top of page

Five Forces Model. Evaluating the company's AI moat to separate the wheat from the chaff.

Writer's picture: Dimitris AdamidisDimitris Adamidis

Updated: Mar 17, 2024


Five Forces Model


A proper demonstration is vital for a successful sales process, and the demo itself can be a make-or-break moment. #Demoboost offers a unique solution, enabling long-lasting effects that elevate your prospects' product experience right from the initial conversation. Say goodbye to tedious, one-off demos - with Demoboost, you can set up free trials and discover a more practical approach to winning over your prospects.

Demo Automation Software
 

The PwC survey of 2,500 executives from large companies in the United States and Europe found that 80% expect their organizations to move or pivot to AI in the next five years. This is up from 60% in 2020. The survey also found that 60% of executives believe AI will be their industry's most critical innovation driver over the next five years.


We have all seen it with cloud computing, big data, machine learning, and AI. Every couple of years, a market, especially startups, brings us a new thing (or rather a toy) that defaults to that one thing. It's a fashion that comes in one season and gets replaced in another. Then, why should we believe the reported sentiment from the executives? Well, the problem with all changing business fashion is that eventually, those that are not following become outdated. Before, we had businesses that didn't follow the big data "revolution" and survived. After the emergence of machine learning, many companies didn't adjust their business model and survived.


Although that may be true, these companies might be on a trajectory of widening the gap between them and highly profitable organizations. The evidence proves this technology and keeps the low technological debt, but they are making more than their counterparts in other organizations that remain behind the new technological advancement. The problem with AI, unlike anything else before, is its prevalence opportunity. That can penetrate almost every technical aspect of our work or the increasingly digitalized work. That's what makes it unique from the productivity perspective. That's the same reason why everyone is trying to make a case about their product to fit that notion of making the work more efficient or hands-free. There is a lot to say about that. Still, I need clarification on whether they can prove their ability to become a genuinely AI-driven product, scale, and eventually dominate their market. Even though many organizations claim their AI-driven capabilities for marketing purposes, the actual game is elsewhere. In other words, the dominance game is on and will change every single market structure.


The reality is that many need more essential capabilities such as predictive analytics, model accuracy, model interpretability, and data quality volumes. If you are a venture capitalist, Angel Investor, CFO, or employee, you must navigate through the landscape of nonsense between the buzzword and sophisticated technological advancement.


That's why you must elevate your game in estimating market opportunities as a professional. It is imperative to evaluate the 'moat' in which a company operates and uses its AI. Assessing a company's moat can be the key differentiator in making informed investment decisions and ensuring long-term success.


The term 'moat' was popularized by Warren Buffet and refers to a company's ability to maintain a competitive advantage over its competitors, thus protecting its market share and profitability. The moat is particularly critical for AI companies as it defines their ability to sustain a competitive edge in a rapidly evolving industry (practically any industry). A strong moat is often characterized by several key factors: Data, Network effects, Brand, Patents, Economies of scale, First-mover advantage, High switching costs, Customer loyalty, and Barriers to entry.


"In investing, what is comfortable is rarely profitable." - Robert Arnott, founder and chairman of the investment firm Research Affiliates. This quote signifies the importance of deepening a company's moat beyond the surface-level comforts of brand name and market presence.


Before we get into the nitty-gritty of the moat evaluation method, I should bring up some of the estimated data regarding the AI market. According to a report by Grand View Research, the global AI market is expected to reach $390.9 billion by 2028, growing at a CAGR of 32.4% from 2021 to 2028. The report cites the increasing adoption of AI in various industries, including healthcare, manufacturing, and finance, as the primary driver of market growth. VCs are expected to allocate a significant portion of their investments to AI-like businesses in the coming years. A study conducted by McKinsey & Company indicates that AI investment is expected to reach $300 billion by 2026, a significant increase from the $50 billion invested in 2020.


However, as the market grows, so does the number of companies claiming to be AI-driven. I need help to think of the volume of posts I see daily on LinkedIn that describe an increased number of companies labeling themselves as AI-like. This surge underlines the importance of accurately evaluating a company's moat to separate the wheat from the chaff.


The simple moat evaluation for AI-type companies could be done using the Five Forces Model:

  1. Threat of new entrants: This is the likelihood of new companies entering the market and competing with the existing players. A high threat of new entrants can make it difficult for companies to maintain their moat.

  2. Bargaining power of suppliers: This is the power that suppliers have over the companies in the industry. Suppliers with a lot of power can charge higher prices, making it difficult for companies to profit.

  3. Bargaining power of buyers: This is the power that buyers have over the companies in the industry. If buyers have a lot of power, they can demand lower prices, making it difficult for companies to profit.

  4. The threat of substitute products or services: This is the likelihood that customers will switch to alternative products or services. A high threat of substitute products or services can make it difficult for companies to maintain their moat.

  5. Rivalry among existing competitors: This is the level of competition between the existing players in the industry. A high level of rivalry can make it difficult for companies to maintain their moat.


Despite the simplicity of the model above, there are a lot of companies that make common mistakes while assessing moat that ultimately lead to poor decision-making:


  • Overreliance on Brand: Companies often overestimate the strength of their brand and underestimate the importance of other significant factors such as data quality, network effects, and patents.

  • Underestimating Competition: Companies often need to pay more attention to the strength of their competitors' moats and the market entry barriers.

  • Neglecting Data Quality: Companies often focus on the volume of data they can access, emphasizing the importance of data quality and uniqueness.


OK, there is one more problem that is hard to solve that often doesn't have a unilateral solution. It's the weight of all of these forces. You will need to take each industry or subindustry separately and evaluate. However, some general guidelines can be followed:


  • Consider the most important factors to customers. The forces most likely to affect customers' buying decisions will have the most weight. For example, if customers are price-sensitive, then the bargaining power of buyers will be a significant force. It's intuitive. Follow the customer's preference in the particular market.

  • Consider the barriers to entry into the industry. The higher the barriers to entry, the lower the threat of new entrants. For example, if there are high regulatory requirements or significant startup costs, it will be more difficult for new companies to enter the market.

  • Consider the bargaining power of suppliers. The bargaining power of suppliers will be higher if there are few suppliers or if the suppliers control essential resources. For example, if only a few suppliers of critical raw materials exist, they will have much bargaining power.

  • Consider the threat of substitute products or services. The threat of substitute products or services will be higher if good alternatives are available. For example, customers will have more choices if there are several ways to deliver a product or service.

  • Consider the rivalry among existing competitors. The rivalry among existing competitors will be higher if the market is mature and there are some well-established companies. For example, if there are a lot of companies competing for the same customers, then the rivalry will be intense.

  • Once you have considered these factors, you can assign a weight to each force on a scale of 1 to 5, with 1 being the least important and 5 being the most important. The five forces' overall weight will indicate the competitive landscape and how difficult it will be for a company to succeed. This simplistic approach with more sophisticated calculations allows companies or investors to avoid being empty-handed and ask the right questions.

  • Talk to customers and industry experts for their insights, including market research and financial statements, and track industry trends to see how the forces change over time.


Fintech Business: Square Inc.

A financial services and mobile payment company founded by Jack Dorsey and Jim McKelvey. The company's moat is characterized by its strong brand, first-mover advantage, and high switching costs. Square was one of the first companies to offer mobile payments, and it has built a strong brand and loyal customer base over the years. Additionally, the high switching costs associated with changing payment processors are a barrier to competitors' entry.


CRM Business: Salesforce

A global leader in customer relationship management (CRM) software. The company's moat is characterized by its strong network effects, brand, and high switching costs. As more companies use Salesforce's CRM software, the platform's value increases for all users. Additionally, Salesforce has a strong brand and reputation in the market, and the high switching costs associated with changing CRM providers act as a barrier to entry for competitors.



Five Forces Model

Conclusion: Evaluating the moat of an AI-type company is a crucial exercise for VCs, CEOs, CFOs, and COOs. By thoroughly assessing key factors such as data, network effects, brand, patents, economies of scale, first-mover advantage, high switching costs, customer loyalty, and barriers to entry, investors and executives can make informed decisions and ensure the long-term success of their investments and operations.


"Risk comes from not knowing what you're doing." - Warren Buffet. This quote underscores the importance of thoroughly evaluating a company's moat before making investment decisions or strategic moves. After this article, I hope we can look at the market more confidently and competently navigate the AI landscape.


Here is an additional list of recommendations while assessing a company's moat:

  • Don't use two different moat methods to assess the market. They are not always the same or reflect assessment between startup vs. mature publicly traded companies. There is a connection, but assuming that a small startup can dominate an established market is an overreach. Smaller players will usually operate in the niche part of the sub-industry, trying to scale it and testing the boundaries. Conversely, will SFDC move to the smaller segment, changing their prices or features without a substantial market shift? Unlikely, right? There you have it. Please see the comparison between the Five Forces Model and the Morningstar Model. They are pretty different:


Five Forces Model

  • Pick one method at the beginning and understand that well before complicating it with other less-defined areas. You can select from many methods like:

    • Porter's generic strategies: This model identifies three strategies companies can use to compete: cost leadership, differentiation, and focus.

    • Strategic group mapping: This method identifies companies competing in similar ways.

    • Industry life cycle analysis: This model describes the evolution of an industry over time.

    • PESTEL analysis: This model analyzes the political, economic, social, technological, environmental, and legal factors that affect an industry.

    • SWOT analysis: This model analyzes a company's strengths, weaknesses, opportunities, and threats. Yes, even that can serve you well at the beginning.

  • Data: Access to high-quality data is a critical competitive advantage for AI companies. Evaluate the volume, quality, and uniqueness of the data the company has access to and utilizes in its AI models. Do they have a sufficient amount of data to drive their model? What is the right level of data to be accurate in a particular industry?

  • Network Effects: Assess the strength of the network effects. A company with strong network effects will see its value increase as more users join the platform. Is the business having a stagnated number of users? Or is it constantly expanding? If so, how much? Are the users increasing the number of interactions between each other?

  • Brand: A strong brand can act as a moat by creating customer trust and loyalty. Evaluate the brand's strength and reputation in the market. There is also value for the engineers to join a company that is serious about it. Do they have a capable team to provide what they claim they are trying to achieve?

  • Patents: Assess the number and quality of patents held by the company. A strong patent portfolio can act as a barrier to entry for competitors. It is pretty straightforward. Do they have patents that can support their claim? Are they unique in what they offer? I'd pay attention to the enforceability of patents.

  • Economies of Scale: Evaluate the company's ability to decrease its cost per unit as it scales up its operations. Scalability = profitability. Can you bring the unit economics under control and keep improving them?

  • First-mover Advantage: Assess whether the company was the first to enter the market and if it has been able to maintain its lead. Is this something that everybody does? Or was someone offering something first? Can you keep your position in the market? What's the plan to do that?

  • High Switching Costs: Evaluate switching costs from the company's product or service to a competitor's. High switching costs can act as a barrier to entry for competitors. Let's say you follow your competitors. Are you able to afford to make the switch? If not, you have to make tough decisions.

  • Customer Loyalty: Assess the loyalty of the company's customer base. High customer loyalty can act as a barrier to entry for competitors. That sounds counterintuitive, but it's an essential assessment element. You need feedback, data usage, and adoption to build your AI-like solution. The higher the loyalty, the better the supply of these critical components.

  • Barriers to Entry: Evaluate the overall barriers to entry in the market. These can include regulatory hurdles, capital requirements, and technological expertise. Training your AI solution in the EU will be challenging due to more restrictive laws and regulations. Suppose you are an EU-based company that is trying to build AI capabilities. In that case, you must obtain the data in different countries or markets before bringing this to the EU (not entirely true, as you can operate in a less privacy-sensitive area, which could be sufficient to train your AI).

9 views0 comments

Comments


Contact
Original (2).png

Phone

+1 650 318 5235

  • LinkedIn

Email

© 2024 Powered and secured by RevOps Venture

social links 

Address

Mountain View, CA 94043

bottom of page