The Innovator's Solution

by Clayton Christensen

  21. We are concerned that as venture capital firms have gradually become populated by less-experienced analysts who learned only about deliberate strategy in their MBA courses, they are subtly demanding more and more rigor, and data and evidence that the strategy of a business is right. They then pressure the management teams of their portfolio companies to “execute.” They only revert to an emergent mode when the initial investment has been squandered and the founding managers sacked, and there is no alternative but to seek a viable strategy through emergent processes.

  CHAPTER NINE

  THERE IS GOOD MONEY AND

  THERE IS BAD MONEY

  Does it matter whose money funds the business I want to grow? How might the expectations of the suppliers of my capital constrain the decisions I’ll be able to make? Is there something about venture capital that does a better job nurturing disruptive businesses than corporate capital? What can corporate executives do to ensure that the expectations that accompany their funding will cause managers to correctly make the decisions that will lead to success?

  Getting funded is an obsession for most innovators with a great idea; as a result, most research about raising capital has focused on how to get it. For corporate entrepreneurs, writers often describe the capital budgeting process as a cumbersome bureaucracy and recommend that innovators find a well-placed “champion” in the hierarchy who can work the system of numbers and politics in order to get funding. For start-ups seeking venture capital, much advice is focused on structuring deals that do not give away too much control, while still allowing them to benefit from the networks and acumen that venture capital firms offer.1

  Although this advice is useful, it skirts an issue that we think is potentially more important: The type of money that corporate executives provide to new-growth businesses and the type of capital that managers of those businesses accept represent fundamental early choices when launching a new-growth business. These are critical fork-in-the-road decisions, because the type and amount of money that managers accept define the investor expectations that they’ll have to meet. Those expectations then heavily influence the types of markets and channels that the venture can and cannot target. Because the process of securing funding forces many potentially disruptive ideas to get shaped instead as sustaining innovations that target large and obvious markets, the very process of getting the money to start a venture actually sends many of them on a march toward failure.

  We have concluded that the best money during the nascent years of a business is patient for growth but impatient for profit. Our purpose in this chapter is to help corporate executives understand why this type of money tends to facilitate success, and to see how the other category of capital—which is impatient for growth but patient for profit—is likely to condemn innovators to a death march if it is invested at early stages. We also hope this chapter will help those who bankroll new businesses understand the forces that make their money good or bad for nurturing growth.

  The most commonly used theories about good and bad money for new-growth ventures have been based on attributes rather than circumstances. Probably the most common attribute-based categorization is venture capital versus corporate capital. Other categories include public versus private capital, and friends and family versus professionally managed money. None of these categorization schemes supports a theory that can reliably predict whose money will best help new ventures to succeed. Sometimes money from each of these categories proves to be a boon, and sometimes it becomes the kiss of death.

  We’ve already demonstrated why the money that funds a new-growth business needs to be patient for growth. Competing against nonconsumption and moving disruptively up-market are critical elements of a successful new-growth strategy—and yet by definition, these disruptive markets are going to be small for a time. The only way that a venture can instantly become big is for existing users of a high-volume product to be enticed to switch en masse to the new enterprise’s product. This is the province of sustaining innovation, and start-ups rarely can win a sustaining-innovation battle. Money should be impatient for growth in later-stage, deliberate-strategy circumstances, after a winning strategy for the new business has emerged.

  Money needs to be impatient for profit to accelerate a disruptive venture’s initial emergent strategy process. When new ventures are expected to generate profit relatively quickly, management is forced to test as quickly as possible the assumption that customers will be happy to pay a profitable price for the product—that is, to see whether real products create enough real value for which customers will pay real money. If a venture’s management can keep returning to the corporate treasury to fund continuing losses, managers can postpone this critical test and pursue the wrong strategy for a long time. Expectations of early profit also help a venture’s managers to keep fixed costs low. A business model that can make money at low costs per unit is a crucial strategic asset in both new-market and low-end disruptive strategies, because the cost structure determines the type of customers that are and are not attractive. The lower it can start, the greater its upside. And finally, early profitability protects a growth venture from cutbacks when the corporate bottom line turns sour.2

  In the following sections we describe in more detail how good money becomes bad. We recount this process from the point of view of corporate investors, with the hope that this telling of the story will help managers who are seeking funding to know good and bad money when they see it, and to understand the consequences of accepting each type. We hope also that venture capital investors and the entrepreneurs whom they fund will be able to see in these accounts parallel implications for their own operations. Bad money can come from venture and corporate investors—as can good money.

  The Death Spiral from Inadequate Growth

  Good money turns bad in a self-reinforcing downward spiral that makes it very difficult for even the best executives to do anything except preside over the company’s demise. There are five steps in this spiral. Once a company has fallen into it, it becomes almost impossible not to take the subsequent steps.

  Step 1: Companies Succeed

  After using an emergent strategy process to find a successful formula, a young company hits its stride with a product that helps customers get an important job done better than any competitor. With the winning strategy now clear, the executive team wrestles control of the strategy-making process away from emergent influences and deliberately focuses all investments to exploit this opportunity.3 Anything that would divert resources from the crucial, deliberate focus on growing the core business is stomped out. Such focus is an essential requirement for success at this stage.4 However, it means that no new-growth businesses are launched while the core business is still thriving.

  This focus propels the company up its sustaining trajectory ahead of competitors who are less aggressive and less focused. Because margins at the high end are attractive, the company barely notices when it begins losing low-end, price-sensitive business in what comes to be viewed as a “commodity segment.” Exiting the lowest-margin products and replacing those revenues with higher-margin products at the top of the sustaining trajectory typically feels good, because overall gross profit margins improve.

  Step 2: Companies Face a Growth Gap

  Despite the company’s success, its executives soon realize that they are facing a growth gap. This is caused by the pesky tendency of Wall Street investors to incorporate expected growth into the present value of a stock—so that meeting growth expectations results only in a market-average rate of stock price appreciation. The only way that managers can cause their companies’ share prices to increase at a faster rate than the market average is to exceed the growth rate that investors have already built into the current price level. Hence, managers who seek to create shareholder value always face a growth gap—the difference between how fast they are expected to grow and how much faster they need to grow to achieve above-average returns for shareholders.5

  As a rule, executi
ves meet investor expectations through sustaining innovations. Investors understand the businesses in which companies presently compete and the growth potential that lies along the sustaining trajectory in those businesses—which they discount into the present value of the stock price. Sustaining innovation is therefore critical to maintaining a company’s share price.6

  It is the creation of new disruptive businesses that allows companies to exceed investor expectations, and therefore to create unusual shareholder value. For precisely the reasons why established companies are prone to underestimate the growth potential in disruptive businesses, investors likewise have consistently underestimated (and therefore have been pleasantly surprised by) the growth potential of disruptions. Creating new disruptive businesses is the only way in the long term to continue creating shareholder value.

  When a company’s revenues are denominated in millions of dollars, the amount of new business that managers need in order to close the growth gap—new revenues and profits from unknown and yet-tobe-discounted sources—also is denominated in the millions of dollars. But as a company’s revenues grow into the billions, the size threshold of new business that is required to sustain its growth rate, let alone exceed investors’ expectations, gets bigger and bigger and bigger. At some point the company will report slower growth than investors had discounted, and its stock price will take a hit as investors realize that they had overestimated the company’s growth prospects.

  To get the stock price moving again, senior management announces a targeted growth rate that is significantly higher than the realistic underlying growth rate of the core businesses. This creates a growth gap even larger than the company has ever faced before—a gap that must be filled by new-growth products and businesses that the company has yet to conceive. Announcing an unrealistic growth rate is the only viable course of action. Executives who refuse to play this game will be replaced by managers who are willing to try. And companies that do not attempt to grow will see their market capitalization decline until they get acquired by companies that are eager to play.

  Step 3: Good Money Becomes Impatient for Growth

  When confronted with a large growth gap, the corporation’s values, or the criteria that are used to approve projects in the resource allocation process, will change. Anything that cannot promise to close the growth gap by becoming very big very fast cannot get through the resource allocation gate in the strategy process. This is where the process of creating new-growth businesses comes off the rails. When the corporation’s investment capital becomes impatient for growth, good money becomes bad money because it triggers a subsequent cascade of inevitable incorrect decisions.

  Innovators who seek funding for the disruptive innovations that could ultimately fuel the company’s growth with a high probability of success now find that their trial balloons get shot down because they can’t get big enough fast enough. Managers of most disruptive businesses can’t credibly project that the business will become very big very fast, because new-market disruptions need to compete against nonconsumption and must follow an emergent strategy process. Compelling them to project big numbers forces them to declare a strategy that confidently crams the innovation into a large, existing, and obvious market whose size can be statistically substantiated. This means competing against consumption.

  After senior executives have approved funding for this inflated growth project, the company’s managers cannot then back down and follow an emergent strategy that seeks to compete against nonconsumption. They are on the hook to deliver the growth that they projected. They therefore must ramp expenses according to plan.

  Step 4: Executives Temporarily Tolerate Losses

  It becomes clear that competing against consumption in a large and obvious market will be an expensive challenge, because if customers are to buy the product, it must perform better than the products that customers already are using. The team warns senior executives that stomaching huge losses is a prerequisite to winning the pot of gold. Determined to be visionary with the long-term interests of the company in mind, executives therefore accept the reality that the business will lose significant money for some time. There is no retreat. Executives convince themselves that investing for growth will result in growth, as if there were a linear relationship between the two—as if the more aggressively you invest to build the new business, the faster it will take off.7

  In order to meet the budgeted timetable for rollout and ramp-up, the project managers put the cost structure in place before there are revenues—and because they must support a steep revenue ramp, these costs are substantial. But overfunding is hazardous to a new venture’s health, because heavy expense levels in turn define the sorts of customers and market segments that will and will not provide adequate revenues to cover those costs. If this happens, then customers who come from nonconsumption in emerging applications and are therefore delighted with simple products—in short, the ideal customers for a disruptive venture—inevitably become unattractive to the business. The ideal channels—those that need something to fuel their own disruptive march up-market against their competition—also become unattractive. Only the largest channels that reach the largest populations appear to be capable of bringing in enough revenue fast enough.

  This completes the character transformation of the corporation’s money. It has become bad money for new-market disruption: Impatient for growth but patient for profit.

  Step 5: Mounting Losses Precipitate Retrenchment

  As the venture’s managers try to succeed by competing against consumption, they find all sorts of reasons why customers prefer to continue buying the products they have always used from the vendors they have always trusted. Often these reasons entail the kinds of interdependencies we discussed in chapter 5. Breakthrough sustaining innovations can rarely be hot-swapped into existing systems of use. Typically, many other unanticipated things need to change in order for customers to be able to benefit from using the new product. While revenues fall far short, expenses are on budget. Losses mount. The stock price then gets hammered again, as investors realize anew that their expectations for growth cannot be met.

  A new management team gets brought in to rescue the stock price. To stanch the bleeding, the new team stops all spending except what is required to keep the core business strong. Refocusing on the core is welcome news. It is a tried-and-true formula for performance improvement, because the company’s resources, processes, and values have been honed exactly for this task. The stock price bounces in response, but as soon as the new price has fully discounted whatever growth potential exists in the core business, the new executives realize that they must invest to grow. But now the company faces an even greater growth gap, and the situation loops back to step 3, where the company needs new-growth businesses that can get really big really fast. That pressure then causes management to repeat the tragic sequence of wrong decisions again and again, until so much value has been destroyed that the company is acquired by another corporation, which itself had been unable to generate its own growth through disruption but saw in the acquisition a synergistic opportunity to wring cost out of the combination.

  How to Manage the Dilemma of Investing for Growth

  The dilemma of investing for growth is that the character of a firm’s money is good for growth only when the firm is growing healthily. Core businesses that are still growing provide cover for new-growth businesses. Senior executives who are bolstered by a sense that the pipeline of new sustaining innovations in established businesses will meet or exceed investors’ expectations can allow new businesses the time to follow emergent strategy processes while they compete against nonconsumption. It is when growth slows—when senior executives see that the sustaining-innovation pipeline is inadequate to meet investor expectations—that investing to grow becomes hard. The character of the firm’s money changes when new things must get very big very fast, and it won’t allow innovators to do what is needed to grow. When you’re a corporate entrepreneur and you sens
e this shift in the corporate context occurring, you had better watch out.

  This dilemma traps nearly every company and is the causal mechanism behind the findings in Stall Points, the Corporate Strategy Board’s study that we cited in chapter 1.8 This study showed that of the 172 companies that had spent time on Fortune’s list of the 50 largest companies between 1955 and 1995, 95 percent saw their growth stall to rates at or below the rate of GNP growth. Of the companies whose growth stalled, only 4 percent were able to successfully reignite their growth even to a rate of 1 percent above GNP growth. Once growth had stalled, the corporations’ money turned impatient for growth, which rendered it impossible to do the things required to launch successful growth businesses.

  In recent years, the dilemma has become even more complex. If companies whose growth has stalled somehow find a way to launch a successful new-growth business, Wall Street analysts often complain that they cannot value the new opportunity appropriately because it is buried within a larger, slower-growing corporation. In the name of shareholder value, they demand that the corporation spin off the new-growth business to shareholders so that the full value of its exciting growth potential can be reflected in its own share price. If executives respond and spin it off, they may indeed “unlock” shareholder value. But after it has been unlocked they are left locked again in a low-growth business, facing the mandate to increase shareholder value.

  In the face of this sobering evidence, chief executives—whose task it is to create shareholder value—must preserve the ability of their capital to nourish growth businesses in the ways that they need to be nourished. When executives allow the growth of core businesses to sag to lackluster levels, new-growth ventures must shoulder the whole burden of changing the growth rate of the entire corporation’s top and bottom lines. This forces the corporation to demand that the new businesses become very big very fast. Their capital as a consequence becomes poison for growth ventures. The only way to keep investment capital from spoiling is to use it when it is still good—to invest it from a context that is still healthy enough that the money can be patient for growth.