There has been a lot of hubbub in the social media around a recent New Yorker article by Harvard historian Jill Lepore sharply disputing the famous “disruptive innovation” model Clayton Christensen, who teaches at the famous business school of the same university. Christensen has responded, with apparent disappointment and anger, in an interview he recently gave to BusinessWeek. Many Silicon Valley VCs seem to have come out in support of Christensen’s theory on Twitter, claiming that they practically live and breathe it in their daily hunt for disruptive startups.

A second, and ostensibly unrelated, meme has also been recently gone viral over Twitter. I think this was due to über-VC Marc Andressen who had one of his famous tweetstorms on offhand remark by his buddy, the former CEO of Netscape, Jim Barksdale:

… there’s only two ways I know of to make money: bundling and unbundling.

I think these two powerful ideas are actually related and underlying both is that ultimate force of technological change  – Moore’s law. I will use this (rather long and meandering) post to try and clarify my own thoughts on this topic since its of high interest to me as an investor in technology related moated companies.

Christensen’s theory of Disruptive Innovation

A provocative analysis of this idea can be found in the work of blogger Ben Thompson. He has illustrated the key idea in one of his distinctive sketches. The path of disruption looks something like the orange line in this:

The key thing to notice is that products improve more rapidly than consumer needs expand. This means that while the incumbent product may have once been subpar, over time it becomes “too good” for most customers, offering features they don’t need yet charging for them anyways. Meanwhile, the new entrant has an inferior product, but at a much lower price, and as its product improves – again, more rapidly than consumer needs – it begins to peel away customers from the incumbent by virtue of its lower price. Eventually it becomes good enough for nearly all of the consumers, leaving the incumbent high and dry.

In an interesting post on this topic that predated the firestorm caused by Lepore, Thompson suggested that there are actually two types of disruption theories articulated by Christensen over time; he argued that one of them is flawed (emphasis in the following excerpt is mine):

The original theory of disruption, now known as new market disruption, was detailed in Christensen’s seminal paper Disruptive Technologies: Catching the Wave and expanded on in the classic book The Innovator’s Dilemma. Based primarily on a detailed study of the disk drive industry, the theory of new market disruption describes how incumbent companies ignore new technologies that don’t serve the needs of their customers or fit within their existing business models. However, as the new technology, which excels on completely different attributes than the incumbent’s product, continues to mature, it eventually takes over the market.

This remains an incredibly elegant and powerful theory, and I fully subscribe to it. We are, in fact, seeing it in action with Windows – the incumbent – and the iPad and other tablets; new technology that is inferior on attributes that matter to Windows’ best customers, but superior on other attributes that matter to many others.

And:

It is Christensen’s second theory of disruption – low-end disruption – that I believe is flawed … Briefly, an integrated approach wins at the beginning of a new market, because it produces a superior product that customers are willing to pay for. However, as a product category matures, even modular products become “good enough” – customers may know that the integrated product has superior features or specs, but they aren’t willing to pay more, and thus the low-priced providers, who build a product from parts with prices ground down by competition, come to own the market.

Thompson then goes on to argue that Christensen has been badly and repeatedly wrong in his prediction of the demise of Apple products based on this second, low end disruption, version of his theory.  He correctly points out that, in fact, Apple’s hit iPhone at its initial launch was clearly much more expensive than many of the products it has successfully “disrupted”: iPods, dumb cellphones, PDAs, GPS navigators, etc. And the iPhone launched with a rich superset of the features of the disrupted devices rather than a cheaper subset. This was not supposed to happen according to the disruption from the “low-end” theory.

But in the recent post on the success of Chromebooks, Thompson himself seems to be using this low-end version of the disruption hypothesis, contradicting his earlier assertion! Apparently, even the low-end disruption idea does work at times.

So the questions remain: Exactly when does which theory predict successfully? Under what circumstances?

Barksdale-Andreessen theory of Bundling and Unbundling

As HBR’s blog explains, Barksdale, a veteran of IBM, FedEx, and McCaw Cellular, “was brought on a few months after Netscape’s founding to provide adult supervision as its CEO”. He made his bundling and unbundling comment at the end of an investor roadshow in answer to Microsoft’s decision to bundle the Internet Explorer with Windows. In the HBR interview he elaborates:

I had worked for several businesses during my career by that time that had become conglomerates, some fairly large, and then had divested themselves of various businesses. I’m on the board of Time Warner, we have just parsed off our third major part — our original company, Time Inc., which is the publishing arm of Time Warner. We [already had] divested ourselves of Time Warner Cable as well as AOL. So, it’s not uncommon to add a bunch of companies together, much less software products, and then divest yourself of them as the shareholders think they have more value standing alone than standing together. You do it to get your stock price up.

… It’s easier to do in the digital age. It’s easier to bundle and unbundle digital products …

In his tweetstorm, Andreessen gives an example of how this process works:

1/A story of unbundling in the tech industry: 20 years of consumer Internet evolution — blogs.hbr.org/2014/06/how-to…

2/One upon a time there was AOL, which was a completely integrated Internet access/information/communication service.

3/Then Yahoo came along and unbundled the information/communication parts like email/IM/sports-scores/stock-quotes from the access service.

4/One of the things you could do on Yahoo was search, then Google came along and unbundled that.

5/You can search for anything on Google, including people; Facebook came along with a much better way to just search for people.

5/You can search for anything on Google, including people; Facebook came along with a much better way to just search for people.

6/Three things you can do on Facebook are messaging, photo sharing, and status updates; therefore Whatsapp, Instagram, and Twitter.

7/And yes, Yo unbundles the creation & existence of a message from the contents of a message, unbundling Whatsapp and Twitter :-).

8/Ev Williams (@ev) is the modern genius of this concept–playing out in our industry continuously since the 1950’s. wired.com/2007/10/twitte…

9/The part people often miss is that you can get extremely powerful second/third order effects at each step with his pattern.

10/The entrepreneurs generally have a pretty good sense of this when they’re doing it, but it doesn’t become clear to others until later.

11/This is a pattern what we love to fund: unbundle X from Y, but then use the liberation of X as leverage to do amazing new things with X.

12/And the howls of press and analyst outrage at the apparent stupidity of each unbundling are very helpful for keeping valuations down :-).

…

1/The flip side of unbundling: Later on, the unbundlers tend to try to rebundle in the image of whatever they unbundled.

2/So Yahoo adds an ISP (investor.yahoo.net/releasedetail.…), and Google adds email/IM/sports-scores/stock-quotes.

3/Twitter changes its user profile page to look more like Facebook :-).

4/Sun unbundled DEC with commodity components, then re-bundled into a proprietary computing stack just like DEC w/Solaris, Sparc, etc.

5/Microsoft likewise unbundled DEC minicomputers w/PC OS + tools, then rebundled into DEC-like integrated stack now including hardware (!).

6/Paraphrasing Harvey Dent: “You either die a hero or you live long enough to see yourself become the company you first competed with.”

7/And then sometimes the rebundlers realize what they’re doing and try to reverse course. E.g. Microsoft building apps for iOS & Android.

8/And thus the cycle of life repeats with yet more unbundling :-).

…

The key driver underneath all this is technology change – the bundles emerge as a consequence:

And so the newspaper bundle, the idea of this slug of news and sports scores and classifieds and stock quotes that arrives once a day was a consequence of the printing plant. Of the metro area printing plant, of the distribution network for newspapers using trucks and newsstands and newspaper vending machines and the famous newspaper delivery boy. That newspaper bundle was based on the distribution technology of a time and place.

When the distribution technology changed with the internet, there was going to be the great unwind, and then the great rebundle, in the form of Google and Facebook and Twitter and all these new bundles.

I think music is a great example of that. It made sense in the LP and CD era to [bundle] eight or 10 or 12 or 15 songs on a disc and press the disc and ship it out and have it sit in storage until somebody came along and bought it.

But, when you have the ability online to download or stream individual tracks, then all of a sudden that bundle just doesn’t make sense. So it [unbundled] into individual MP3s.

And I think now it makes sense that it’s kind of re-bundling into streaming services like Pandora and Spotify.

Often, a key characteristic of large incumbents in any industry is, they have a bundle that is accumulated over time, for the reasons that Jim described [“because it’s an effective growth strategy. Once you try to grow the business, it’s an easier out to stay focused on your core and then add things to it.  And you become a big bundle again”].

And then what we look for is for something to have changed in the underlying technology. The arrival of the Internet was a big one. The arrival of mobile distribution. The arrival of social networks. The arrival of Bitcoin is a current example.

So, we look for something to change in the underlying technology, and then basically say, “Well, you know, gee, if you were to sit down today with a clean sheet of paper, and you knew that the technology was changing, then what would be the proper form of the product, if you were starting from scratch?”

That’s the question that’s always the hardest for an incumbent to ask, because that’s the classic innovators dilemma. And that’s the question that’s the easiest for the startup to ask, because the startup literally is somebody sitting down with a clean sheet of paper. All they have is the ability to think from first principles, think from scratch.

I would say we look actively for the pattern of large incumbent, established industry, bundled product or service offering, coupled with underlying technology change, coupled with idea for unbundled product that the customer might prefer, and then of course coupled with an entrepreneur who can actually build a business around that. I think that’s a fairly common pattern.

Andy Grove’s theory of vertical-to-horizontal transition

But even before Christensen and Netscape, way back in early 1980s, Intel’s legendary former CEO Andy Grove had already commented upon the remarkable transition from vertical silos to horizontal modules that was then completely disrupting the landscape of the computer industry:

 

• Every few years, like clockwork, the incessant, exponential rise in price/performance of silicon hardware alters what is scarce and what is abundant in the value chain of any product that depends upon silicon.
• Economic value shifts to whatever is scarce. The newly abundant becomes a commodity and loses its value.
• It is precisely this constant shift in the point of scarcity over time that ultimately drives all the disruptive bundling, unbundling and rebundling that goes on in so many industries.

• Every few years, this scarcity shift causes a specific “module” of a value chain bundle to become vastly more valuable than the surrounding pieces.
• This creates an opportunity for value creation by unbundling. As Andreessen has observed, this can exploited by a competitor (or entrepreneur) starting from scratch and offering just that valuable point of scarcity as an attractive product offering.
• This unbundling disrupts the existing value chain incumbents. Some nimble companies may be able to co-opt this process and quickly adapt; those who cannot decline. The devil is in the details, as Lepore has pointed out. of course, predicting the winners and losers in this transition cannot be easy otherwise everyone would be a great investor! It is probably helpful to conduct the mental exercise suggested by Andreessen: what would be the proper form of the product, if you were starting from scratch today? This is useful since some things can be done very differently – perhaps more simply (hence cheaply) today due to the ongoing scarcity shift. For example, the high speed internet and smartphones make digital distribution nearly a free commodity today. Many businesses that have spent a lot of money on distribution infrastructure will find that many parts of their overall value proposition have become a commodity. Imagining building an existing product or service all over from scratch can cause this fact to pop out in our minds, leading to better predictions.
• Once the unbundled product has succeeded in capturing its market, its fairly easy to rebundle more and more features around it to increase its value (as Barksdale has observed).
• This goes on until Moore’s law changes the game – the point of scarcity – again, causing the disruptive cycle to repeat!