Why Preventing Disruption in 2017 Is Harder Than It Was When Christensen Coined the Term12 September, 2017 / Articles
Every winter, my colleagues and I invite CEOs of some of the world’s largest businesses to join our students at Stanford University. Those that do spend an evening discussing the challenges of digital disruption with us and some of the brightest MBA students on the planet. Invariably, each CEO we host recognizes two truths: Digital disruption will reshape their industry in one fashion or another and they must find a way to embrace these changes.
Yet, despite the fact that all of our guests across our 18 sessions (and counting) have embraced these truths, the average result of such commitments to innovation seems to have been tenuous.
For the everyday student of business history, this might be unsurprising. Disruption is a systemic problem: Clayton Christensen outlined in 1997 why it was so difficult for any individual business to defuse disruptive threats and embrace disruptive trends. But the corporate innovators we’ve talked to all know that. They’ve read Christensen’s book The Innovator’s Dilemma. They’re combating their organizational challenges head-on — and still coming up short.
Naturally, the question is why. Why are executives who do everything they do to heed the recommendations of innovation theorists continuing to come up short? The answer may be that the innovator’s dilemma is no longer the only paradox at play in innovation management.
The Old Dilemma
During my time with Harvard Business School’s Forum for Growth and Innovation, we regularly referred to disruption as a problem of accounting and organizational design. For managers of industrial-era organizations, the economics of investing in disruptive opportunities were vexing. Disruptive products and services were, by definition, cheaper, lower quality, and lower margin.
If you were running a profitable business with growth opportunities from an existing customer base, it was unlikely that you’d prioritize building low-quality products for over-served customers at lower margins. Such investments would drag down your profitability, do nothing for your most loyal customers, and fail to make use of your hard-won technical capabilities. So naturally, as a manager, you left such innovations to new entrants. Over time, their products and services became better and better, and those innovative entrants moved up market, slowly increasing performance. Buoyed by low-margin structures and new technological architectures that could support lower costs, the competitors that entered your industry were able to take more and more market share — eventually convincing even your best customers to embrace their products and services. Such was the nature of disruption.
Fortunately, for senior executives there was a solution. If an organization could isolate a unit and focus it exclusively on the disruptive market, it had an opportunity to succeed. The managers of the new business or organizational unit would have incentives similar to those of their new competitors. They would start with a low-end product and creep up market, ultimately cannibalizing the businesses of their colleagues.
It wasn’t easy to do, but it was a good strategy. For those companies with the skill to pull it off, it worked. Businesses such as IBM and Apple were able to weather disruptive shifts in their markets by taking such a course, creating separate teams and units focused on new innovations (PCs and smartphones respectively). And every industrial leader that has joined us at Stanford over the past few years has taken such a course. But despite textbook execution, it seems that such maneuvers are no longer enough.
Because this organizational design challenge is turning into one for the financiers and public stockholders. A problem where the solution is less readily apparent.
To understand the trouble facing our senior leaders today, it’s critical to understand the nature of our modern disrupters. When Christensen conducted the research for The Innovator’s Dilemma, he looked at industries that were asset-heavy. Construction equipment and disk-drive manufacturing required heavy machinery, distribution facilities, and immense amounts of working capital. In today’s world the most pointed disruptive threats look different. They are not asset-heavy. They are asset-light. And while that may seem appealing to unsavvy onlookers, it can be the kiss of death for a CEO facing disruptive entrants.
Why? Asset-light businesses are not financed with debt. They’re financed with equity—in other words, a stake in the company. That’s a resource that is much less expensive for new businesses with no track record than for established businesses with all the credibility in the world.
Consider automakers like Ford, Daimler, or General Motors. Each company has a core business to run and investors to please. Each company has to deal with new models of mobility, autonomous driving, and the electrification of the fleet. And in each of those spaces there are asset-light competitors (like Uber, Cruise, Zoox) that can borrow billions at 10X–30X revenue multiples — while Ford, Daimler, and GM would be lucky to finance their own endeavors at the same multiples on earnings. It’s not a level playing field.
And the losses that must be absorbed are staggering. A study done by my former colleagues at Sapphire Ventures demonstrated that the median B2B software company that achieved meaningful scale in the market absorbed more than €100 million in operating losses on the path to significance. What institutional investor would clamor for such losses? Let alone multiple such businesses being built under the mantle of transformation.
In the early era of the dilemma, this challenge didn’t exist. When you could finance growth with debt, large companies had enormous advantages if they could incentivize managers to embrace disruption (largely by creating new business units). They could borrow against the future earnings of their core businesses and build the new businesses in the interim period. Their creditors priced capital for the new efforts along with the core. Their equity investors saw little impact. If a new business unit failed, it wasn’t usually due to financial challenges, but to organizational ones: the wrong organizational structure, the wrong strategy, the wrong talent, or a parent organization terrified of self-cannibalization and thus either unwilling or unable to give the new business unit the freedom it needed to succeed.
Today that’s not the case: organizational challenges are still tough to solve for, but they’re not the major reason most incumbent firms struggle to disrupt themselves. In most cases, setting up a new business unit correctly will still leave leaders handcuffed, because they’ll be unable to invest capital at a pace similar to their upstart competitors’. It’s primarily a financial problem, not an organizational one.
Over the next few years, I think this reality will become more and more apparent. The businesses that fight off their digital disrupters will be creative not just in their organizational design but also in their financial structures and and legal models. (WeWork’s recent capital raise of $500 million for a China-focused entity — a perfect example of financing risky endeavors with the help of legal innovation — will become more commonplace.) With these new challenges, a new era of exploration and corporate experimentation will be vital to renewal.
Avoiding disruption is never as easy as following a guidebook. But it might be even harder today than it was twenty years ago.