Book Highlights: The Innovator’s Dilemma by Clayton Christensen

A little over six months ago I heard Clay Christensen speak at one of HubSpot’s BizTalks.  The ideas and research that he presented were eye opening in quite a few ways.  The concept of the innovator’s dilemma was something that I had understood at an uncanny fundamental level for what feels like forever, but I wasn’t sure why.

Check out The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail

The power of the innovator’s dilemma revolves around the problems that sometimes occur when perfectly smart and able businesses making rational decisions in the pursuit of future growth and profits.  Sometimes this same rational and the right sort of innovation comes along which ultimately undercuts them and lets a smaller, agile company come in and eat their lunch.  It is what Wal-Mart did to Sears and is what the Dollar Stores (Family Dollar, Dollar General, Freds, etc) are doing to Wal-Mart today.  Companies continue to chase higher profits and more revenue and to do this they must go upstream into more lucrative markets.  By shifting focus they become vulnerable from this same bottom markets that got them started.

Although much of what he was sharing is very relevant to someone who is looking to create a business, it also is very powerful ideas for any investor to understand too.  From an investors standpoint the fundamental truth that he shared is that “when you purchase a stock you are buying based on the future value of the company based on all available information”.  This absolutely explains why a company like Netflix is priced at the same level of a company much larger than it is because people see it with excellent future growth.  The growth possibilities of Netflix are already built into the price and result in incredibly high stock price to actual earnings evaluations.

The innovator’s dilemma teaches you to look for innovations that completely change the playing field and to look at why the strong companies in the previous generation won’t make the leap.  It is exactly why Blockbuster is in the process of going belly up as Netflix sees great user growth.  The movie rental industry went through a fundamental shift in the way consumers rented movies.  It was a way that Blockbuster couldn’t easily “innovate” into from their traditional model.

Needless to say after Clay’s talk I downloaded his book that night on my Kindle and read through it pretty quickly.  I’m behind on book reviews of some of the excellent books I’ve read over the last six months and this was definitely one of them.  I also noticed after reading this book how many times I noticed references to it pop up in other locations like other books including Steve Jobs biography and Marc Benioff’s Behind the Cloud.

If you are an entrepreneur, investor or otherwise deeply interested in understanding why some great businesses fail then this is a MUST read.  The concepts aren’t really completely surprising once you learn the fundamentals why but it’s one of those moments where the light bulb will go off and it changes the way that you look at everything else.

Book Highlights

Below are my Kindle highlights if you want to get my main nuggets without reading the whole book:

One theme common to all of these failures, however, is that the decisions that led to failure were made when the leaders in question were widely regarded as among the best companies in the world.

The research reported in this book supports this latter view: It shows that in the cases of well-managed firms such as those cited above, good management was the most powerful reason they failed to stay atop their industries. Precisely because these firms listened to their customers, invested aggressively in new technologies that would provide their customers more and better products of the sort they wanted, and because they carefully studied market trends and systematically allocated investment capital to innovations that promised the best returns, they lost their positions of leadership.

There are times at which it is right not to listen to customers, right to invest in developing lower-performance products that promise lower margins, and right to aggressively pursue small, rather than substantial, markets.

Occasionally, however, disruptive technologies emerge: innovations that result in worse product performance, at least in the near-term. Ironically, in each of the instances studied in this book, it was disruptive technology that precipitated the leading firms’ failure.

Generally, disruptive technologies underperform established products in mainstream markets. But they have other features that a few fringe (and generally new) customers value. Products based on disruptive technologies are typically cheaper, simpler, smaller, and, frequently, more convenient to use.

the observation that technologies can progress faster than market demand, illustrated in Figure I.1, means that in their efforts to provide better products than their competitors and earn higher prices and margins, suppliers often “overshoot” their market: They give customers more than they need or ultimately are willing to pay for. And more importantly, it means that disruptive technologies that may underperform today, relative to what users in the market demand, may be fully performance-competitive in that same market tomorrow.

the conclusion by established companies that investing aggressively in disruptive technologies is not a rational financial decision for them to make, has three bases. First, disruptive products are simpler and cheaper; they generally promise lower margins, not greater profits. Second, disruptive technologies typically are first commercialized in emerging or insignificant markets. And third, leading firms’ most profitable customers generally don’t want, and indeed initially can’t use, products based on disruptive technologies. By and large, a disruptive technology is initially embraced by the least profitable customers in a market. Hence, most companies with a practiced discipline of listening to their best customers and identifying new products that promise greater profitability and growth are rarely able to build a case for investing in disruptive technologies until it is too late.

the only instances in which mainstream firms have successfully established a timely position in a disruptive technology were those in which the firms’ managers set up an autonomous organization charged with building a new and independent business around the disruptive technology.

Creating an independent organization, with a cost structure honed to achieve profitability at the low margins characteristic of most disruptive technologies, is the only viable way for established firms to harness this principle.

It is in disruptive innovations, where we know least about the market, that there are such strong first-mover advantages. This is the innovator’s dilemma.

When the performance of two or more competing products has improved beyond what the market demands, customers can no longer base their choice upon which is the higher performing product. The basis of product choice often evolves from functionality to reliability, then to convenience, and, ultimately, to price.

This is one of the innovator’s dilemmas: Blindly following the maxim that good managers should keep close to their customers can sometimes be a fatal mistake.

The fear of cannibalizing sales of existing products is often cited as a reason why established firms delay the introduction of new technologies. As the Seagate-Conner experience illustrates, however, if new technologies enable new market applications to emerge, the introduction of new technology may not be inherently cannibalistic. But when established firms wait until a new technology has become commercially mature in its new applications and launch their own version of the technology only in response to an attack on their home markets, the fear of cannibalization can become a self-fulfilling prophecy.

The popular slogan “stay close to your customers” appears not always to be robust advice. One instead might expect customers to lead their suppliers toward sustaining innovations and to provide no leadership—or even to explicitly mislead—in instances of disruptive technology change.

In the tug-of-war for development resources, projects targeted at the explicit needs of current customers or at the needs of existing users that a supplier has not yet been able to reach will always win over proposals to develop products for markets that do not exist. This is because, in fact, the best resource allocation systems are designed precisely to weed out ideas that are unlikely to find large, profitable, receptive markets. Any company that doesn’t have a systematic way of targeting its development resources toward customers’ needs, in fact, will fail.

Research has shown, in fact, that the vast majority of successful new business ventures abandoned their original business strategies when they began implementing their initial plans and learned what would and would not work in the market. The dominant difference between successful ventures and failed ones, generally, is not the astuteness of their original strategy. Guessing the right strategy at the outset isn’t nearly as important to success as conserving enough resources (or having the relationships with trusting backers or investors) so that new business initiatives get a second or third stab at getting it right.

Because a company’s stock price represents the discounted present value of its projected earnings stream, most managers typically feel compelled not just to maintain growth, but to maintain a constant rate of growth.

One of the bittersweet rewards of success is, in fact, that as companies become large, they literally lose the capability to enter small emerging markets. This disability is not because of a change in the resources within the companies—their resources typically are vast. Rather, it is because their values change.

When are spin-outs a crucial step in building new capabilities to exploit change, and what are the guidelines by which they should be managed? A separate organization is required when the mainstream organization’s values would render it incapable of focusing resources on the innovation project. Large organizations cannot be expected to allocate freely the critical financial and human resources needed to build a strong position in small, emerging markets. And it is very difficult for a company whose cost structure is tailored to compete in high-end markets to be profitable in low-end markets as well. When a threatening disruptive technology requires a different cost structure in order to be profitable and competitive, or when the current size of the opportunity is insignificant relative to the growth needs of the mainstream organization, then—and only then—is a spin-out organization a required part of the solution.

When performance oversupply has occurred and a disruptive technology attacks the underbelly of a mainstream market, the disruptive technology often succeeds both because it satisfies the market’s need for functionality, in terms of the buying hierarchy, and because it is simpler, cheaper, and more reliable and convenient than mainstream products.

Each of the disruptive technologies studied in this book has been smaller, simpler, and more convenient than preceding products. Each was initially used in a new value network in which simplicity and convenience were valued. This was true for smaller, simpler disk drives; desktop and portable computers; hydraulic backhoes; steel minimills as opposed to integrated mills; insulin-injecting pens as opposed to syringes.

We have learned in this book that in their straightforward search for profit and growth, some very capable executives in some extraordinarily successful companies, using the best managerial techniques, have led their firms toward failure. Yet companies must not throw out the capabilities, organizational structures, and decision-making processes that have made them successful in their mainstream markets just because they don’t work in the face of disruptive technological change. The vast majority of the innovation challenges they will face are sustaining in character, and these are just the sorts of innovations that these capabilities are designed to tackle. Managers of these companies simply need to recognize that these capabilities, cultures, and practices are valuable only in certain conditions.