WHAT ARE SWITCHING COSTS?

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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

COMPATIBILITY REQUIREMENTS

TRANSACTION COSTS

COGNITIVE COSTS

UNCERTAINTY

LEARNING COSTS

LOST-BENEFIT COSTS

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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.


TRANSACTION COSTS

COGNITIVE COSTS

UNCERTAINTY

LEARNING COSTS

LOST-BENEFIT COSTS

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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


TRANSACTION COSTS

COGNITIVE COSTS

UNCERTAINTY

LEARNING COSTS

LOST-BENEFIT COSTS

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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


TRANSACTION COSTS

COGNITIVE COSTS

UNCERTAINTY

LEARNING COSTS

LOST-BENEFIT COSTS

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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.


TRANSACTION COSTS

COGNITIVE COSTS

UNCERTAINTY

LEARNING COSTS

LOST-BENEFIT COSTS

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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.


TRANSACTION COSTS

COGNITIVE COSTS

UNCERTAINTY

LEARNING COSTS

LOST-BENEFIT COSTS

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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.

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.

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HOW MIGHT SWITCHING COSTS BECOME A DISADVANTAGE?

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

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WHAT ARE THE COMPETITIVE STRATEGIES AT PLAY IN MARKETS IN WHICH

SWITCHING COSTS MATTER?

1

2

3

4

5

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.

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The incumbent sells to existing customers, rival new-entrant serves new buyers1

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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.

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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.

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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.

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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.

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

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CONCLUSION ON SWITCHING COSTS

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4INTANGIBLE ASSETS

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.

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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

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https://hbr.org/2004/06/sharpening-the-intangibles-edge

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THE DIFFERENT TYPES OF INTANGIBLE ASSETS

As far as early stage technology startups are concerned I am

mostly interested in:“Copyrights

Trademarks

Patents

Trade secrets

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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

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.

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INTELLECTUAL PROPERTY Copyrights 1/2

Note on copyrights for early stage startup: “WORK FOR HIRE DOCTRINE”

“

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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

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

“

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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.

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.

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INTELLECTUAL PROPERTY Trademarks 2/2

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.

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INTELLECTUAL PROPERTY Patents 1/7

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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.

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.

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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.

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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

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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.

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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

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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.

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INTELLECTUAL PROPERTY Trade secrets 1/2

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 apatent.

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INTELLECTUAL PROPERTY Trade secrets 2/2

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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.

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BRAND 1/3

“ “

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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

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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?

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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.

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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.

INTELLECTUAL

PROPERTYBRAND R&D

REGULATORY

ENVIRONMENT

CULTURE &

MANAGEMENT

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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.

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.

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http://digitalcommons.law.seattleu.edu/cgi/viewcontent.cgi?article=2041&context=sulr

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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.

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.

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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.

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INTELLECTUAL

PROPERTYBRAND R&D

REGULATORY

ENVIRONMENT

CULTURE &

MANAGEMENT

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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.

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REGULATORY ENVIRONMENT 1/2

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.

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REGULATORY ENVIRONMENT 2/2

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.

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CONCLUSION ON INTANGIBLE ASSETS

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5COST ADVANTAGES

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.

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WHAT IS A COST ADVANTAGE?

For early stage technology startups, these are the most important sources from which a cost advantage may be

derived.

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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.


derived.

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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.


derived.

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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.


derived.

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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.

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6EFFICIENT SCALE

“ 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

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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.

http://eu.wiley.com/WileyCDA/WileyTitle/productCd-1118760239.html

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.

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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.

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.

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KEY CONSIDERATIONS FOR EFFICIENT SCALE

77

7CONNECTING THE

DOTS

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.

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SOME FINAL OBSERVATIONSwhen assessing early stage technology startups and their potential economic moats

CONTACT

ME

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Twitter: @brianlaungaoaeh

Blog: http://innovationfootprints.com/

THANK YOU!

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