Circumstances that give a business an advantage over its competitors, strengthen its strategic position, or can be leveraged for future gain boosts business value. Why? Because it increases the probability of the continued profitability of the business and decreases perceived risk by prospective buyers.
As with all value drivers, it’s all about risk. Lower risk achieves higher value. Buyers will pay a premium price for a business that has barriers to competitive entry.
One way to describe this barrier value driver is to use Warren Buffett's term, "business moat." Buffet compares a castle's moat to the protection that a business needs to ward off encroaching competitors. For instance, the wider the moat, the more easily a castle can be defended. A narrow moat does not offer much protection and allows a castle to be breached. To Buffett, the castle is the business and the moat is the barrier that protects its competitive edge. The wider the moat, the longer a company can protect its profits.
Understanding a company's competitive position is an important process in determining business value. Therefore, a business owner who is considering a sale should understand what can be characterized as moat.
Widen Your Business MoatThe following are barriers that widen the moat and keep competitors at bay.
Identify and articulate the company's intangible assets such as:
- Trade Secrets
- Developed Processes
- Proprietary Designs / Proprietary Know-how
- Patents / Trademarks / Copyrights
- Government Approvals
- Brand Names / Trade Names
- Hard-to-get Licenses (zoning, permits, regulatory approvals)
- Engineering Drawings
- Customized Software Programs
- Step-by-Step Training Systems / Operations Manuals
- Customized or Proprietary Databases
- Published Articles or Industry Press
- Exclusive Contracts/Agreements with Suppliers, Distributors, etc.
- Contracts with difficult-to-penetrate entities (government, for example)
- Is your product or service so much better than anyone else’s that your customers feel compelled to talk about it with others?
- Do you get a lot of word-of-mouth business and referrals?
- Do you provide guaranteed on-time delivery that makes you more reliable than anyone else and put money on that guarantee?
- Do you offer same-day service that makes you faster than anyone else in your market?
- Do you have a 99% success rate or other signifier that makes you better than anyone else in your market at getting the job done?
- Do you have 24/7 on-call service or other such practice that gives customers confidence that you go the extra mile?
- An Efficient Business Model - The firm that can achieve the highest efficiency for the same service or product can widen profit margins over its competitors. Not only is the business model important, in some cases innovation rests not in the product or service but in the business model itself. Having the ability to transform with the market is key to staying on top.
- Economies of Scale - When a company can effectively cut costs on a per-unit basis, this often gives it the flexibility to drop its prices, charge the same amount as its competitors but pocket a higher profit, or some combination of the two. Spreading fixed costs over a larger production base can also generate operational efficiencies. Other ways include specialization of labor, reorganization of key processes, implementation of new technology that speeds up systems or operations, or the purchase of materials at bulk prices.
- Niche Market Domination - "The big fish in a little pond." Usually, the niche is only large enough to support one entrant profitability so it makes little sense for competitors to spend the capital necessary to displace the incumbent.
- High Switching Costs - Switching costs can be quantified by measuring the level of inconvenience, expense, learning curve, or other hassle that customers would incur should they want to switch from one product or service to another. The more locked-in to that product or service, the lower the likelihood that the customer will stray. For example, we use Quick Books and it would not just be a headache, but a migraine, to migrate all our data and learn a new software product. Quick Books is so entangled in the day-to-day business operations of many small and midsize companies that it is impossible to easily change. The power of switching costs is clearly evident in the annual licensing and maintenance fees that Quick Books charges, which seem to be increasing with every new convenience they add to their service. This brings another important value driver into play - Recurring Revenues!
- The Network Effect - The network effect exists when the value of a particular product or service increases for both new and existing users as more people use that product or service. While eBay, Twitter and Facebook are ready examples of the power of the network advantage, other venues like LinkedIn, VRBO.com, and Dropbox are growing models of this barrier to entry. These companies control more territory in their space than their competitors and make it difficult for other companies to enter.
Got Moat?To determine whether or not your business has moat, follow these four steps:
- Evaluate the firm's historical profitability. Has the firm been able to generate a solid return on its assets? This is probably the most important component to identifying whether or not a company has a moat.
- Assuming that the firm has solid returns and is consistently profitable, try to identify the source of those profits. Is the source an advantage that only this company has or is it one that other companies can easily imitate? The harder it is for a rival to imitate an advantage, the more likely the company has a barrier in its industry.
- Estimate how long the company will be able to keep competitors at bay; it can be as short as several months or as long as several decades. The longer the competitive advantage period, the wider the moat.
- Is the company in a highly competitive industry or is it in one that has only a few companies vying for customer dollars? Highly competitive industries will likely offer less attractive profit growth over the long haul.