This week: revisiting the classic Clay Christensen/ Michael Raynor growth bible, The Innovator’s Solution. If you have not already read this, or have not done so recently, it is worth it. Hands down one of the most articulate and well-researched analyses of how companies can achieve repeatable growth from within. Christensen and Raynor explicitly describe the culture, resource allocation, product development and marketing processes that lead even the most logical managers to make decisions that tourniquet, rather than cultivate growth. Then they offer a clear framework of alternatives.
The book is geared primarily for operational managers, but I tend to view most things from an investment perspective and in this go-round, found it a practical and timely lens for evaluating long-term return potential.
I’ve Got Friends in Low Places
One of the book’s most compelling points hinges on how to identify fertile grounds for growth. The focus is on disruptive innovations: those with the potential to upend an existing market or create a new market where there was none before. Christensen and Raynor suggest that potential for growth of this magnitude can be found exactly where most companies REFUSE to look: at the least-profitable, lowest ends of the current market.
How can these of't overlooked populations be so fruitful?
- There is little or no existing competition
- For existing customers - Incumbent firms will flee, rather than fight to continue to defend low-margin customers. Incumbents are often thrilled, relieved in the short term to be able to shed low-margin customers and move up-market
- It is possible to bring customers who were previously not consuming at all - because prior products were too pricey, too complicated, or hard to access. When new companies can enable these customers to participate, it makes the whole market bigger, it “grows the pie”
- The low-end customer base is easily delighted and does not require perfection in early days - their alternatives are no access to the product, or prohibitively costly access
Christensen and Raynor go on to describe pitfalls and solutions in each subsequent step related to capturing and developing growth from these kinds of markets.
Takeaways: Blueprint for Investment?
1) This is excellent business strategy. Ranks with Geoffrey Moore’s Crossing the Chasm as best clear and implement-able logic.
2) Elements of this book could easily be used as part of an investor’s playbook - from early stage venture to institutional scale - an explicit, repeatable method and language by which to evaluate the growth prospects of potential investments (most relevant to investments in operating companies).
3) The focus on reaching customers at the lowest ends of the market spectrum sounds awfully familiar. It sounds a lot like CK Prahalad’s Fortune at the Bottom of the Pyramid, and a host of other multi-faceted investment strategies labeled anything in a range from “impact investment” to “triple bottom line” to “social enterprise”.
4) At the time of publishing (2005, two years after the Innovator's Solution) Prahalad’s and related strategies were widely circulated in the nonprofit and government sector, but rarely made it to the table for profit-seeking investors or those with a fiduciary responsibility to generate the highest risk adjusted returns for their constituents. That felt prematurely limiting at the time, and like a missed opportunity.
5) At the moment, investment managers all over the world are struggling to find returns, complaining that while we used to seek “risk-free return” we now must accept “return-free risk”. Pension and sovereign funds are dramatically at risk of missing return targets, despite having taken on higher risk, higher reward platforms. Their managers are now seeking yield through niche opportunities ranging from parking meters to Greek lotto companies, but (correctly) express concern that these strategies may not be scalable in a way that addresses the funds' needs for return. In this environment - it may be worth revisiting not only Christensen and Raynor’s work, but also that of Prahalad and others who have gleaned insight into how to reach big, eager low-end populations with appetite for growth, but this time explicitly from the lens of investment.
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Click through the “Read More” link below for the most salient ideas from each chapter. Selfishly, these are a scratch pad to help my own synthesis – and should not be considered as cliff’s notes to the real thing.
It is completely worth reading the full version – or listening. At 2x speed you’re only out 280 minutes…
Global capital markets behave as if they expect a type of consistent growth that is, in reality, not at all common. This chapter outlines a number of it is so hard to achieve.
o Punishment & Reward
The capital markets brutally punish companies that do not grow by beating up stock prices and restricting access to capital. However, even growing is not enough. Because expected growth is already priced into stock values, firms must outperform expectations in order to raise stock values and increase value to shareholders. This becomes increasingly difficult for large, mature businesses.
o Incentives matter
Within even the best companies, management incentives and risk aversion often limit growth potential.
Most new ideas are vetted by middle managers. But successful middle managers want quick promotion, and tend to recommend ideas they believe will succeed in a way that fuels their own progress. This leads to a bias towards ideas which - resemble programs which have been successful in the past. Ie: have big, established markets and ample customer data. However, the most exciting growth markets for “tomorrow” are often small today. The existence of similar products means the growth opportunities may be limited and competition may be tough.
- Can come to fruition quickly to speed manager promotion. ie have a short development cycle, which again, means many longer term strategies get ignored.
o All in positioning
Even innovative ideas can get weeded, massaged, and recast to appear less risky. In doing so, ideas with great potential become “me-too” innovations positioned for markets with existing competition, when they COULD have been positioned to achieve truly disruptive growth.
o Most growth theories are prescriptive, without clearly articulating the role of specific internal and external circumstances. “We can trust a theory only when its statement of what actions will lead to success describe how this will vary as a company’s circumstances change”
o The goal of this book is to improve the predictability of business building by focusing on CIRCUMSTANCES
Chapter 2: How can we beat our most powerful Competitors?
This chapter articulates the difference between “sustaining” and “disruptive” innovations and clarifies the circumstances under which start-ups can succeed. To understand whether new entrants or incumbent companies will win, identify circumstances of innovation
o Sustaining Innovation: where innovation makes better products, to be sold for MORE money, to existing attractive customers: incumbents will win
- as a product reaches higher and higher performance (in order to reach more demanding, higher profit margin customers), many mainstream or low-end customers simply don’t need anything so fancy and will be “over-served”
- These products are designed to make money in the SAME WAYS that incumbents make money.
- Innovation is seen as a threat.
- The start-up should aim to sell out quickly to an incumbent, because incumbent firms will fight to defend existing, profitable customer segments.
o Disruptive Innovation: where challenge is to commercialize a simpler, more convenient, less expensive product to a new or unattractive customer set: new entrants can win
- New Market Disruptions: If a start-up targets a market that is not currently served, they will not have to fight for market share b/c the customers are currently “non-consumers”
- Non-consumers previously lacked money or skills or access to buy and use a product
- When these customers are served, their participation increase the overall “pie”.
- Innovation does not invade the mainstream market until it matures and eventually PULLS customers from the mainstream market, because it is cheaper and more convenient.
- Once incumbents realize this shift is happening, it is already too late to catch up.
o Low End Disruptions: Disruptive companies can start by serving “low end,” undesirable customers, often in commodity markets. The loss of these customers is not contested. Rather, it is often seen as a RELIEF to incumbents, because those customers are viewed as “unprofitable”
- But disruptive companies can then begin to move up-market, picking off the next lowest-end customers. Incumbents will allow this, and consistently “flee” the lowest-end of their markets, because they NOT motivated to defend unprofitable segments.
- Incumbents cannot usually afford to increase investments into low-profit segments, given their cost structure.
- For this to work – the innovation needs to be disruptive to ALL of the incumbents, not just some...
Three Litmus Tests to determine whether an innovation has disruptive potential:
o Is there a large population who lacked skills, equipment, money to do the job themselves – and otherwise would go without it altogether, or pay someone with more expertise to do it for them?
...OR do they need to go to an inconvenient, centralized location?
o Are there customers at the low end of the market who would be happy to purchase a product with less (but good) performance if available at a lower price? Can the start-up build a business model to reach these low-end customers, profitably?
o Is the innovation disruptive to ALL of the significant incumbent firms in the industry? If it appears to be sustaining to one/ more significant players in the industry, then the start-up should ABANDON this effort, as the incumbent will always fight to win.
Chapter 3: What Products will Customers want to Buy?
This chapter stresses the importance of targeting the right customers, in the right way. The authors suggest focusing on un-served customers at the low end of the market place, or those who are not currently consuming at all. Then, design products specifically to satisfy “jobs” the customer is already trying to get done. Warning: market data is always historical, and should not be the basis for decisions related to new market development.
o Normal Product Development doesn’t work.
60% of new product development ideas never reach the market, 40% of the surviving products are not profitable and are quickly withdrawn
o Market Segmenting
-Is normally broken out by product type, price point, or demographic/ psych profiles of customers. Segments are traditionally defined by ATTRIBUTES of products or customers. While there may be correlations, customer attributes are NOT what causes a customer to buy a product
A better categorization is: what “jobs” customers are seeking help with, and what alternatives they use to satisfy THAT job.
- Target product at the “circumstance”, rather than customer themselves yields more efficient branding and communication, b/c it reaches consumer’s true desire.
- Re: “jobs to be done” approach: develop hypotheses by observing what people are trying to achieve, then ASK THEM ABOUT IT. Aim for rapid product development, then get fast feedback and iterate till you get it right.
- Best outcome: disrupt the market by winning over low-end customers. THEN go get higher end, more profitable customers.
- For New Market disruptions – the company will need to invent the move up-market, b/c no one has been there before! Always approach product development from a jobs perspective.
- Focus is scary: unless you think of it as walking away from jobs you would LOSE anyways
- Data only exists for current products. So do NOT use market data for historical performance to develop a new product. You can quantify job or circumstance-based markets, but the logic will be diff’t than most market quantification approaches.
o Marketing and distribution: Marketing channels will often reject a disruptive idea, simply b/c they have no place to put it. So startups will need to either convince them it is good for them too, or work around.
o Branding: sometimes disruptive companies worry that a low-end brand can hurt the parent brand. BUT if firm specifies that the functional purpose is a different JOB, then consumers are delighted. Clarify who you are serving and why. Ex: high end experiential hotels vs. no-frills business travel hotels
- This does NOT work if you are targeting a phantom job, something the customer does NOT already need to do. Ex: textbooks online...
Chapter 4: Who are the best customers for our products?
This chapter is about customer selection. It also addresses challenges in getting the required internal and external resources and relationships aligned in ways that help the product succeed.
o New Market Disruptions compete against non-consumption.
The Ideal Customer
1) is trying to get a job done, but lacks skill, $ or a reasonably cheap option
2) Alternative is having nothing at all. Therefore delighted to purchase the product at a low performance hurdle, knowing it is not as good as other products available at a higher price.
3) Can access the disruptive product (even if the technology is sophisticated) through a simple, convenient and ‘foolproof’ buyer/ user experience. A good disruption enables people with less resources and training to begin consuming.
4) Causes a WHOLE new value framework. Purchase through new channels and use the product in new venues.
o This can be hard to pitch inside an existing company for several reasons
- Threats vs. Opportunities: Clark Gilbert studies loss aversion – companies get much more excited about a new threat, feel complacent about opportunities. So talk about disruption as a threat DURING resource allocation meetings.
- BUT once the resources are provided, turn it into an opportunity, so that a company can think flexibly, rather than freeze up. Allow an independent entity to build out the opportunity, and let them participate in upside.
- Distribution channels often do not want to change. So your new customers need to be attractive enough to also win favor of channels – you need to lift ALL boats.
Chapter 5. Getting the Scope of the Business Right
This chapter talks about how decide what to do internally, and what to outsource. The deciding factors are the CIRCUMSTANCES under which the company is operating, and the basis for competition, given the stage in the market/ product’s life cycle.
o Core competencies
- Traditional business logic suggests that businesses should stick to their “core competencies” and outsource everything else.
- However, non-core activities may end up being critical for the company to have mastered in a proprietary way, in the future.
- The authors suggest a new way of breaking this down based on whether the product’s architecture is fundamentally interdependent or modular.
- In this case – the circumstances, what is going on in the market, and how the basis of competition is defined, are CRITICAL to deciding what to keep in-house.
o Interdependent architecture: is critical when the interface between two parts of the product or process CANNOT be created independently. Ie: when the way one piece is designed depends on the way another is designed. In this case – the same organization must develop ALL components.
- This is especially important if there is a proprietary technology, and if there is any confusion around how it will eventually work. Ie: to remove the bugs in a product, the same company has to control the whole process.
- This works the best when the basis of competition is performance. When the product has to function better, interdependent architecture allows better control.
- This means the disruptive company must take responsibility for EVERY critical component.
- This can take an EXTREMELY long time with a new technology.
- However, companies should be careful not to spend so much time in this mode that they create products that are “too good” – beyond what the customer really wants and needs...
o Modular architecture: when the interface between two parts of the product or process are so cleanly separated and clearly defined that they can be produced separately.
- This means there can be NO unpredictable interdependencies across components or stages of the value chain. Specs are so well understood that independent groups can work on different parts of the product at the same time.
- This works best when the basis of competition is speed, convenience, price and flexibility, not performance.
- This often occurs when the products have become SO good that they exceed most users’ requirements and most customers would be happy for cheaper, faster versions.
- This environment favors smaller, specialized players.
- Will modular work in an environment where performance is an issue and current products are not good enough?
- Be careful: it’s tempting to think you can launch a new-growth business by providing one piece of the product’s value. At first, it seems less costly and daunting.
However, this can lead to reduced functionality and reliability, and most new ventures of this sort fail.
It is only OK to be modular when all three criteria are met:
1) Specificity - Both suppliers and customers know what to specify, which attributes of the component are critical to the product
2) Verifiability - Suppliers and Customers must be able to measure those attributes, and verify that the specifications have been met
3) Predictability - There cannot be ANY poorly understood or unpredictable interdependencies across the customer-supplier interface... so that the product can be used with predictable effect.
From Integrated to Modular, and Back Again
· Industries can evolve, so that the basis of competition is DIFFERENT over time!
· Watch out, and know what is happening as the basis of competition begins to move.
· It is possible for a company to change and adapt in order to be structured for where the market is going, but is extremely rare.
Chapter 6. How to Avoid Commoditization
- The commoditization of a market occurs when modularity has set in, and the industry becomes dis-integrated.
- This means it becomes hard to differentiate, and profit margins shrink for everyone.
- The authors suggest continually moving business activity and growth expectations to parts of the market where the customer is not yet satisfied with the performance of available products.
o This requires complex, interdependent integration, the better to differentiate through proprietary product solutions.
o As the new disruptors begin to work, they can move up the market to higher and higher margin customers.
o Note that commoditization and de-commoditization occur at the edges, rather than at the core.
- Interdependent, proprietary products are profitable because 1) differentiation is easier 2) the high ratio of Fixed: Variable costs provides economies of scale AND barriers to entry for competitors.
1) This ONLY works when the basis of competition is PERFORMANCE, ie: when existing products are ‘not good enough’. The advantage evaporates when products are adequate or “more than good enough”
2) Eventually, incumbents usually fall to commoditization
3) However – as an industry commoditizes, there is always a reciprocal de-commoditization happening in another part of the value chain!
a. Ex: a low-cost strategy only works if there are high-cost players in the same market. Once the high-cost players leave, low-cost providers have to duke it out among themselves and then move up market as fast as possible.
b. The goal is to find the performance-defining “subsystems” and incorporate them as fast as possible. Wherever the current performance is “not-good-enough.”
c. Competition among sub-system providers drives engineers to create proprietary, interdependent designs in order for the customers to receive better performance than competing sub-systems.
d. The leading providers become differentiated, and profitable
e. Now the cycle can start all over again.
It is important to understand that an “industry” is not inherently unprofitable. Rather, the CIRCUMSTANCES of commoditization can make specific parts of the value chain unprofitable. But there are ALWAYS profitable components – wherever the performance is “not good enough” for the specific customer. Ie: when the guns in a war are “more than good enough” and the basis of competition is no longer performance, it is better to sell bullets to both combatants.
1) The ROA Death Spiral
a. An excessive focus on ROA (return on assets) can force companies to reduce asset holdings. This can feel good, because it allows the company to appear more efficient.
b. Similarly, excess focus on sticking to “core competencies” can limit a company’s potential by focusing on historic strengths, as opposed to market dynamics and consumer demand.
c. The better strategy is to constantly keep an eye on where in the market the performance is NOT GOOD ENOUGH, and build complex, interdependent solutions that serve real customers on their own terms.
I'll come back later to finish notes on the subsequent chapters:
Chapter 7. Is your organization capable of disruptive growth??
Chapter 8. Managing the strategy development process
Chapter 9. There is good money and there is bad money
Chapter 10. The Role of senior executives in leading new growth
Epilogue: Passing the Baton