Disrupted Innovation

Its great to see so many people reacting strongly To Jill Lepore’ critique of disruptive innovation in the New Yorker. In spite of the ad hominen fallacy that both Lepore and her critics indulge in, reality is that disruptive innovation has received strong criticism within management academia. My Ph.D. comprehensive exams were on disruptive innovation (long story, will write a long read on it some time) so I am a little familiar with the scholarly literature on disruption. A few points:

  1. Disruptive innovation has repeatedly received high quality criticism from serious scholars, some examples are:

Danneels, E. 2004. Disruptive technology reconsidered: A critique and research agenda. Journal of Product Innovation Management, 21(4): 246-258.

Govindarajan, V. & Kopalle, P. K. 2006. The Usefulness of Measuring Disruptiveness of Innovations Ex Post in Making Ex Ante Predictions. Journal of Product Innovation Management, 23(1): 12-18.

Markides, C. 2006. Disruptive Innovation: In Need of Better Theory. Journal of Product Innovation Management, 23(1): 19-25.

Schmidt, G. M. & Druehl, C. T. 2008. When Is a Disruptive Innovation Disruptive? Journal of Product Innovation Management, 25(4): 347-369.

Yu, D. & Hang, C. C. 2010. A reflective review of Disruptive Innovation Theory. International Journal of Management Reviews.

2. Clayton Christensen has himself acknowledged the significant amount of work that has gone into (& still needs to be done) the evolving theory of disruption:

Christensen, C. M. 2006. The ongoing process of building a theory of disruption. Journal of Product Innovation Management, 23(1): 39-55.

3. The most common critique of disruption – that Prof. Christensen completely misread the emergence of the Apple iPhone ecosystem is true. But that was driven by the original theory of disruption being focused on low-cost disruption, i.e. new technology or business models enabling small/new firms to beat incumbent/large firms by taking away their over-served customers. Subsequent criticism of this low-cost focus (see e.g. Danneels 2004) and development of high-end disruption concept (see Govindarajan & Kopalle 2006) actually show the evolution of the theory. The key problem with disruption seems to be that many of its skeptics and critics are not aware of the vast literature (48 peer-reviewed articles at the time of my comps in 2012, probably higher now) and have obviously not kept up with newer developments in the theory.

I’ll revisit disruptive innovation in much more detail in a future blog post, especially to address some key issues/ misconceptions around it, such as:

  1. Disruption does not imply fatalism: it is not a given that a startup will unseat the incumbent from its throne…provided the larger firms keep catering to shifting customer demands.
  2. Disruption has similarities with real options theory: this is a tricky one since it implies asymmetric payoffs – which makes people skeptical since “on average” most new technologies/startups fail, however the ones that do succeed more than cover for the losses (ask any successful VC). Theoreticians used to evaluating “the average” firm underestimate the power of power law distributions.
  3. Disruption also has similarities with the lean startup movement: the lean startup methodology helps new firms find new sources of customer value (through hypotheses tests) that may not be obvious to larger, more established companies.

Startups & Growth: Cui bono?

Bias checklist: this post is probably riddled with recall bias, but all  references were checked and re-read. A key assumption I am making is that the entrepreneurs reading this post are focused on building businesses that make operating profits (and aren’t just targeting quick exits).

Feel free to point out biases/errors you see in Comments section, i’ll come back to this topic in a future post. As always caveat lector.

A recent blog post by Paul Graham got me thinking about how growth in recent years has being positioned as THE goal of all early stage firms (i.e., startups). All good things flow from the achievement of this ephemeral target, in fact those who can help early stage firms get this growth have been labeled growth hackers. One of the fascinating things about this focus on growth above all else is that it was not always so. The purpose of this post is to (very briefly) give an overview of two distinct priorities in the pursuit of success (growth vs. profit) that have been common not just in the tech sector but also in more traditional industries (public company valuations have for a long time been split into these two categories). Ostensibly in the technology sector growth either accompanies or is shortly followed by profitability.

In order to build on these two distinctions and link them to this “growth fallacy” i’ll divide the business landscape into the two categories conceived by Nassim Taleb, namely mediocristan and extremistan , he developed this distinction in his book The Black Swan: Second Edition: The Impact of the Highly Improbable: With a new section: “On Robustness and Fragility”.

In order to show how entrepreneurs can better analyze these landscapes i’ll use some simple concepts from strategic management (value creation vs. capture and disruptive innovation) to explain why this pursuit of growth is great from the point of view of angel investors and venture capitalists but not necessarily for entrepreneurs (critical distinction that is glossed over in most posts on startup growth).

Growth Hacking: Cui bono?

The gist of Paul Graham’s growth post is that startups are citizens of Extremistan while most conventional businesses are in Mediocristan, i.e. startups are exclusively high growth ventures that are not constrained by distribution and other barriers that limit the growth of most conventional businesses. However, the lack of these barriers also means that you have global competition and a crowded landscape which makes the entrepreneurial idiosyncrasies more valuable.

These idiosyncrasies are valuable because they not only allow entrepreneurs to spot new openings in the landscape but also utilize new technologies to target these opportunities. High growth (either revenues or users in case of Y Combinator) startups will presumably after n iterations hit upon some form of success, Paul emphasizes this frequent iteration and targeting of growth in his post:

“Nine times out of ten, sitting around strategizing is just a form of procrastination. Whereas founders’ intuitions about which hill to climb are usually better than they realize. Plus the maxima in the space of startup ideas are not spiky and isolated. Most fairly good ideas are adjacent to even better ones.”

Obviously, if the primary objective of a startup is growth then targeting Extremistan landscapes makes sense. These tend to be highly scalable businesses that are (frequently) populated by competitors since barriers to entry are lower (e.g. mobile applications). However, barriers to success (= growth?) are higher simply because these fields tend to be cluttered and its harder to genuinely differentiate oneself and create customer value. Its even harder to actually capture that value because close substitutes are usually available at low cost. From the perspective of the entrepreneur, the base rate of success is pathetic.

Which raises the question: who benefits from this unbridled pursuit of growth? Here again, Nassim Taleb’s insights (more used than acknowledged) are valuable. One of the key features of Extremistan is that it is the domain of Black Swans (unexpected events with high impact that give illusion of predictability after the fact). These Black Swans can have negative impact (financial crisis of 2008 for those who didn’t see it coming) as well as positive (investing in the next big thing). Taleb’s consistent advice (in Fooled by Randomness, The Black Swan and his forthcoming book on Antifragility) has been to position oneself on the winning side of Black Swans, both by minimizing exposure to risky non-linearities and increasing exposure to their upside. The latter include venture capital/ angel investing opportunities that (for limited $ investment) have a call option on a potential bigger upside. And therein lies the rub, the answer to the question I asked earlier is that blind pursuit of growth benefits the buyers (VC or Angel investors) of these call options and not the individual options (the entrepreneur) themselves, because for the entrepreneur the average outcome of his angel investor’s portfolio is meaningless (you can drown in a river that is 4 ft. deep on average) but for the angel, that is a key metric. Thus, what works for early investors may not be optimal for entrepreneurs wanting to create real businesses.

Now I turn my attention to the basic goal of all business strategies.

Competitive Advantage

If you are an entrepreneur, your goal ought to be profitable growth that accrues from competitive advantage, some have already pointed out the complex issues surrounding pursuit of growth in tech investing. But calls for pursuing revenue and/or user growth with no talk of profits merely risks repeating the errors of the last tech bubble. With few outliers (who get media coverage without any mention of base rates of success) getting all the attention, its easy to forget how much the system goes against common sense approaches to building real businesses.

The simplest and most relevant framework in this context is Clayton Christensen’s disruptive innovation. An additional benefit of using this lens to look at the growth question is that disruption is commonly invoked (often un-justified) in the internet and tech investing sector. Since his theories are so well known, I won’t rehash them here. For entrepreneurs, a good starting point is his book Seeing What’s Next: Using Theories of Innovation to Predict Industry Change

One overlooked element of the disruption framework of Clayton Christensen is his emphasis on profits (not revenue or user growth). There are a couple of reasons why this distinction is so critical for entrepreneurs:

  1. Pursuit of profits forces entrepreneurs to vet ideas on a critical dimension: are customers actually willing to pay for it? Early pursuit of profitability thus becomes important as a validation exercise.
  2. Profits imply that the cost structure is low enough for the startup to actually manage to capture value in addition to merely creating it (which metrics like user or revenue growth indicate). Value capture cannot happen unless genuine moats are present around the business. Hence, high traction in users or revenues may imply that you have reached a local maxima that is valuable but indefensible. Great for exits that may not be such good ideas for the acquirer. This factor is another reason why raising lots of venture capital in early rounds can distort the value of the opportunity since external capital can makeup for weaknesses in profitability. Groupon is a classic example of why growth (revenue or user) at the expense of profitability and competitive advantage may not be sustainable.

Which brings us back to the key difference between being a buyer/holder of multiple call options (VC/ Angel) vs. being an actual entrepreneur. If you are in the former category, pursuing multiple opportunities in Extremistan and pushing them for high growth makes sense since you only need one or two outliers to make your performance exceptional. However, if you are the entrepreneur, it is highly risky to pursue un-profitable growth (every time someone gives you the example of unprofitable startups that made 8 or 9 figure exits like Instagram, take a few deep breaths and silently repeat..anecdote…anecdote…anecdote). Ask yourself cui bono?