The Innovator's Dilemma

The Innovator’s Dilemma by Clayton Christensen begins with an insight.

In business, it’s hard to imagine how the current market leaders could lose their position: they have the most resources, the best people, the best partnerships, and the best customer relationships. But looking historically, it’s all too common for market leaders to get put out of business by scrappy startups.

The book asks: what are the mechanics behind this counterintuitive pattern?

It’s one of the few business books I’ve read, but also a favorite: 5/5 stars. Here’s how I understand it.

Business Inertia

If the book had an alternate title, it’d be The Physics of Business Inertia.

Those physics follow a few principles.

First, the value of a new technology is extremely uncertain. Most innovations fail to meet their promise. But established technologies have clearer value, and market leaders can see that value clearer than everyone else.

Given this edge, market leaders have both confidence in what works and anxiety in what’s new. Whereas a market leader can see three steps ahead of an established technology, they can’t see a single step ahead of a new technology.

This brings us to the principle of business inertia: the bigger a business, and the faster it moves in a given direction, the more likely it is to continue in that direction. For startups, their gift/curse is their lack of inertia. They’re not moving successfully in any direction, so they’re better of trying their luck with new technologies.

And when a new technology is actually valuable, startups can steal an established leader’s lunch. Given their strong market leads, unrivaled cash flow, and the best selection of talent, managers at disrupted companies have a history of blowing it in the face of game-changing technologies.

This creates the innovator’s dilemma: knowing full-well that disruptors will eventually crash your party, how should your business survive – let alone thrive?

Making the Right Decision

The first challenge is choosing the right technology to invest in.

Market leaders struggle to invest in disruptive technologies early enough because they begin by serving small markets. Market leaders are used to serving big markets, so disruptive technologies often fly under their radar until it’s too late.

But even when a market leader is interested in a new technology, they inform their investment decisions in counterproductive ways. Because information about established technologies is rich, market leaders can successfully inform their decisions through research, analysis, and slide decks. But those early markets don’t have much information on them, so these types of analysis are likely to be based on flawed assumptions.

Effective startups rather inform their decisions through experiments. Rather than making projections based on strategic assumptions, then convincing stakeholders of their accuracy, startups are skeptical about any assumptions, and conduct data in order to challenge those assumptions. These experiments may be too expensive to justify for established companies, especially if it puts their customer base at risk. But startups don’t have any customers to lose! This asymmetry empowers - but also requires - startups to explore uncertain markets and discover product-market fit for their new technologies.

For an established company to pick a winning technology, they have two options. They can either break away from the analytical approach and pioneer a discovery-based approach to decision-making, or they can admit their structural incompetence and simply invest in a startup who can do that scrappy exploration for them.

Executing on the Right Decision

But even if a market leader picks a winning technology, another form of business inertia means they’re still unlikely to win.

Market leaders are hyper-optimized to efficiently serve their current customer base. The more established the company, the more likely that they sell high-margin business to a large customer base. By contrast, disruptive technologies often start by serving a small customer base with a low-margin business. The values, processes, and culture optimized for serving large, high-margin customer bases is fundamentally different from those required to serve small, low-margin customer bases.

Due to this clash, Christensen details several companies who tried to create “internal startups” that faced serious difficult or failed. Rather than forcing it, market leaders should invest in a new organization which can take the shape of its new market.

If we had to summarize the solution to the innovator’s dilemma for market leaders: it’s to embrace your success while it lasts, and use the profits to invest in potential disruptors as an insurance policy.

If we had to summarize it for startups, it’s to read The Lean Startup and learn how to explore new markets better than any established company can.

Modern Examples

One of the book’s strengths is that Christensen validates his principles across different industries over time. For the price of a single book, you get history lessons in hard drives, PCs, printers, retail stores, motorcycles, steel mills, and even excavators! Whereas a single case study might beg the question - “does this really apply to my business?” - Christensen takes a robust approach and dispels that concern with confidnece.

But The Innovator’s Dilemma was published in 1997. Since then, software has disrupted so many industries, that in 2011 Marc Andreesen claimed total victory, simply stating: “software is eating the world”:

Six decades into the computer revolution, …. all of the technology required to transform industries through software finally works and can be widely delivered at global scale. … Companies in every industry need to assume that a software revolution is coming.

Just a few years after the first iPhone was released and before Facebook had even IPO’d, Andreesen proclaimed software as the omni-disruptor.

And even that was over ten years ago! So let’s look at some modern examples of disruption and how they highlight principles from the book.

Amazon

Amazon started out by disrupting book stores, then went on to disrupt the entire retail industry.

This “land and expand” strategy is typical of disruptors and one of the reasons market leaders end up blindsided. Jeff Bezos had “the everything store” in mind since the beginning, but started with a smaller, more feasible market; one that none of the bigger retail players would recognize as a threat.

In 2001, Borders - then one of the largest US bookstores - sold their online business to Amazon. This move was interpreted as a cost-cutting measure, so that Borders could focus on its more successful brick-and-mortar business. Ten years later, Borders went out of business.

While not as tragic as Borders' story, even Walmart has a similar one. An article on Walmart vs Amazon describes the conversation between Walmart’s CEO and the head of Walmart.com in 1998:

The CEO predicted that Walmart’s online store would never register more sales than the largest single Sam’s Club brick-and-mortar location. That may sound absurd now, but sales data at the time backed it up. In 1997, Amazon posted revenue of just $148 million, while Walmart celebrated its first $100 billion sales year.

This echo’s one of the book’s principles: “small markets don’t meet the growth needs of established businesses.” Whereas back then 10% sales growth would mean a $14M for Amazon, the same growth for Walmart would require $10B in sales. The Innovator’s Dilemma says that it’s not despite Walmart’s size that they couldn’t compete with Amazon, but because of their size that they couldn’t see it coming.

Airbnb

If you’ve ever pitched a business, you’ve probably been challenged with: “what’s stopping a giant from doing the same thing?" And The Innovator’s Dilemma give us a systematic answer.

Christensen makes a data-driven case that giant-crushing mainly happens with sustaining technologies; disruptive technologies are safe. But this begs an essential question: am I working on a truly disruptive solution, or just a sustaining solution?

Christensen allows us to answer this with two questions: does the solution change the definition of quality, and does it require different value networks to take it to market?

Take Airbnb: they certainly changed the definition of quality for vacation rentals. Hotels provide lodging where consistency is highly valued, so much so that a simple star rating can tell us most of what we need to know about a given hotel. Airbnb threw that consistency out the window. Instead, customers dealt with different hosts on each stay, each with completely different offerings. One night you’ve got an entire house to yourself, and another night you’re sleeping on a couch while the host still lives there! I can hear hotel executives laughing the first time they heard about Airbnb. Fast forward to last year, when Airbnb did $10B in annual revenue. That’s the same revenue as Hilton Hotels, a global brand who’s been in business for more than one hundred years.

But perhaps more importantly than redefining quality, Airbnb redefined the vacation rental value network. Whereas a hotel chain requires a network centered on real estate, operational staff, and suppliers, Airbnb provides the same fundamental service with none of those. Instead, their network is almost entirely centered on hosts. While the diversity of hosts incurs significant risk relative to vertically-integrated hotel chain networks, by solving that problem, Airbnb is far more scalable than any hotel chain could be. In the early days, hotel executives may have joked, “how could Airbnb possibly work?”, but today, they may be pleading “how could we possibly compete?”

Disruptive technologies don’t only solve problems in new ways, they require building new networks. Giants have already-optimized networks for their current solution, which are expensive to change. So if you’re able to build out a new value network as a disruptor, you can expect a more of a competitive advantage than you - or the giants - would expect.

Microsoft

When Satya Nadella was hired to lead Microsoft in 2014, it was clear that they had missed a big, obvious-in-hindsight cycle: the smartphone.

Another principle from The Innovator’s Dilemma is that disruptive technologies have strong first-mover advantages. If a new technology market is uncharted territory, then a first-mover is its pioneer. They alone hold those precious initial maps. By comparison, competitors play follow-the-leader and thus lack insights that would give them any competitive advantage.

In the modern smartphone market, Apple was the first-mover. Steve Ballmer, then CEO of Microsoft, laughed when asked about the first iPhone release:

Five hundred dollars? … That’s the most expensive phone in the world! And it doesn’t appeal to business customers because it doesn’t have a keyboard … Right now we’re selling millions of phones, and Apple is selling zero.

That’s another takeaway from the book: established businesses are bound to their highest-margin segments. Looking at Microsoft’s annual reports, the year of that interview was when Microsoft’s Business Division (i.e. Microsoft Office) first eclipsed their founding operating system in operating income. At the time, a majority of Microsoft’s revenue was coming from business customers, whereas Apple, although their total revenue was about half of Microsoft’s at the time, made almost all of it from consumers. While the interview makes Ballmer look clueless in hindsight, his mention of business customers may not be a coincidence; it’s exactly what The Innovator’s Dilemma would predict.

I call this “the B2B vacuum." Seeking growth, consumer products are pressured to venture upmarket towards more-profitable business customers. If that movement is successful, consumers often become a second-class customer. Free plans become limited, releases are increasingly tailored towards enterprise functionality, and new opportunities emerge for customer-centric consumer products to fill the void. Perhaps distracted by their growing B2B segment, Microsoft was unable to see the opportunity to lead on smartphones like Apple or Google did.

But Microsoft did eventually see the opportunity, it was just too late. Another disruption principle is that late-movers face significant challenges in commanding a disruptive technology. Microsoft tried to catch up on mobile by releasing the Windows Phone in 2010, redesigning Windows to suit touchscreens in 2012, and even acquiring Nokia in 2013. All three of these efforts were disasters.

Admitting defeat on mobile but having enough footing to fight another day, Nadella is hired. He vows to make Microsoft a leader in AI. At the time, Google was so far ahead of Microsoft that this sounded ridiculous. How would they do that?

The Innovator’s Dilemma claims that since it’s near-impossible to deliver a disruptive technology within an established organization, you’re better off investing in a separate organization which can cultivate a growing market while it’s small. Hello, OpenAI.

In 2015, Microsoft signs an exclusive cloud deal with OpenAI and in 2019 they invest $1B in the startup. Three years later, ChatGPT launches. Immediately, it shows signs of disrupting Google Search - one of the most ubiquitous and profitable products of all time. And the underlying GPT technology was pioneered by Google!

Microsoft - without developing the product themselves - was able to invest in OpenAI again in 2021, 2023, and most recently in a round valuing the company at $157B. Microsoft will reportedly receive 75% of OpenAI’s profits until they recoup their investment, at which point they’ll retain 49% equity in the company. As Nadella wrote to the Microsoft board:

If OpenAI disappeared tomorrow, we have all the IP rights and all the capability. We have the people, we have the compute, we have the data, we have everything. We are below them, above them, around them.

In the 2010s, it seemed like Microsoft was a nobody. But while nobody was looking, they proved that if one can survive the embarrassment of disruption, they can still become the disruptors of the future.

Which leads to my favorite takeaway from The Innovator’s Dilemma: that the extremely-dynamic business world is full of opportunities.