The Innovator's Solution

by Clayton Christensen

  Copyright

  Copyright 2003 Harvard Business School Publishing Corporation

  All rights reserved

  No part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form, or by any means (electronic, mechanical, photocopying, recording, or otherwise), without the prior permission of the publisher. Requests for permission should be directed to permissions@hbsp.harvard.edu, or mailed to Permissions, Harvard Business School Publishing, 60 Harvard Way, Boston, Massachusetts 02163.

  ISBN: 978-1-4221-9657-1-4

  CONTENTS

  Copyright

  In Gratitude

  1. The Growth Imperative

  2. How Can We Beat Our Most Powerful Competitors?

  3. What Products Will Customers Want to Buy?

  4. Who Are The Best Customers for Our Products?

  5. Getting The Scope of the Business Right

  6. How to Avoid Commoditization

  7. Is Your Organization Capable of Disruptive Growth?

  8. Managing the Strategy Development Process

  9. There Is Good Money and There Is Bad Money

  10. The Role of Senior Executives in Leading New Growth

  Epilogue: Passing the Baton

  About The Authors

  IN GRATITUDE

  I have spent much of the past decade puzzling over two questions. The first: It is easy to explain why poorly run companies fail; but many of history’s most successful and best-run firms have lost their positions of leadership, too. Why is it so hard to sustain success? The Innovator’s Dilemma summarized what I learned about this puzzle. It’s not just management mistakes that cause failure. Certain practices that are essential to a company’s success—like catering to the needs of your best customers and focusing investments where profitability is most attractive—can cause failure too.

  The second centered on the opportunity in the dilemma: If I wanted to start a company that could become significant and successful and ultimately topple the firms that now lead an industry, how could I do it? If indeed there are predictable reasons why businesses stumble, we might then help managers avoid those causes of failure and help them make decisions that predictably lead to successful growth. This is The Innovator’s Solution.

  The challenge of this research quickly outstripped my abilities; and I have relied upon some extraordinary people to help me complete it. Michael Raynor, who has tutored me from the day he arrived as a doctoral student at Harvard, has been an exceptional colleague. To describe Michael’s integrated grasp of arts, letters, philosophical discourse, and history as “incisive” would understate his intellect. Confident that I could expose and rectify the gaps in my evidence and logic by examining my rough ideas through the lenses of the varied academic disciplines that Michael’s mind has mastered, I asked him to join me as coauthor. Michael has balanced this work with his duties as a husband, father, and director of research at Deloitte Consulting, all the while shuttling between Toronto and Boston. I deeply appreciate his selfless, humble, and persistent hammering to get these ideas shaped right. He has become a great friend.

  Scott Anthony, Mark Johnson, and Matt Eyring each have forsaken or postponed far more lucrative careers to join me in this effort. As my primary research associate, Scott has managed our staff of researchers, written crucial case studies, helped me teach and explain complicated concepts, and reviewed and refined every draft of this book. Mark and Matt, through our firm Innosight, have translated these concepts into practical tools and processes to help managers build businesses that will be significant and successful—and in so doing have taught me how our findings can interface with managerial reality. My office manager, Christine Gaze, and research partners Sally Aaron, Mick Bass, Will Clark, Jeremy Dann, Tara Donovan, Taddy Hall, John Kenagy, Michael and Amy Overdorf, Nate Redmond, Erik Roth, and David Sundahl each have helped me stay atop the huge volume of interesting ideas, opportunities for inquiry and authorship, and requests for assistance that flow into and out of my office. They have painstakingly helped us get the data, logic, and language right for every purpose.

  I have a profound debt to Harvard Business School and my colleagues here. The insightful research of Professors Clark Gilbert and Steve Spear has been exceptionally valuable. Other faculty, including Kent Bowen, Joseph Bower, Hank Chesbrough, Kim Clark, Tom Eisenmann, Lee Fleming, Frances Frei, Alan MacCormack, Gary Pisano, Richard Rosenbloom, Bill Sahlman, Don Sull, Richard Tedlow, Stefan Thomke, Michael Tushman, and Steve Wheelwright have also shaped what we have come to understand—as have Professors Rebecca Henderson, Paul Carlile, James Utterback, and Eric von Hippel of MIT, Robert Burgelman of Stanford, and Stuart Hart of UNC. The extraordinary benefit of Harvard’s case method of teaching is that the teachers can carry issues they don’t understand into the classroom, ask questions of the students in the context of a case, and then listen to and learn from some of the brightest people in the world. I express my love and my gratitude to my students for preparing so hard every day to teach each other and their teacher in so many ways. It is a learning system without parallel.

  I also have sought the advice of some the most capable business thinkers and executives in the world. Matt Verlinden and Steve King of Integral, Geoffrey Moore of the Chasm Group, Tony Ulwick of Strategyn, Crawford del Prete of IDC, Andy Grove of Intel, Ken Dobler of Johnson & Johnson, Dan Carp and Willy Shih of Kodak, Dennis Hunter of Applied Materials, Michael Putz of Cisco, Chris Rowen of Tensilica, Bill George of Medtronic, Meir Weinstein of EMC, Michael Packer and Kelly Martin of Merrill Lynch, Mark Ross of Cypress Semiconductor, and Ron Dollens, Ginger Graham, and Rod Nash of Guidant have all tutored me.

  I owe the deepest debt to my family. My children, Matthew, Ann, Michael, Spencer, and Katie, each have discussed, used, and bettered my understanding through their own work and schooling. My wife, Christine, is the smartest person I have known. Her standards for clarity and completeness are uncompromising, and her language and intellect are imprinted on every concept in this book—which is remarkable, given that much of her advice came at the end of long days that were filled with the pressures of motherhood and her selfless service to others. She brings love and light to me and everyone she meets, every day.

  Academia for some can be an enterprise of solitary pursuits. I am blessed in contrast to work within a community of selfless, humble, smart, and intellectually courageous men and women who as a group have made the substantial progress that is summarized in this book. I am grateful to have been able to play my role in this effort.

  Clayton M. Christensen

  Boston, Massachusetts

  Like Clayton, I offer my thanks to the many people who have shared their experiences and talents with us. Without their willingness to be part of our learning processes, neither this book nor our respective careers would be possible.

  The latitude I have enjoyed within Deloitte Research is, as far as I know, unparalleled in the consulting industry. The firm has gone beyond simply tolerating my idiosyncratic undertakings—of which this book is certainly one—to actively encouraging them, making possible the exploration of a different way to create and share knowledge. I am especially grateful to Ann Baxter, the head of Deloitte Research, and Larry Scott, global leader of Deloitte Consulting’s Strategy and Operations practice, for making it possible for the ball to start rolling, and to innumerable others in Deloitte Consulting and Deloitte & Touche for their enthusiasm and support that has maintained and accelerated that momentum.

  These few sentences are one of the few opportunities I shall have to acknowledge for posterity my intellectual debt to Clayton. My first contact with Clayton’s work was as a doctoral student at Harvard Business S
chool. In his writings I found a rare combination of theoretical elegance, intellectual rigor, creative data analysis, and managerial relevance. When I read The Innovator’s Dilemma, I, like so many others, felt that a mote had been removed from my eye, and that what I had previously seen only dimly, if at all, was suddenly brought into the light. Clayton’s work has become for me a standard to which I continue to aspire, and so it is truly a privilege to have had the opportunity to contribute to and be part of the continued development and elaboration of those ideas. During the course of my doctoral studies, I was lucky enough to have Clayton as a teacher. In the course of our work together on this book, he has become a mentor, colleague, and friend.

  I save for last the one to whom I owe the most: my wife, Annabel. Her love and support have been unconditional through the years of doctoral studies, through the inevitable absences attendant to a career in consulting, through my preoccupation with this and other projects (but mostly this one!), and through the various other challenges resulting from the somewhat oddball path I have chosen. Without her, I could not pursue my dreams. Without her, and without our daughter, Charlotte, I wouldn’t have any worth pursuing.

  Michael E. Raynor

  Mississauga, Ontario

  CHAPTER ONE

  THE GROWTH IMPERATIVE

  Financial markets relentlessly pressure executives to grow and keep growing faster and faster. Is it possible to succeed with this mandate? Don’t the innovations that can satisfy investors’ demands for growth require taking risks that are unacceptable to those same investors? Is there a way out of this dilemma?

  This is a book about how to create new growth in business. Growth is important because companies create shareholder value through profitable growth. Yet there is powerful evidence that once a company’s core business has matured, the pursuit of new platforms for growth entails daunting risk. Roughly one company in ten is able to sustain the kind of growth that translates into an above-average increase in shareholder returns over more than a few years.1 Too often the very attempt to grow causes the entire corporation to crash. Consequently, most executives are in a no-win situation: equity markets demand that they grow, but it’s hard to know how to grow. Pursuing growth the wrong way can be worse than no growth at all.

  Consider AT&T. In the wake of the government-mandated divestiture of its local telephony services in 1984, AT&T became primarily a long distance telecommunications services provider. The break-up agreement freed the company to invest in new businesses, so management almost immediately began seeking avenues for growth and the shareholder value that growth creates.

  The first such attempt arose from a widely shared view that computer systems and telephone networks were going to converge. AT&T first tried to build its own computer division in order to position itself at that intersection, but was able to do no better than annual losses of $200 million. Rather than retreat from a business that had proved to be unassailable from the outside, the company decided in 1991 to bet bigger still, acquiring NCR, at the time the world’s fifth-largest computer maker, for $7.4 billion. That proved only to be a down payment: AT&T lost another $2 billion trying to make the acquisition work. AT&T finally abandoned this growth vision in 1996, selling NCR for $3.4 billion, about a third of what it had invested in the opportunity.

  But the company had to grow. So even as the NCR acquisition was failing, AT&T was seeking growth opportunities in technologies closer to its core. In light of the success of the wireless services that several of its spun-off local telephone companies had achieved, in 1994 the company bought McCaw Cellular, at the time the largest national wireless carrier in the United States, for $11.6 billion, eventually spending $15 billion in total on its own wireless business. When Wall Street analysts subsequently complained that they were unable to properly value the combined higher-growth wireless business within the lower-growth wireline company, AT&T decided to create a separately traded stock for the wireless business in 2000. This valued the business at $10.6 billion, about two-thirds of the investment AT&T had made in the venture.

  But that move left the AT&T wireline stock right where it had started, and the company had to grow. So in 1998 it embarked upon a strategy to enter and reinvent the local telephony business with broadband technology. Acquiring TCI and MediaOne for a combined price of $112 billion made AT&T Broadband the largest cable operator in the United States. Then, more quickly than anyone could have foreseen, the difficulties in implementation and integration proved insurmountable. In 2000, AT&T agreed to sell its cable assets to Com-cast for $72 billion.2

  In the space of a little over ten years, AT&T had wasted about $50 billion and destroyed even more in shareholder value—all in the hope of creating shareholder value through growth.

  The bad news is that AT&T is not a special case. Consider Cabot Corporation, the world’s major producer of carbon black, a compound that imparts to products such as tires many of their most important properties. This business has long been very strong, but the core markets haven’t grown rapidly. To create the growth that builds shareholder value, Cabot’s executives in the early 1980s launched several aggressive growth initiatives in advanced materials, acquiring a set of promising specialty metals and high-tech ceramics businesses. These constituted operating platforms into which the company would infuse new process and materials technology that was emerging from its own research laboratories and work it had sponsored at MIT.

  Wall Street greeted these investments to accelerate Cabot’s growth trajectory with enthusiasm and drove the company’s share price to triple the level at which it had languished prior to these initiatives. But as the losses created by Cabot’s investments in these businesses began to drag the entire corporation’s earnings down, Wall Street hammered the stock. While the overall market appreciated at a robust rate between 1988 and 1991, Cabot’s shares dropped by more than half. In the early 1990s, feeling pressure to boost earnings, Cabot’s board brought in new management whose mandate was to shut down the new businesses and refocus on the core. As Cabot’s profitability rebounded, Wall Street enthusiastically doubled the company’s share price. The problem, of course, was that this turnaround left the new management team no better off than their predecessors: desperately seeking growth opportunities for mature businesses with limited prospects.3

  We could cite many cases of companies’ similar attempts to create new-growth platforms after the core business had matured. They follow an all-too-similar pattern. When the core business approaches maturity and investors demand new growth, executives develop seemingly sensible strategies to generate it. Although they invest aggressively, their plans fail to create the needed growth fast enough; investors hammer the stock; management is sacked; and Wall Street rewards the new executive team for simply restoring the status quo ante: a profitable but low-growth core business.4

  Even expanding firms face a variant of the growth imperative. No matter how fast the growth treadmill is going, it is not fast enough. The reason: Investors have a pesky tendency to discount into the present value of a company’s stock price whatever rate of growth they foresee the company achieving. Thus, even if a company’s core business is growing vigorously, the only way its managers can deliver a rate of return to shareholders in the future that exceeds the risk-adjusted market average is to grow faster than shareholders expect. Changes in stock prices are driven not by simply the direction of growth, but largely by unexpected changes in the rate of change in a company’s earnings and cash flows. Hence, one company that is projected to grow at 5 percent and in fact keeps growing at 5 percent and another company that is projected to grow at 25 percent and delivers 25 percent growth will both produce for future investors a market-average risk-adjusted rate of return in the future. 5 A company must deliver the rate of growth that the market is projecting just to keep its stock price from falling. It must exceed the consensus forecast rate of growth in order to boost its share price. This is a heavy, omnipresent burden on every executive who is sensitive to enha
ncing shareholder value. 6

  It’s actually even harder than this. That canny horde of investors not only discounts the expected rate of growth of a company’s existing businesses into the present value of its stock price, but also discounts the growth from new, yet-to-be-established lines of business that they expect the management team to be able to create in the future. The magnitude of the market’s bet on growth from unknown sources is, in general, based on the company’s track record. If the market has been impressed with a company’s historical ability to leverage its strengths to generate new lines of business, then the component of its stock price based on growth from unknown sources will be large. If a company’s past efforts to create new-growth businesses have not borne fruit, then its market valuation will be dominated by the projected cash flow from known, established businesses.

  Table 1-1 presents one consulting firm’s analysis of the share prices of a select number of Fortune 500 companies, showing the proportion of each firm’s share price on August 21, 2002, that was attributable to cash generated by existing assets, versus cash that investors expected to be generated by new investments.7 Of this sample, the company that was on the hook at that time to generate the largest percentage of its total growth from future investments was Dell Computer. Only 22 percent of its share price of $28.05 was justified by cash thrown off by the company’s present assets, whereas 78 percent of Dell’s valuation reflected investors’ confidence that the company would be able to invest in new assets that would generate whopping amounts of cash. Sixty-six percent of Johnson & Johnson’s market valuation and 37 percent of Home Depot’s valuation were grounded in expectations of growth from yet-to-be-made investments. These companies were on the hook for big numbers. On the other hand, only 5 percent of General Motors’s stock price on that date was predicated on future investments. Although that’s a chilling reflection of the track record of GM’s former management in creating new-growth businesses, it means that if the present management team does a better job, the company’s share price could respond handsomely.