a16z Podcast

A16Z Podcast: Holy Non Sequiturs, Batman! — What Disruption Theory Is … and Isn’t

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This episode centers around Clayton Christensen's theory of disruptive innovation—one of the most discussed, analyzed, challenged, and misunderstood concepts in business. Christensen coined the term in a 1995 Harvard Business Review article and expanded upon it in his 1997 book, The Innovator's Dilemma.

A16Z's Sonal Chokshi interviews Michael Raynor, who co-authored Christensen's follow-up book, The Innovator's Solution, in addition to his own work, The Innovator's Manifesto, which attempts to test the predictive power of the theory. The key question at hand: what is disruptive innovation? And what isn't?

The Use and Overuse of the Term "Disruption"

Raynor notes that the term "disruption" has come to be used far too frequently with far too little precision. When people use it, especially in a business context, they forget what the word actually means, and often confuse it with the typical meaning of "disrupt": to hold up something, to slow it down, to interrupt an otherwise smooth and even flow. They also overuse the word to describe all manner of phenomena, many of which have little to do with the original meaning (Raynor calls this "verbal inflation").

The Innovator's Dilemma focuses on a particular class of phenomena whereby companies (often small under-resourced startups) are able to successfully enter markets that are dominated by well-managed incumbents. Disruption, as laid out in the book, describes a very particular pathway by which a scrappy little upstart is able to overturn a successful incumbent in an established market.

Chokshi gives her summary of the disruptive path: the startup comes in, usually from the lower end of the market, with lesser features or reaching a niche customer set that is not being served. The startup utilizes an accelerator technology that then allows them to be able to move up-market. Raynor notes that the accelerator (or "enabling technology" or "extensible core") is often ignored, but is a critically important, necessary condition to disruption.

Raynor lays out the three necessary conditions for disruption:

1. Disruptors start in segments of the market that incumbents aren't motivated to fight for, or fundamentally don't see (i.e., the "low end," or an entirely new market for that product, where the only competitor is non-consumption).

2. Disruptors have a fundamentally different business model that allows them to profitably serve the niche that the incumbents don't want. While the incumbents can't make profit there, the disruptor must—losing money in a niche market is not a disruption, it's just losing money.

3. Disruptors utilize an enabling technology that allows them to take the same business model and (later) serve the mainstream markets that the incumbents do care about. By that point, it's too late, the incumbents can't respond, because the disruptor has broken the trade-offs that they were depending on. 

Pace of Disruption

Chokshi notes that disruption seems to be happening a lot faster, and Raynor agrees. Disruption in the steel industry, for example, took over 40 years—Nucor, the archetypal disruptor, started with rebar, a low-volume, low-margin segment of the steel business that incumbent steel makers were not motivated to defend. The company built a fundamentally different business around the mini-mill, but it took 43 years for it to become the size of the largest integrated mills. Why? The enabling technology was electric-arc furnaces and continuous casting, which improve relatively slowly.

In contrast, personal computers, which started as toys sold to hobbyists, disrupted mainframes and minicomputers in just a couple decades, because the enabling technology was the microprocessor, which gets better quickly.

Disruption Theory's Predictive Power

In Raynor's book, The Innovator's Manifesto, he attempted to investigate the predictive power of disruptive theory, and whether it could be taught to MBA students in a way that improved their ability to predict company outcomes (he's since replicated the experiment with executives). The participants were presented a portfolio of case studies on businesses that had been launched by Intel over the years. First, they were asked to pick winners and losers, then they were asked to do so after being taught about disruption theory. The users of disruption theory improved their accuracy up to fifty percent, but in absolute terms, modestly. Their success rate was around ten percent in picking winners, and it was about fifteen percent in picking winners with disruption theory. (Because, Raynor notes, "it's a big noisy world.")

What is Disruption Theory Not

Raynor, Christensen, and another professor at HBS named Rory McDonald have a piece coming out in the December issue of the Harvard Business Review tackling this question.

First case: Uber (Chokshi belives Uber is disruptive, like the audiences Raynor surveys). Raynor discusses the characteristics of the theory as it applies to Uber. First and foremost, it's a theory of customer dependence—whom are you selling to? Whom did Uber sell to? Was it the low-end of the taxi market, that the established taxi companies simply couldn't be bothered to serve? Was Uber selling to people who found hailing a cab and paying for it so inconvenient and so expensive that they had just never used cabs before? No.

Uber was and is going after folks who want a cheaper, more convenient, cleaner, nicer, cab ride. A data point: Uber has gone from roughly 350k rides a month in Manhattan to 3 million rides a month in Manhattan. Over that same period of time, the drop-off in yellow cab rides was roughly equal: 3 million rides a month. 

Raynor reiterates: what disruption describes is a pathway, a particular way in which a small under-resourced entrant can succeed against well-managed, dominant incumbents. So it's a pathway. It's not a description of impact on an established market, which is how people have tended to use it. They'll say, "Oh, Uber's disruptive because it's turned the industry upside down..." While it has revolutionized the industry, it's not disruption, and that matters. Because if we think it's disruption, then other folks who want to pursue a disruptive strategy will think, "Well I need to do what Uber did". What did Uber do? Uber did something that, to Raynor's mind, is a fairly long-odds proposition: they built a better mouse trap.

Second case: Tesla. Was Tesla targeting a small, unprofitable, unattractive segment of the car market that was of no interest to incumbent car companies? No, they're targeting people willing to spend $100k on a car. Which is very interesting and important to companies like Mercedes and BMW and Lexus. The customers were underserved by existing solutions, meaning Tesla's electric drivetrain and software-oriented experience are examples of "sustaining innovation." (Disruptive innovations target overserved customers, for which established solutions are too good, too expensive.) Tesla is better explained by Jeff Moore in "Crossing the Chasm"—to cross the chasm, a company finds very demanding customers, and creates a highly effective solution that solves their problems really well, and then rides a cost-reduction curve into the mainstream. That's completely different from what disruption describes, which is a very different path from the fringe to the mainstream. 

Third case: Theranos (Raynor proposes that Theranos is disruptive). As Raynor understands the company, they've created a whole series of blood tests that are able to give a high level of accuracy with very low expense and very low inconvenience. That's an innovation, because it has broken trade-offs—an innovation for Raynor is "anything that breaks a constraint," or "more for less." Theranos is having difficulty finding adoption in mainstream hospital application, so they're finding their first commercial applications in clinics and drug stores—on the fringes of the core mainstream blood testing market. Theranos has broken certain constraints, and is following a path from the fringe to the mainstream. What Raynor doesn't know enough about is whether there's the enabling technology that is going to allow their solution to improve to the point that it can penetrate mainstream markets.

To reiterate: disruptors need to start at the fringe and move to the middle. While some people think disruption is "it started small and got big," that's meaningless. Almost nothing big starts big.

What Christensen Got Wrong?

Chokshi raises the argument that Christensen missed the disruptive potential of the iPhone. Raynor argues that companies face two distinct problems: the cross-sectional problem and the longitudinal problem. Apple showed up with the iPhone in the mobile phone market, with a better mousetrap: it did not enter the smartphone market disruptively. (Whom were they trying to sell the iPhone to? People who wanted a better phone.) So, "cross-sectionally," their entry was not disruptive, but sustaining. On the other hand, Raynor argues "the longitudinal problem" is how Apple raced up the disruptive trajectory displacing the personal computer. Every company is playing both games at the same time. They have to be winning the cross-sectional battle, as well as getting equipped for the long game.

Similarly, Xerox, in personal copiers, had a cross-sectional battle to win. They were competing with carbon paper and Gestetner machines. They had to win the cross-sectional strategic battle for the niche market that they wanted. Then they followed a disruptive path into commercial applications for photocopying technology. Companies need a different toolkit to understand how to win that cross-sectional battle, which is a strategy problem: strategy's about the constraints you embrace. The innovation problem is about the constraints you break, and you need a different toolkit to understand that, and I think a very powerful tool in that toolkit is disruption theory. And there are other tools: diffusion theory, crossing the chasm, and others. 

Are all disruptive products successful?

Raynor goes back to the core research that lead Clay to discover the theory: the disk drive market. With each subsequent generation of disk drives, from Winchester drives to eight-inch drives to five-and-a-quarter to three-and-a-half, there was a ravenous horde of companies seeking to deliver that new generation of technology, all eager and in fact quite ably following the disruptive path. Not all of them succeeded: some did, some didn't. Companies have to win the cross-sectional battle as well as the longitudinal one.

Disruption theory doesn't say anything about the longitudinal battle. That's not a shortcoming of the theory. Theories are powerful when they have boundaries. If you start applying the theory when it doesn't apply, you're more likely to make the wrong decisions than if you just didn't use it at all.

How to win the "cross-sectional battle"

Raynor points out there's a long stream of scholarship, both theoretical and applied, that seeks to tackle that problem. His contribution to that body, the 2013 book "The Three Rules," was an attempt to try and unpack: what does it take to win in the here and now? When you face trade-offs, which trade-offs should you embrace? And how do you go about remaining committed to those choices over time? 

The three rules: Better before cheaper, revenue before cost, and "there are no other rules."

The rules are intended to address the three core questions that define any business. In the first instance, how do you create value for your customers? There's basically two ways you can do that: superior value, or lower price. Raynor concluded that companies that deliver exceptional profitability over time focus systematically on better before cheaper.

The second question is how to capture value, in the form of profits? The arithmetic of profitability is pretty straightforward: revenue minus cost. But companies that deliver superior profitability focus on generating revenue before minimizing cost.

Finally, what do you change when everything around you changes? The answer is anything except those first two rules. Which is why the third rule is there are no others.

The rules pass the test of being falsifiable. The first rule, for example, might be "cheaper before better." There are people who believe that price-based competition is extraordinarily powerful, such as the big discounters in any industry. But the data pointed in the other direction. Similarly, arguing that being a cost leader is the key to superior profitability is sensible. But it happens not to be true. Systematically, over the long term, companies that focus on superior revenue, either through higher unit price or higher total unit volume, deliver superior products, and are more likely to deliver superior profitability than companies that focus on cost leadership. 

But there are exceptions, like Amazon, which is why it's called "The Three Rules", not "The Three Laws". But if you, as a strategist, can't be bias-free (and you can't), the best you can hope for perhaps is to have the right bias. Play house odds, if you will. The bias should be better before cheaper, revenue before cost. If the data convince you otherwise, go in the other direction.