Mar 21

Adam Messinger

Adam Messinger

Innovation in Business Models

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.

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Comments: 12

  andy [03.21.07 03:40 PM]

Could you elaborate more on what Mr Hambrecht did?

  Patrick [03.21.07 06:02 PM]

Online IPO using Dutch auction made famous by Google's IPO.

  Nivi [03.21.07 10:16 PM]

Good article.

I would like to hypothesize that none of these companies thought that they were "reworking the way they make money". They were simply trying to make a great product for a customer.

Using a new 'model' was a route to that goal. And I would guess that they even considered that new 'model' to be the only obvious way of doing things.

  Nick [03.22.07 05:36 AM]

Southwest has been profitable in the 2000's mainly because of their fuel hedge. While this was definitely a clever move on their part, it has nothing to do with the point-to-point model etc.,8816,1074147,00.html

  JC [03.22.07 08:56 AM]

it's easier to notice technical innovation because it's not abstract.

"innovations" in business models or business concepts sound like someone having a brilliant idea, and few in the tech field would give much credit to it.

  Ed Rockey [03.22.07 10:28 AM]

Interesting,relevant stuff!
Let's re-define the aspects of business to which creativity can be applied to develop innovations.
1. Products. (Incremetal and radical developments)
2. Services.
3. Processes.
4. Employee motivation.
5. Business models.
6. Organizational structures.
7. Redefining the nature of the enterprise.
8. et al ?????

  frazier [03.22.07 10:53 AM]

Hey Adam - good to see you're getting the biz background! Cheers

  Ian Holsman [03.22.07 03:40 PM]

I'm not sure what you mean by hedge funds. each hedge fund is unique in the way its brings value to it's customers and there is a lot of innovation in financial engineering happening in each one.

sure there is some theory out there which claims to be able to replicate them, but it's just theory at the moment (also you can claim the replication itself is innovation)

as for the fees they charge, that is dominated by market forces, not innovation. A fund manager is judged by assets under management and their risk-adjusted return. (after they pay the hedge funds fees).

vanguard's innovation was passive management, and the realization that active fund managers don't add any real value. they automated the stock-selection process to be index-based and could lower their fees as they didn't need to pay the active fund managers. (which was their large cost). it wasn't self-service, but the realization that not many funds (in the long term) outperforms the benchmark.

if anything, index-based funds + hedge funds are evolving the market and squeezing the traditional portfolio managers from both sides, and that in turn is squeezing margins in the entire value chain.

The 'innovation' will be when hedge funds charge for their advice as a flat fee, and not as a percentage of funds under management (which is the next step in the evolution)

Is this innovation or competition?

  Adam Messinger [03.22.07 09:02 PM]

Great responses everyone, thanks!

Ian, I think a lot of hedge funds are selling beta and calling it alpha. So while it is true that many of them are finding unique strategies, the evidence I've seen suggests that many of them are just getting paid to take unique risks. In many categories, such as merger or convertible arbitrage, I think that it would be possible to have an index fund style strategy.

Jessica, I absolutely agree that technical innovations are easier to spot. As you point out, part of this is due to the fact that the innovations are more abstract, and I think that part is that they just seem obvious in retrospect. This obviousness, which Nivi also refers to, seems to be a hallmark of most innovation.

Nick, I understand that about half of Southwest's post 2001 profits have been due to hedging. Even ignoring this period, its performance has been tremendous.

  Bryan Spry [05.11.07 08:46 AM]

As a technical guy, I have also have been a bit suspect of the so called business innovations. There are strong parallels however in the way both disciplines seek optimizations and deal with the trade offs necessitated by the operating constraints.

I'm glad to see that you are exploring the business side these days. Even with current business compensations models, the most brilliant of engineers these days are still just capital in the system.

I agree with your examples of fat industries in need of innovation. Let me suggest a couple more. Real Estate sales and title insurance. Neither industries have changed their pricing structure or business models to take advantage of the productivity gains and potential seen in the last two decades. The barriers to entry seem low, so it is surprising that competitors have not sprung up that rework the business models to siphon off the fat.

  sumit vadera [11.12.07 04:33 AM]

i think 'innovation and business' stories are very rare in the success categories. most of the great innovative ideas just go down the drain due to lack of resources.
i say this out of my own experience.

  Patrick [05.29.08 08:16 AM]

Dear Adam

Loved to see you write about business model innovation. I absolutely agree with you. It is quite fascinating to see how little changes in the business model can change a whole industry. Take Dell, IKEA, Aldi in Germany, Walmart or Prepaid cellulars vs. post-paid. None of them used a technological innovation. They just changed their business model. From a model perspective the change was not dramatically, but it totally changed the economics of the whole business and quite often, the incumbents could not follow because their competitive advantage was just based on the old configuration of the business model.

I wrote my Ph.D. on this topic in 2000. Unfortunately, it is only in German, but I have an article in English as well. If interested in more information, just contact me.


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