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.

Ray is an engineer by training and has the laid-back style typical of a technology start-up CEO. His story of the early days at easyJet also had the distinct feeling of a start-up, from the SoMa-style warehouse office to the Chairman who would personally walk the terminal helping with customer service. What I found most interesting however was the way in which the key easyJet’s success, namely innovation in the business model, was similar to technology-driven innovation.

In particular easyJet, and the other low-cost providers, were the first to move away from a hub-and-spoke route architecture towards a point-to-point architecture. In the traditional airline business, a combination of regulation and economics lead to each hub being dominated by single carrier. This dominant player then made most of its money on hub-to-hub routes where it enjoyed monopoly pricing power. Feeder flights to these hubs were provided as required by regulation and as loss leaders to keep the inter-hub flights full.

With the point-to-point model, time and expense are greatly reduced if no transfers are required. Additionally, and quite importantly, the hubs are no longer a bottleneck and thus a source of delay. Finally, because the route network is no longer interconnected, delays tend not to propagate around the system. The reduction in delays is important, not only because it impacts customer satisfaction, but also because it allows for more efficient utilization of the very expensive aircraft.

Webster and easyJet founder Stelios Haji-Ioannou had a number of fundamental insights which led them to this architecture. The first was that the E.U. had agreed to deregulate travel within Europe, thus breaking the strangle hold of the national carriers. The second was that the smaller, efficient, jets, originally designed for feeder flights, would make excellent point-to-point platforms. Finally, the realized that demand for air travel was extremely sensitive to price and that a lower price product could attract a whole new range of customers rather than just competing with existing offerings (this is important given the installed capacity of the existing airlines).

They then went on to lease 2 airplanes and eventually build an airline which focussed directly on this new customer base — which is primarily cost-sensitive holiday travellers — which bucked industry trends in a number of other ways, including bypassing the travel agents and selling high quality food in-flight. As I listened to Ray, it occurred to me that in many ways the low cost carriers are not that different than a traditional start-up like Skype. They’ve seen a way to use changing technology and regulation to challenge massive incumbents, to give customers a better value, to make a product which was once a luxury available to the masses, and to make a ton of money in the process. It is precisely because easyJet prevailed against the conventional wisdom that it is good reminder to cast a wide net when considering what could make a successful business.

The talk I attended was mostly on this final topic and specifically what it is about Silicon Valley which allows it to continue to re-invent itself to change with the times. Miller has documented a list of a dozen factors in his book “The Silicon Valley Edge” which he claims are the ingredients that make Silicon Valley successful. I thought his perspective was interesting partly because it related to some previous Radar and Paul Graham posts I’d read, but also because it came from a man who had seen the Valley move from vacuum tubes to silicon, then from silicon to software, and finally from software to the internet. Much of what he said overlapped with these earlier articles, but there are a few points in particular which I think are worth calling out here:

1. Universities and research institutes which interact with industry

A key point from Miller’s perspective is that having great universities around isn’t enough, they need to be a functioning part of the community. Clearly this means having alumni who go out to form companies, but it needs to also include a way for the university insiders to participate in innovation. Taking the case of Stanford, Miller points out that there are revenue sharing incentives in place which encourage schools and departments to allow their professors to take part in professional activities.

2. Meritocratic and risk-taking culture

Miller points out that as compared to much of the world, Silicon Valley relatively devoid of old boys clubs which act as gatekeepers. If your idea is good enough, you can generally get financing, deals, employees, etc., here. Additionally, Silicon Valley is relatively tolerant of failure, with some entrepreneurs succeeding only after many failed attempts. This is something that is in stark contrast with much of the world.

3. Global linkages

For any number of reasons, be it world-class universities or the high quality of life, people from all over the world move to Silicon Valley. This creates a flux of people with a variety knowledge bases and personal connections. Miller claims that it is in this mixing of knowledge that new ideas are formed and that in the unique network of relationships that they are able to be realized.

One area of particular interest to us as of late has been the management of home energy use. We’ve noticed a number of technology early adopters showing an interest in reducing their energy usage or even getting off the grid. These early adopters driven by the same concerns as people who offset their carbon emissions. However, with the advent of wide spread demand response systems such as PGE’s Smart Meter, it appears that the financial incentives needed to drive wide-spread interest in home electricity management might finally be in place.

Simultaneously, it appears that the technology for enabling this might be emerging. In particular, we’re fascinated by the combination of low-cost wireless sensors and widespread home broadband.. One can easily imagine an energy saving kit comprising of sensors to monitor the power usage of all major appliances , a WiFi gateway to connect these sensors to the internet, and a web application which aggregates the information. The web application could then provide energy saving tools such as trend analysis, comparisons to aggregate usage, and what-if modeling (for a bit of news from the future, check out the UK Design Council’s work in this area).

We think that the potential for energy savings from concepts like this is tremendous. It is doubly attractive for the opportunity to create a lot of economic value while simultaneously achieving clear environmental benefits. If you’ve got an interest in this area, and particularly if you’ve got an entrepreneurial itch, we would love to hear from you.