Binary Moats

August 19th, 2018

I believe that moats are binary. They take one of two forms: legal moats or technical moats. Contracts create legal moats. Patents do, as well. Engineers create technical moats.

Before Nike became the famous apparel company it is today, it operated by a different name: Blue Ribbon Sports. At first, Blue Ribbon -- a shoe company -- didn’t make shoes at all: it imported and sold them. Blue Ribbon’s profits had nothing to do with its ability to produce shoes -- they existed because Blue Ribbon held the sole legal right to sell Onitsuka Tiger shoes in a given area.

Over time, however, Nike evolved its legal moat into a technical one. It was the first company to create, among other things, waffle-soled shoes (for increased traction), airbag insoles (for increased comfort), and “flyknit” uppers (for decreased weight). Of course, these technologies would eventually be copied, to varying degrees of success, by competitors. However, Nike’s superior R&D function enabled it to create tailwinds -- not simply draft off of them. Nike became known for leading the pack in sports apparel and has profited handsomely for doing so.

While it began as a legal moat, the profits it accumulated during that time enabled Nike to invest in R&D and evolve into a technical moat. This is decidedly pro-innovation and is a common argument made in favor of moats. (This is an argument applicable to any business, but I have seen it most enthusiastically used to defend the existence of pharmaceutical patents.)

However, we’ve also seen the opposite occur: technical moats that regress into legal ones. Microsoft circa 2001, when it would forcibly bundle Internet Explorer into Windows machines, is the most famous example of this.

I’m not here to pass judgement on moats. Creators should be rewarded for the advances in technology that they bring to society. After expending blood, sweat, and tears over many years, it seems fair to me that they should be able to sit back, relax, and reap the rewards of the struggles they endured. And yet, we must also incentivize creators to eventually develop other new technologies, as well.

The pro-innovation outcome, I think, is when a legal moat is able to transform itself into a technical one. This can be done by harvesting legal moat profits to invest into research and development. By planting these seeds, one hopes that, over time, technical superiority will blossom.

The anti-innovation outcome is the opposite: when a technical moat regresses into a legal one over time. We’ve seen this occur throughout history: an upstart firm creates something new and brilliant, before collecting rents and resting on its laurels.

Where this matters most, I think, is inside the rooms of a company’s decision makers. Specifically, what should they choose to invest in: their legal capabilities? Or their research and development ones? Should they litigate their competitors out of existence? Or should they just build better products.