I’ve spent most of my life thinking that value was generally created by technical innovation–a view I suspect is shared by many of my engineering brethren. Over the past year I’ve had the distinct pleasure of studying at the Stanford GSB and my perspective on this has started to change. As usual, Tim beat me to the punch, but for me it is better late than never. One of the things that has caught my attention are the similarities between engineering and business.
I’m not talking about “financial engineering” here, but plain old business model and revenue model. I’m impressed by how many companies have come to dominate their space simply by reworking the way they make money. Doing this usually requires a fair amount of systems engineering to ensure that the company and its partners are set-up to make money in this new way. Accordingly, model innovation is particularly effective when attacking an existing industry because the incumbents often cannot match the change because doing so would require massive organizational changes. Here are some examples that come to mind.
Southwest: Low-cost airlines have gotten their fair share of coverage in this space before. Southwest is the grand-daddy of them all, having started in 1971. Southwest pioneered the change from the hub-and-spoke model, which made sense in a highly regulated environment, to a point-to-point model which highly utilizes the expensive aircraft. Its not that the incumbents didn’t understand how Southwest was doing it, its just that for a number of reasons, from their inflexible labor policies to their addiction to long-haul revenue, they couldn’t match the Southwest model. As a result, Southwest has been able to generate more profits over the last 30 years than all of its incumbent competitors combined.
Vanguard: Vanguard shook up the mutual fund industry by introducing the index fund in 1975. Since then it has grown into a powerhouse, ranked fourth worldwide in assets under management, by focussing on this model which offers average performance at very low prices. Key to making this work is the largely self-service distribution model. While most mutual fund companies offer index funds now, the incumbents at the time could not react quickly enough to prevent Vanguard from becoming a force. This was largely because they sold their product through brokers who were used to sharing in the high fees the old funds charged.
Google: I’m sure that everyone in this space knows the story of Google, but it is worth noting that beyond PageRank and all the technical prowess, it was the AdWords model which made them profitable. Without this they would probably have just been another Inktomi. With it they were able to make money by selling to advertisers that the big incumbents, such as Yahoo!, weren’t servicing.
W.R. Hambrect: Google is of course the perfect segue to this nascent player in investment banking, which it used for its IPO. Bankers presently take something like 7% off the top of every IPO, bond issuance, and other financial deal done. Veteran banker Bill Hambrect (this is the second investment bank he founded) realized that this could be made more efficient while at the same time removing many of the conflicts of interest inherent in the process. The incumbents I’ve spoken to are largely in denial that his approach will work. Ultimately time will tell, but I think he is on to something.
I’m sure that there is room for more model innovation in the future. My favorite targets: hedge funds and managed healthcare. Both are fat and sitting on piles of money just waiting to be liberated by someone with a better idea. So if you’ve got an entrepreneurial itch, but don’t have a technical insight you want to pursue, give some thought to what it would take to re-work an existing model to capture more value for yourself and for customers.