The never-ending cycle of disruptive innovation in enterprise software
Unlocking Potential is a newsletter by me, Francisco H. de Mello, CEO of Qulture.Rocks (YC W18)
|Francisco Souza Homem de Mello||Sep 2, 2019||6|
This is the second update to this post. The date of this update is Dec 2021 (Substack won't allow me to update the publishing date).
Do you know what “disruptive” means? It probably doesn’t mean what you think it means.
Some people think about the creation of something new. About a new solution to a problem. Big product innovations come to mind, like the Oculus Rift, for example. The more radical the new thing is as compared to previous things, the more “disruptive” sounds like a good adjective.
Other people tie disruption less to innovation and more to whenever an incumbent firm - a big, well-established player in a given market - gets its lunch eaten by a new competitor, especially if said competitor is viewed as a “tech company.”
Disruptive innovation is neither of those.
The term - and the concept that gives substance to the term - was created by Clayton Christensen in his The Innovator’s Dilemma to mean the process in which an attacking company - usually a new entrant - enters a market with a smaller war chest, less technological prowess, and, most importantly, a simpler, cheaper offering of some incumbent's product or service, and ends up, after some time, totally displacing the incumbent's comfortable initial market position.
There's a lot to unpack here.
Incumbents and sustaining innovation
The first important ingredient for disruptive innovation to flourish is an incumbent (or incumbents) trying to outdo each other with incremental sustaining innovations. Sustaining innovations are those that “improve” a product along an established angle. According to Christensen (2001) himself,
Sustaining innovations are what move companies along established improvement trajectories. They are improvements to existing products on dimensions historically valued by customers. Airplanes that fly farther, computers that process faster, cellular phone batteries that last longer, and televisions with incrementally or dramatically clearer images are all sustaining innovations.
Faster or longer-range planes, faster computers, smaller phones, are all, et ceteris paribus, sustaining innovations that usually happen in an incremental fashion - small bits at a time.
In most markets, competitors will try to outdo each other in terms of incremental sustaining innovations in their never-ending quest for differentiation and pricing power which, when successful, lead to higher prices and better gross margins.
(It's important to note that some markets have even worse dynamics where products get better every year but prices go down every year. Think about flat-screen TVs, for example, that get thinner, smarter, more bright, higher resolution, but also much cheaper, or at least not more expensive. We'll ignore these markets for the purposes of disruptive innovation.)
Attackers and disruptive innovation
So on the one hand we have incumbents fighting each other by trying to improve their products around well-known product attributes. Products get ever more sophisticated and expensive.
What inevitably then happens is that some portion of the market's customers become overshot (a critical concept of the theory). For this portion of the market, products end up becoming too complex and too expensive. They don't really need all that functionality.
That's the opening a disruptive innovation needs to do its thing.
Disruptive innovators then enter this market by offering a cheaper, simpler product or service that is good enough (another key concept of the theory) for the overshot portion of the market.
What makes disruptive innovations so wicked is what comes next.
You might think “well, all pretty simple: why doesn't the incumbent build an offering to compete on the overshot segment of the market?” And the pernicious answer is “because it's not the ‘rational’ thing to do.” The ‘right’ thing for an incumbent to do given such a competitive setup is to give up this overshot segment because said customers don't value the stuff that's most dear to the incumbent: the innovative features it has worked so hard to introduce. Not only that but offering something simpler and cheaper will often cause a deterioration in margins and cannibalization of the incumbent's brand.
Therefore, most incumbents that are faced with disruptive innovation in their markets will usually ‘rationally’ retreat from the more overserved low-end of the market and double down on the less overserved high-end of the market. And that's their death kiss. The disruptive attacker enters the market by catering to formerly overshot customers but will start introducing sustaining innovations that will gradually eat its way up the market until the incumbent is totally displaced or relegated to a niche.
The fact that ‘rationality’ will almost always drive incumbents to their demise is what makes disruptive innovation theory so interesting:
The theory holds that existing companies have a high probability of beating entrant attackers when the contest is about sustaining innovations. But established companies almost always lose to attackers armed with disruptive innovations.
Enterprise software: and incredibly fertile ground for disruption
Enterprise software is an incredibly fertile ground for disruptive innovation. Let’s take the example of Salesforce to illustrate that assertion.
Salesforce’s CRM offering goes much further than what a “simple” CRM is expected to do: aside from storing prospective customer information and allowing for a pipeline of deals to be managed, it has all sorts of bells and whistles, such as industry-specific reports, complex workflow automation, AI, an app store, and LOTS of flexibility that cater to all different sophisticated customer needs; it costs a lot and takes long to be implemented. And Salesforce keeps adding incremental sustaining innovations to the product every year and causing a bigger and bigger portion of the market to become overserved.
If we analyze Salesforce as the incumbent to be disrupted, one of the most obvious candidates for the role of the disruptive attacker would be Pipedrive: a simpler, cheaper version of Salesforce’s CRM offering that gets “the job” done just fine for a great number of customers, but for much less of a - time and money - hassle.
(Here, the concept of a “job” is important: a job, or job-to-be-done, is the actual progress a customer can make given a set of circumstances. Sales managers probably need more process, organization, and data so, therefore, they buy a software product and some services to do just that. And that product is usually a CRM system.)
If we take into account that Salesforce’s CRM is a multi-billion dollar business, there are opportunities for new entrants to build simpler, cheaper solutions that get the basic job done and cost half of the price, and can be implemented fast, and still build huge companies in the process.
Watching a keynote by Stripe founder Patrick Collison the other day, I stumbled on the following passage:
This is really key a very important part of the stripe strategy is we're building for businesses of every size we're building for the highest potential graduates of accelerators around the world and we're building for some of the biggest companies in the world as you all know the sort of standards pattern in enterprise software for some innovative product to come along you get kind of pulled up market it gets a bit kind of longer the tooth a bit stagnant a bit a bit calcified and then in turn it's replaced by some you know nimbler and more agile upstart this is the software cycle of life this of course really bad for the customers who get stuck using the old version and so this is why we obsess over startups startup to some of those demanding customers in the world they can't tolerate complexity and they simply won't put up with outdated technology and so our strategy is very deliberately to serve both ends of the continuum and every point in between this ensures we can provide the most powerful functionality to the youngest companies in the world and that we can provide the most forward-thinking technology to the largest and the most established.
What Patrick is saying, essentially, is that by continuously focusing at least part of their efforts on the startup market, they will decrease their chances of being disrupted by a new entrant to their market.
Smart guy, isn't he?
Do disruptive innovations ever end?
So, my point here is that companies will continue to be “disrupted” forever. Products will always be created to serve overserved customers. They will be simpler, and cheaper. These products will draw customers away from incumbents. These new entrants, that built the products, will grow, bloat their products to better serve their customers, and start to overserve a big part of them, and so on and so forth, ad eternum.
Some questions remain unanswered: does this phenomenon happen in all industries? It looks like it happens quite often in enterprise software.