A moat is a deep and wide ditch that surrounds a building. In the Middle Ages, many rulers built moats around their castles and filled them with water in order to protect against attackers.
Legendary investor Warren Buffett coined the term economic moat to describe a company that is protected from competitors by an unbreachable competitive advantage. For example, a leading brand can serve as an economic moat that ties customers to a company. It is not a surprise that Buffett often invests in very well-known brands such as Wal-Mart, American Express, and Coca-Cola.
A startup does not need a moat in order to have short term success. Recently a company called The Home T was featured on Shark Tank. The company’s main products are t-shirts that feature the shape of a state such as Texas with the word ‘home’ emblazoned across it. By leveraging social media and putting celebrities in his shirts, founder Ryan Shell has sold over $1 million of these t-shirts at $30 a piece. Great, right? Yes… for now.
Startups must build economic moats in order to keep their customers over time and maximize their staying power. This issue is routinely raised on Shark Tank by “Mr. Wonderful” Kevin O’Leary. If a soap business can be easily copied, for example, O’Leary is likely to ask why he should invest in the presenter’s company rather than simply creating Uncle Kevin’s Soapery.
It’s easy to imagine an imitator – let’s call it UKT: Uncle Kevin’s T-shirts – doing major damage to The Home T over time. UKT could start selling t-shirts for $15 that show the outline of a state and include a phrase such as “Dreaming of” or “Born in” that is similar to “home” but is different enough to avoid getting sued. Shell would then either have to hope that his customers would stick with his $30 shirts (doubtful) or slash his prices (and profits) in order to keep them.
How likely is it that one or more imitators will emerge? Very likely, as shown by the ironic fact that Shell himself may have copied the “home” t-shirt idea from a 2011 startup called Home State Apparel. This illustrates a hard reality: sooner or later, the absence of an economic moat leads many startups to be drowning in competition.