When conducting due diligence, assessing a startup involves more than just looking at its current situation, historical financials, and future plans. One important component of due diligence is assessing a startup’s defensibility – does it have a competitive advantage that differentiates it from competitors? Does it have an economic moat making it difficult for others to replicate or challenge its market position? In this blog, learn more about assessing a startup’s defensibility, evaluating product-market fit, and gauging a startup’s economic moat.

Assessing a Startup’s Defensibility

We’ll take a look at three aspects of a startup’s defensibility: economic moat, product-market fit, competitive advantage.

Understanding the Economic Moat

Popularized by Warren Buffet, an economic moat refers to a company’s ability to maintain competitive advantage over its competitors, in change protecting its market share. While certain aspects of moat, like brand recognition, aren’t quite there for startups yet, there are other characteristics that private market investors can assess when evaluating a startup’s economic moat.

According to Morningstar, there are generally five sources for economic moats:

1. Cost Advantage

Cost advantage refers to the ability to deliver its product or service at a lower cost than competitors. For startups, this may be reflected in proprietary technology, unique supply chain, or scalable operational models.

2. Intangible Assets

Intangible assets are the non-physical, but valuable, aspects of a startup. For example, patents, trademarks, proprietary technology, and brand strength are all examples of intangible assets. While startups may not have a recognized brand yet, their intellectual property (IP) pipeline or filed trademarks may serve as an economic moat compared to other startups.

3. Network Effects

Network effects refer to the value of a product or service increasing as more people use it. For example, Uber became more valuable as it gained additional drivers and riders in various geographical markets, meaning that riders were more likely to find a driver and drivers were more likely to find riders. If a startup has organic user growth and strong engagement of its current user base, that may point towards a network effect moat.

4. Switching Costs

If it is difficult or costly for customers to switch to a competitor, the startup may have an economic moat in terms of switching costs. This can be more common in B2B software models where integration, data migration, or training creates friction.

5. Efficient Scale

Startups operating in niche markets with limited room for competitors may benefit from efficient scale as an economic moat. This is less common in early-stage ventures but may be applicable to highly specialized sectors.

While economic moats can be more difficult for a startup to prove, investors may want to compare a startup to these five aspects in order to identify whether the startup might be able to achieve an economic moat in the future.

Evaluating Product-Market Fit

Product-market fit refers to the degree to which a product satisfies strong market demand. It can be considered a foundational element of a startup’s defensibility because even the most groundbreaking, innovative product will fail if it doesn’t resonate with people and doesn’t gain customers.

For investors, assessing product-market fit involves quantitative and qualitative methods:

Quantitative Indicators:

• Retention Rates: High customer retention may suggest that the product delivers ongoing value
• Net Promoter Score (NPS): A high NPS can indicate strong customer loyalty and willingness to recommend the product
• Usage Metrics: Metrics such as daily active users, session length, and feature adoption can signal engagement and dependency

Qualitative Indicators:

• Customer Surveys: Surveys that ask users how they would feel if they could no longer use the product can be revealing. A high percentage of “very disappointed” responses (often cited as 40% or more) is a strong indicator of product-market fit.
• Pilot Programs and LOIs: Signed letters of intent or pilot programs with reputable companies can signal validation. However, investors must scrutinize the terms and conversion likelihood of these agreements.

In cases where the startup does not yet have a sellable product, investors can still gauge potential product-market fit through:

• Market research and validation of the problem being solved
• Engagement with a minimum viable product
• Pre-launch waitlists or early access demand

A startup with clear product-market fit may be better positioned to withstand competitive pressures.

Analyzing Competitive Advantage

A startup’s competitive advantage is its ability to outperform competitors on a longer-term basis than an economic moat. This advantage can stem from innovation, business model design, execution speed, or strategic positioning. During due diligence, investors may want to focus on the startup’s unique value proposition and the sustainability of its advantages.

Some key areas to evaluate include:

• Intellectual Property: Verify the ownership, scope, and defensibility of patents, trademarks, and copyrights. Assess whether the IP is core to the product and difficult to design around
• Team Capability: The founding team’s expertise, industry knowledge, and execution history can be important to research. A team with deep domain experience and a track record of adaptability is more likely to navigate challenges
• Business Model Scalability: Evaluate whether the startup’s model can scale without proportional increases in cost. Recurring revenue models, for example, often provide more stability than one-time sales
• Barriers to Entry: Assess whether the startup has built structural barriers, such as regulatory approvals, exclusive partnerships, or data network effects, that would be difficult for new entrants to replicate

It is also important to contextualize these advantages within the competitive landscape. A thorough competitive analysis should identify direct and indirect competitors, strengths and weaknesses, and the startup’s differentiated positioning.

Final Thoughts

Assessing a startup’s defensibility can need a disciplined, evidence-based approach. Defensibility is not a static trait, but rather an evolving outcome of strategic decisions, execution excellence, and market dynamics.  By assessing economic moat, product-market fit, and competitive advantage, private market investors may be able to determine if a startup has enough differentiators to help it maintain market share and scale efficiently in the face of competition.

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Want to learn more about investing in startups? Check out the following MicroVentures blogs to learn more:

• Assessing Overemphasized Startup Metrics
• Secondaries and Tenders: Private Market Liquidity
• Assessing Startup Financial Health
• Going Digital: The Rise of HealthTech

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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.