Chapter 27
Tearing Down and Running Around the Barriers to Entry

Barriers to entry form a wall that is built around an existing company protecting it from competitors. A start-up does not care how they breach the wall, they just want to get to the other side and take some of the revenue and customers that are inside. They want to find the weakness in the barrier and exploit it. There have been many lists of critical barriers to entry. Michael Porter, a Harvard professor, has done a significant amount of work on business strategy and his work on five forces of competition highlights barriers to entry. Below is a list of some of the key barriers to entry inspired by Mr. Porter’s work and work by others:

Outlined below are details on how relevant, or not, some of these barriers are in the current era of innovative technology. The internet has changed economies of scale. It has given people the potential for almost immediate scale by being able to reach many potential clients at once without needing to build out physical locations. It seems as if every time someone says a specific item can not be sold on the internet, it becomes available and people adapt to buying it, clothes, cars and dog food all come to mind. Scale is often considered an effective way of lowering your price and leveraging your fixed costs. Using multiple global value-added supply chains can help lead to cost advantages as well and counteract the advantage of a larger competitor to some extent. More often though success is achieved by figuring out a new way to do something cheaper, for example, using peer-to-peer car services rather than buying an entire taxi fleet. Additionally, cost savings through scale matters less if a company is willing to compete without having to make a meaningful profit and it can still attract capital.

The advantages of brand loyalty and product differentiation can disappear quite quickly. At one time many people would go to the supermarket, but remain loyal to their butcher. Then eventually the ease, cost, time and, perhaps, even the quality of the supermarket meat drove customers to leave the local butcher. People may have had their favorite grocery store. Now the supermarkets are being challenged by internet grocery delivery companies like FreshDirect in the northeast United States or Ocado in the U.K. and as for the butcher a whole bunch of people do not even eat meat anymore. People still care about brands, but it is more fleeting, and ease of access seems to have outweighed brand value. An outgrowth of this is that since unique products are rare, this has also caused pricing power to be rare.

There are more ways to access capital and more different types of capital available. Thanks to the ability to gather and share financial and credit information, funds can be raised more quickly than in the past. Like other eras of great positive economic change, capital is increasingly available for growth opportunities, even if the risks are high. This is causing capital flows to favor newer start-ups. The ready availability of capital is also taking away the advantage of capital as a barrier to entry. Technology, the internet, peer-to-peer networks, and other developments are also lowering the amount of capital needed for new businesses. A consequence of these business “lite” models where much of the process is outsourced is what happens if the company fails. The assets of the company may be worth significantly less than older style companies that owned significant cash flow producing assets. Detailed and specialized computer codes from a failed business may not be as easy to sell off as the real estate of a shopping mall to help repay investors.

Switching costs, in some cases, can still be a solid barrier to entry. If a company has an outside vendor manage an elaborate suite of software that allows a company’s various operating systems to communicate between sales, logistics, and production—it might be quite time consuming, risky, and expensive to switch vendors. There are many areas where switching costs are minimal. For example, in the past there was some disruption in switching your video service from cable television to satellite, however, switching costs are very low to switch to watch a show on Netflix or Amazon Prime. While technology has generally helped to lower prices, increase competition, and weaken barriers to entry, the complexity of technology has made switching costs in some areas much higher, but in other areas it has made it virtually painless.

Nowadays distribution can be bought. Federal Express, DHL, even Amazon, along with a multitude of other operators can come in and provide a huge portion of distribution for a company. This does not mean that there are still not some unique protected logistical advantages, think of a gas pipeline or a port. However, many companies can save a huge amount on infrastructure spending by farming out much of the distribution to vendors. Getting a product noticed may be the more difficult part of the process, but the internet can lower the costs and paying for placement may be more effective and time saving while also reaching a broader audience than paying to get actual shelf space at thousands of locations.

If an industry is highly regulated it remains a significant barrier to entry. Licensing, registration, and supervision are all major costs and cause delays in developing a new business, the more burdensome the steeper the barrier. There have been significant peer-to-peer projects that have moved ahead with their offering in regulated businesses and just chose to fight the legal battle after they had scale.

While not often listed in classic barrier to entry, time can be a massive barrier to entry. An existing or entrenched incumbent business company has more of a first mover advantage, this is a time advantage. Starting, capitalizing, and organizing all aspects of a new company or a new business line take time away from competing in the market place. If the incumbents are efficient and flexible it may be difficult for a start-up to catch-up, especially if the incumbent sees the competition coming.

In many cases a start-up has an advantage because an incumbent is not willing to adapt. An incumbent is often not as willing to change the way they are doing something because they have invested so much capital into that process, moving forward to newer methods may destroy the value of capital they have already invested. If a company has built out and staffed 1,000 restaurants, they may be reluctant to switch to a prepared food delivery service that could lessen the value of those dining establishments that they own. It takes bold leadership to undertake these types of big changes in an established business and it takes management time. However, as new generations of management come in to leadership roles it may be a more common place to see incumbents switch business models more quickly. As big incumbents try to be more nimble and adapt technologies more quickly it may get harder for start-ups. New companies will need more creativity in developing ways of doing something.

Overall, many traditional barriers to entry are weaker than in past eras. This can cause the value of invested capital to shift more quickly. Theoretically it can lead to more volatility and impact the value of traditional business assets. Traditional balance sheet measurements of asset value in a company like book equity value and property, plant and equipment can be of little meaning in the real world when innovative technologies are causing the real market value of old assets to decline very quickly.

Many of the traditional moats that have protected companies from competition are getting narrow enough to jump across. This will increase market share battles and likely cause more frequent industry centric pocket crashes, recessions, and booms. When market leaders show a leak in any of their barriers to entry, such as their brand getting lambasted in the press or service failings, competition will pour in through that breach in the barrier. However, the same is true for new economy start-ups. Companies with a good idea on the internet or in peer-to-peer businesses will quickly see imitators, many of which will correct some of the problems they see the pioneers struggling with. There will have to be more and more differentiation between a company with a good idea, and a good company with a good idea. It can not just be a good idea, it must be able to be executed with a better product, process or cost and have long-term demand.