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50 Questions: How does a VC consider barriers to entry?

Twenty-second in a series of weekly posts by myself and Nicholas Lovell of Gamesbrief which answer the fifty questions you should ask before raising venture capital.  We expect the series to run for a year after which we will collate the posts into a book.  You can find the rationale behind the series here, and the list of questions here.  We welcome your comments on any and every aspect of what we are doing.

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Barriers to entry, sometimes also called sources of unfair advantage or sustainable competitive advantage are hugely important to VCs.  A business with good barriers to entry is able to compete more effectively against competitors because the barriers prevent the competition from offering equivalent product.  Further such companies typically command a higher valuations on exit because acquirers know they will struggle to build an equivalent product themselves and/or public market investors are less worried about competitors.  Finally, there is a good correlation between strong barriers to entry and good margins as businesses scale.

The best and most valuable source of competitive advantage is network effects.  A business has network effects if the value for existing customers goes up when new customers join the network.  The classic example of a network effects business is a telephone network, prior to interconnect regulations the more people that were available to phone and could phone you the more valuable the service to you (and everyone else).  Once a critical mass of users has been achieved no one wants to jump ship to a competitors network with none of their friends on it.

Businesses with strong network effects often destroy the competition to such an extent that they end up as monopolies and then get regulated.  This has happened to telecoms companies around the world who are now forced to interconnect with competing networks at regulated prices.

Social networks exhibit some network effects as all users benefit as the number of users increases.  However, the low switching costs and ease of participating in two or more social networks simultaneously means these network effects are weaker than one might think and explains the demise of former industry leaders Friendster and Myspace.  I think Facebook and LinkedIn are safer because they have managed to create high switching costs as well as massive scale.

Intellectual property (IP) is the other barrier to entry that VCs look to first, and is at the heart of many cleantech, medtech and semiconductor (and some software) investment theses (very few internet businesses have meaningful IP).  IP is attractive to startup investors because it can be seen and touched much earlier in the life of a company than the other sources of competitive advantage. We use the term IP to cover both clever innovations that will be hard to replicate and inventions that are protected by patents.

Below is a list of the other barriers to entry we look for.  Most of them are only available with scale and at the point of investment we look at the business plan and the inherent characteristics of the model and the market to assess the likelihood of any of them driving value to the company over the three to five years of our investment.

  • Data – increasing numbers of web companies are able to harness the data generated by their customers to improve their service, often a very powerful barrier to entry.
  • High switching costs – common for software companies where it is a pain for their customers to switch to alternative providers.  A medium strength barrier to entry.
  • Know how – many companies develop detailed knowledge of industries, manufacturing processes and product or service assembly that make it harder for competitors to enter the market.  A weaker barrier to entry.
  • Brand – most large companies use their brand to keep competitors at bay, but some smaller companies do a great job in this area with more limited resources, particularly in the consumer space.  Our portfolio companies Graze and Lovefilm stand out in this regard.  Having a good company name helps.  Brand is a medium to weak barrier to entry, particularly at the early stages.
  • Scale – sheer scale often makes it hard for competitors, due to economies of scale, ability to spend more on marketing, and appearing as the safe and obvious choice for customers.  For large companies like Facebook, Google, Microsoft, IBM and Cisco scale is a very strong barrier to entry.  For smaller companies, including nearly all venture backed companies it is obviously less strong.
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