By Dylan Fitzpatrick

Today, we’re returning to basics and asking the age-old, notorious question, “What prevents someone else from doing this?”

While the early stages of a startup are all about execution (i.e., talking to users and iterating on a product), investors often think about defensibility over the long run. There doesn’t have to be a competitive edge today – in fact, there realistically isn’t until a company finds product-market fit and achieves scale – but there does have to be a path to it for a successful, enduring business.

Many people (especially young founders I meet) often confuse differentiation with defensibility. Differentiation is simply the act of doing something differently, often resulting from a founder’s unique insights. Now, this is extremely important during a startup’s 0-1 phase – the founders might be focused on solving a different problem than existing solutions, building a product with a better value proposition than competitors, or attacking an underserved part of the market – all of which can certainly contribute to a company’s ability to acquire new customers. Peter Thiel’s “0-1” philosophy is predicated on this notion – build something novel and different that no one else is doing to avoid competition and chase monopoly opportunities. Founders Fund’s investments in Anduril (defense technology contractor) and Faire (online wholesale marketplace) are perfect examples. No Silicon Valley technologists were interested in the defense sector because of political controversy and existing defense primes don’t use much automation, so Anduril’s team of technologists and automation-first approach has seen early success because of its differentiation. For Faire, most people initially wrote them off under the assumption that Amazon would gobble up the long tail of direct sales from independent retailers. However, independent retailers have continued to flourish (+2% annual revenue growth, even under e-commerce marketplace pressure) despite this consensus view. While many technologists focused on e-commerce, Faire’s different approach to commerce now dominates brand discovery and inventory fulfillment for independent retailers. Now, both of these startup successes weren’t just a function of differentiation – they’ve architected competitive advantages that will sustain them over the long run (more on this later) – but it’s important to note the power of differentiation as an entry point. Less competition enables lower customer acquisition costs (CAC) and a quicker path to scale.

So, differentiation is a great way to get in the door, but what about retaining those customers over time? If someone else builds a new product with differentiated features at a lower cost, why would a company’s existing customers not jump ship? And why would potential new customers choose their product over a newer, cheaper one? That’s where defensibility comes in – a company’s ability to successfully acquire and retain customers due to a structural competitive advantage that others can’t replicate.

In his book 7 Powers, Hamilton Helmer describes these competitive advantages, or powers, as 1) cornered resources, 2) process power, 3) scale economies, 4) switching costs, 5) branding, 6) network effects, and 7) counter- positioning. Power is two-fold – providing benefits to its owner and establishing barriers against competitors – so it should not be confused with strategy. For example, Starbucks choosing a cheaper plastic cup supplier might enhance its bottom line (benefit) but isn’t a barrier to other coffee chains, as competitors could theoretically use the same supplier. While companies successfully employing any of these powers are certainly compelling, some tend to be overstated and misunderstood, while others are underrated.

Let’s start with the overrated – cornered resources, scale economies, switching costs, and brand.

With cornered resources, a company relies on access to specialized talent (i.e., Open AI’s research team, Pixar’s Braintrust group, etc.) or intellectual property (i.e., Eli Lilly’s drug patents) to build superior products. Cornered resources are especially powerful for early-stage startups, as talent and IP can be present at the outset of a company’s lifecycle. However, patents are less relevant today (outside of biotech) given the commoditization of software, surge in open-source models, and less reliance across deeptech (even SpaceX avoids them). On top of that, OpenAI’s recent CEO blunder has highlighted the vulnerability of perceived talent edges, as people are critical but not structurally tied to businesses. Due to their rarity and binary outcomes, many early-stage investors don’t value cornered resources highly, nor are they that valuable in reality, so founders must prove that access to a key input is actually proprietary and directly tied to the business itself.

Conversely, investors get excited about scale economies (high perceived contribution to enterprise value), where the cost per unit declines as production volume increases due to a higher proportion of fixed costs relative to variable costs. Essentially, a business becomes more profitable as its revenue grows (pretty beautiful, right?). This matters because larger players can reinvest their extra margin in new products, customer success, etc. to further extend their lead ahead of smaller competition. Given 80% gross margins, many believed cloud software companies would see incredible economies of scale with near-zero marginal product costs after their innovative 0-1 phases. However, this low cost of goods sold has yielded an enormous amount of competition as almost anyone can whip up a software product on a weekend and has instant access to unlimited online distribution. Consequently, another major variable cost driver emerged – sales & marketing (S&M). While some argue S&M cost lines are more fixed than variable, it’s logical that CAC would be linear or even inflationary as software businesses expand into new end markets outside of their initial customer profile. For context, the average public cloud company spends 161% more on S&M than R&D, and some of the largest software businesses, like Salesforce and ServiceNow, have 3.5% and 5.5% operating margins, respectively. As cloud category creators and market leaders with $34B and $8.5B in revenue after 20+ years, respectively, do they really benefit from scale economies? Maybe to an extent, but zero marginal product costs come with a price (i.e., intense competition and thus more variable S&M spend) and reduce the benefit of this power – hence, its only moderate contribution to creating enterprise value.