The Innovator's Solution

by Clayton Christensen

  With almost all of its resources devoted to supporting and promoting the problematic larger machines against well-financed and successful incumbents, the Honda personnel in the United States turned to using the 50cc Super Cubs as their own transportation. They were reliable, cheap to run, and Honda figured they couldn’t sell them anyway: There simply was no market for motorbikes that small. Right?

  The exposure the Super Cub got from the daily use of the Honda management team in Los Angeles generated surprising interest from individuals and retailers—not motorcycle distributors, but sporting goods shops. Running low on cash thanks to the difficulties encountered in selling the big bikes, Honda decided to sell the Super Cubs just to stay afloat.

  Little by little, continued success in selling the Super Cub and continued disappointment with the larger machines eventually redirected Honda’s efforts toward the creation of an entirely new market segment—off-road motorbikes. Priced at one-fourth the cost of a big Harley, these were sold to people without leather jackets who never would have purchased deep-throated cycles from the established U.S. or European makers. They were used for fun, not over-the-road transportation. Apparently a low-end disruption wasn’t a viable strategy because there just weren’t enough over-the-road bikers who were over-served by the brands and muscle of Harleys, Triumphs, and BMWs. What emerged was a new-market disruption, which Honda subsequently did a masterful job of deliberately exploiting.

  What pushed Honda to discover this market was its lack of financial resources. This prevented its managers from tolerating significant losses and instead created an environment in which the venture’s managers had to respond to unanticipated successes. This is the essence of managing the emergent strategy process.18

  It is important to remember that this policy—to limit expenses and seek early profit in order to accelerate the emergent strategy process—is not a one-size-fits-all mandate. In circumstances in which a viable strategy needs to emerge—such as new-market disruptions—this is a helpful policy. In low-end disruptions, the right strategy often is much clearer much earlier. As soon as the market applications become clear, and a business model that can viably and profitably address that market has emerged, aggressive investment—impatience for growth—is appropriate.

  Insurance for When the Corporation Refocuses on the Core

  Another reason why turning an early profit is important to a new business’s success is that funding for new ventures very often gets cut off not because the ventures are off-plan, but because the core business is sick and needs all of the corporation’s resources to recover. When the downturn occurs, new-growth ventures that cannot play a significant and immediate role in the corporation’s return to financial health simply get sacrificed, even though everybody involved knows that they are cutting off the road to the future in order to salvage the present. The need to survive trumps the need to grow.19

  Dr. Nick Fiore, who periodically speaks to our students at the Harvard Business School, is a battle-scarred corporate innovator whose experiences illustrate these principles in action. Fiore was hired at different points in his career by the CEOs of two publicly traded companies to start new-growth businesses that would set their corporations on robust growth trajectories.20 In both instances, the CEOs—powerful, reputable executives who were secure in their positions—had truthfully assured Fiore that the initiative to create new-growth businesses had the full and patient backing of the companies’ respective boards of directors.

  Fiore cautions our students that if they ever receive such assurances, even from the most powerful and deep-pocketed executives in their companies, they had better watch out.

  When you start a new growth business, there is a ticking clock behind you. The problem is that this clock ticks at a variable rate that is determined by the health of the corporate bottom line, not by whether your little venture is on plan. When the bottom line is healthy, this clock ticks patiently on. But if the bottom line gets troubled, the clock starts to tick real fast. When it suddenly strikes twelve, your new business had better be profitable enough that the corporate bottom line would look worse without you. You need to be part of the solution to the corporation’s immediate profit problems, or the guillotine blade will fall. This will happen because the board and the chairman have no option but to refocus on the core—despite what they may have told you with the best and most honest of intentions.21

  This is why being impatient for profit is a virtuous characteristic of corporate capital. It forces new-growth ventures to ferret out the most promising disruptive opportunities quickly, and creates some (always imperfect) insurance against the venture’s getting zeroed out when the health of the larger organization becomes imperiled.

  Figure 9-2 summarizes the virtues of policy-driven growth. It shows that appropriate policies, if well understood and appropriately implemented, can generate an upward spiral to replace the death spiral from inadequate growth that we described at the beginning of this chapter. When this happens, companies place themselves in a circumstance of continual growth. They invest their good money and avoid letting it go bad. This is the only way to avoid letting the growth engine stall and to sidestep the death spiral from inadequate growth.

  FIGURE 9 - 2

  Self-Reinforcing Spirals from Adequate and Inadequate Growth

  Good Venture Capital Can Turn Bad, Too

  Those working to build disruptive growth businesses within established corporations sometimes look longingly at the green grass on the other side of the corporate fence, where innovators who build independent start-ups not only can avoid the encumbrances of corporate bureaucracy but also have the freedom to fund their ideas with venture capital. The belief that venture capitalists can fund start-ups much more effectively than corporate capitalists is so pervasive, in fact, that the venture capital investment arms of many corporations refuse to participate in a deal unless an independent venture capital firm will co-invest.

  We would argue, however, that the corporate-versus-venture distinction isn’t nearly as important as the willingness or inability to be patient for growth. Just like Honda, most successful venture capital firms had precious little capital to invest at the outset. The lack of money conferred on their ventures a superior capability in the emergent strategy process. When venture capitalists become burdened with lots of money, however, many of them seem to behave as corporate capitalists do in stages 3, 4, and 5 of the growth-gap spiral.

  In the late 1990s venture investors plowed huge sums of capital into very early-stage companies, conferring extraordinary valuations upon them. Why would people with so much experience have done something so foolish as to invest all of that money in companies before they had products and customers? The answer is that they had to make investments of this size. Their small, early-stage investments had been so successful in the past that investors had shoveled massive amounts of capital into their new funds, expecting that they would be able to earn comparable rates of return on much larger amounts of money. The venture firms had not increased their number of partners in proportion to the increase in the assets that they were committed to invest. As a consequence, the partners simply could not be bothered with making little $2 million to $5 million early-stage investments of the very sort that had led to their initial success. Their values had changed. They had to demand that the ventures they invested in must become very big, very fast, just like their corporate counterparts.22

  And just like their corporate counterparts, these funds then went through steps 3, 4, and 5 that were described at the beginning of this chapter. These venture funds weren’t victims of the bubble—the collapse in valuations that occurred between 2000 and 2002. In many ways they were the cause of it. They had moved up-market into the magnitudes of investment that normally are meted out in later deliberate strategy stages, but the early-stage companies in which they continued to invest were in a circumstance that needed a different type of capital and a different process of strategy.23 The paucity of early-stage cap
ital that continues to prevent many entrepreneurs with great disruptive growth ideas from getting funding as of the writing of this book is in many ways the result of so many venture capital funds being in their equivalent of step 5 of the death spiral—retrenching and focusing all of their money and attention to fix prior businesses.

  We often have been asked whether it is a good idea or bad idea for corporations to set up corporate venture capital groups to fund the creation of new growth businesses. We answer that this is the wrong question: They have their categories wrong. Few corporate venture funds have been successful or long-lived; but the reason is not that they are “corporate” or that they are “venture.” When these funds fail to foster successful growth businesses, it is most often because they invested in sustaining rather than disruptive innovations or in modular solutions when interdependence was required. And very often, the investments fail because the corporate context from which the capital came was impatient for growth and perversely patient for profitability.

  The experience and wisdom of the men and women who invest in and then oversee the building of a growth business are always important, in every situation. Beyond that, however, the context from which the capital is invested has a powerful influence on whether the start-up capital that they provide is good or bad for growth. Whether they are corporate capitalists or venture capitalists, when their investing context shifts to one that demands that their ventures become very big very fast, the probability that the venture can succeed falls markedly. And when capitalists of either sort follow sound theory—whether consciously or by intuition or happenstance—they are much more likely to succeed.

  The central message of this chapter for those who invest and receive investment can be summed up in a single aphorism: Be patient for growth, not for profit. Because of the perverse dynamics of the death spiral from inadequate growth, achieving growth requires an almost Zen-like ability to pursue growth when it is not necessary. The key to finding disruptive footholds is to connect with a job in what initially will be small, nonobvious market segments—ideally, market segments characterized by nonconsumption.

  Pressure for early profit keeps investors willing to invest the cash needed to fuel the growth in a venture’s asset base. Demanding early profitability is not only good discipline, it is critical to continued success. It ensures that you have truly connected with a job in markets that potential competitors are happy to ignore. As you seek out the early sustaining innovations that realize your growth potential, staying profitable requires that you stay connected with that job. This profitability ensures that you will maintain the support and enthusiasm of the board and shareholders. Internally, continued profitability earns you the continued support and enthusiasm of senior management who have staked their reputation, and the employees who have staked their careers, on your success. There is no substitute. Ventures that are allowed to defer profitability typically never get there.

  Notes

  1. Many books have been written on the challenges of matching the right money with the right opportunity. Three that we have found to be useful are the following: Mark Van Osnabrugge and Robert J. Robinson, Angel Investing: Matching Startup Funds with Startup Companies: The Guide for Entrepreneurs, Individual Investors, and Venture Capitalists (San Francisco: Jossey-Bass, 2000); David Amis and Howard Stevenson, Winning Angels: The Seven Fundamentals of Early-Stage Investing (London: Financial Times Prentice Hall, 2001); and Henry Chesbrough, Open Innovation: The New Imperative for Creating and Profiting from Technology (Boston: Harvard Business School Press, 2003).

  2. A stream of academic research explores the nature of “first-mover advantage” (for example, M. B. Lieberman and D. B. Montgomery, “First-Mover Advantages,” Strategic Management Journal 9 [1988]: 41–58). This can manifest itself in “racing behavior” (T. R. Eisenmann, “A Note on Racing to Acquire Customers,” Harvard Business School paper, Boston, 2002) in the context of “get big fast” (GBF) strategies (T. R. Eisenmann, Internet Business Models: Text and Cases. New York: McGraw-Hill, 2001). The thinking in this field is that in some circumstances it is preferable to pursue a particular strategy very aggressively, even at the risk of pursuing a suboptimal strategy, because of the benefits of establishing a significant market position quickly. The drivers of the benefits of a GBF strategy are strong network effects in customer usage (N. Economides, “The Economics of Networks,” International Journal of Industrial Organization 14 [1996]: 673–699) or other forms of high customer switching costs. The arguments of this school of thought are well articulated and convincing, and suggest strongly that there are conditions when being patient for growth could undermine the long-run potential of a business.

  Harvard Business School Professor William Sahlman, who also has studied this issue extensively, has noted in conversations with us that on occasion venture capital investors en masse conclude that a “category” is going to be “big”—even while there is no consensus which firms within that category are going to succeed. This results in a massive inflow of capital into the nascent industry, which funds more start-ups than can possibly survive, at illogical valuations. He notes that when investors and entrepreneurs are caught up in such a whirlwind, they almost have no alternative but to race to out-invest the competition. When the bubble pops, most of these investors and entrepreneurs will lose—and in fact in the aggregate, the venture capital industry loses money in these whirlwinds. The only way not to lose everything is to out-invest and out-execute the others.

  The challenge is determining whether or not one is in such conditions. Compelling work by two scholars in particular suggests that network effects and switching costs that are sufficiently strong to overwhelm more prosaic determinants of success arise far less frequently than is generally asserted. See Stan J. Liebowitz and Stephen E. Margolis, The Economics of QWERTY: History, Theory, Policy, ed. Peter Lewin (New York: New York University Press, 2002.) As an example, Ohashi (“The Role of Network Externalities in the U.S. VCR Market 1976–86,” University of British Columbia working paper, available from SSRN) argues that Sony under-invested in customer acquisition in the VCR market, suggesting that it could have been successful had it “raced” harder. Economic modeling suggests that indeed, controlling for product quality, it makes sense to invest more aggressively in customer acquisition when network effects are present than when they are not.

  This ceteris paribus assumption with respect to product quality, however, is somewhat heroic, for it assumes away the very reason to be patient and avoid racing. As Liebowitz and colleagues (The Economics of QWERTY) have shown, in the case of the Betamax/VHS battle, a critical element driving customer choice was recording time: Although first to market and offering better video quality, Betamax did not permit two-hour recording times—the minimum typically required to record a movie being broadcast over network television. This turned out to be a critical driver of consumer adoption. JVC’s VHS standard did enable this kind of recording, and met at least minimum acceptable standards for video fidelity. As a result, it was far better aligned with the job to be done, and this superior alignment overcame Betamax’s first-mover advantage. It is doubtful that the incremental market share that a more aggressive marketing spend by Sony might have yielded for the Betamax standard would have beaten back the superior VHS product.

  With these caveats in place, it is nevertheless important to recognize the possibility of powerful payoffs to optimal racing behavior, which, in our language, would capture a particular aspect of the job to be done by a given product or service. In the case of network effects, this is captured by the notion that in order for a product to do a job well for me, it must also be doing this same job for many other people. To the extent that such competitive requirements undermine profitability where racing behavior is called for, the need to be patient for profits can be mitigated.

  Because the focus of this book is to help corporate managers launch new-growth businesses consistently, we anticipate that they will be caught in GBF racing si
tuations less often than, for example, certain venture capital investors whose strategies might be to participate in big categories.

  3. In the language of author and venture capitalist Geoffrey Moore, this is when the “tornado” happens. See Geoffrey A. Moore, Inside the Tornado (New York: HarperBusiness, 1995) and Living on the Fault Line (New York: HarperBusiness, 2000).

  4. We refer the reader again to Stanford Professor Robert Burgelman’s outstanding, book-length case study on the processes of strategy development and implementation at Intel, Strategy Is Destiny (New York: Free Press, 2002). In that account, Burgelman emphasizes how important it was that once the winning microprocessor strategy had emerged, Andy Grove and Gordon Moore very aggressively focused all of the corporation’s investments into that strategy.

  5. See Alfred Rappaport and Michael Mauboussin, Expectations Investing: Reading Stock Prices for Better Returns (Boston: Harvard Business School Press, 2001). We mentioned this point in chapter 1, but it merits repeating here. Because markets discount projected growth into the present stock price, companies that deliver what investors have foreseen and discounted will only earn market-average rates of return to shareholders. It is true that over the sweep of their histories, companies that grow at faster rates give higher returns to their shareholders than those that grow more slowly. But the particular shareholders in that history who realize above-average returns are those who find themselves holding the stock when the market realizes that its forecast of the company’s growth was too low.

  6. Cost reductions that enable a company to generate stronger cash flows than investors have expected also create shareholder value, of course. We classify these as sustaining innovations because they enable the leading companies to make more money in the way they are structured to make money. Because investors typically can expect ongoing efficiency improvements from any company, our statements here simply reflect the reality that generating shareholder value by exceeding investors’ expectations for operational efficiency typically can only raise share prices to a higher but flat plateau. Tilting the slope of the share price graph upward requires disruptive innovation.