This article originally appeared in the Harvard Business Review
As more and more companies face disruption from globalization, new technology, and startups that have more capital than the incumbents, the continuing cry from Wall Street investors is, “Why can’t companies be as innovative as startups?”
Here’s one reason why:
Startups can do anything.
Companies can only do what’s legal.
Startups can do anything
One of the unheralded advantages of a startup is what at first glance appears to be its weakness. Initially, a startup has no business model and no market share to defend. Its employees and investors don’t depend on an existing revenue stream. If they select a business model that targets industry incumbents, they don’t have to worry about upsetting existing customers, partners or distribution channels.
Yet those very weaknesses give startups an overwhelming advantage in innovation. Startups can try any idea and any business model—even those that are on the surface patently illegal.
At times laws and regulations are in place for the health and safety of consumers. But often the legal obstacles confronting startups have been put in place by companies that look to the government and regulators as their first line of defense against new market entrants. (Existing companies also use network effects of monopolies/duopolies, distribution channel kickbacks, etc., to stifle competition.)
In the past, these anti-innovation tools were sufficient to keep new entrants out. But today, investors realize that companies that depend on regulation and artificial market constraints are actually vulnerable. Once presented with an alternative to the status quo, customers who have been locked into rent-seeking companies flock to innovative startups with business models that provide better service, lower prices, etc. Enormous financial returns are available to startups taking on incumbents, regulators and the law. So, startup investors comfortable making a risk capital bet are actively encouraging startups to go after large, static industries that look prime for disruption.
Here are some of the most visible examples.
Uber – current valuation >$70 billion – knew the day they started that their ridesharing service violated the law in most jurisdictions. Carrying passengers for payment, historically considered commercial use, was regulated in most cities. In addition, some cities put an artificial limit on the number of taxi operators by requiring them to buy medallions and agree to a set of local regulations. Uber ignored all of these requirements and reinvented local transportation by offering a more convenient service. Today, New York City has 13,587 yellow-taxi medallions and more than 50,000 Uber and Lyft cars.
PayPal – acquired by eBay three years after it was founded for $1.5 billion – started as a money transfer system for buyers and sellers on eBay. Banks protested that PayPal was an unregulated bank; and of course, are regulated by the federal government and states. As PayPal grew, incumbent banks forced it to register in each state. Ironically, once PayPal complied with state regulations by registering as a “money transmitter” on a state-by-state basis, it created a barrier to entry for future new entrants.
Airbnb – current valuation $31 billion – allows people to rent out their homes, rooms or apartments to visitors. Not surprisingly Airbnb violates local housing laws and regulations in many cities. None of the renters pay hotel or tourist tax. Every Airbnb rental is a lost night of revenue for hotels that hate it. The company has more rooms available then any hotel chain.
Tesla – current valuation $50 billion – sells cars directly through its own distribution channel. To protect auto dealerships in the 1920s, direct sales by an automobile manufacturer were made illegal in most states in the U.S. Because Tesla believed that existing auto dealers would have no incentive to sell electric cars, they created an alternative option for consumers.
Companies can do anything legal
In the 20th century companies worried about increasing their market share, profit margins, return on investment and return on net assets. They tenaciously protected their existing markets from other existing companies that were using the same business model. They very rarely worried about disruption from new firms as the barriers to entry (financial, legal, regulatory) were so high.
Ironically once companies become locked in their entrenched market positions, it became difficult for them to compete by breaking the same laws or untangling their existing channel relationships. In contrast to startups, companies are constrained by local, state and federal laws and regulations. The risk of breaking laws can result in large penalties and shareholder lawsuits. The Justice Department and State Attorneys General find large companies attractive targets.
As a consequence, one of the roles of the legal department in large corporations is to protect the company from straying into any legal or regulatory danger. (For example, when Volkswagen discovered their diesel cars couldn’t pass U.S. pollution standards, it faked the tests by programming cars to pass inspections. However, in normal driving these cars put out over 40 times the allowed nitrous oxide pollutants allowed by law. After it was discovered, legal penalties cost Volkswagen $18 billion and several indicted executives.)
Yet trying to stay within the legal lines companies paint themselves into a corner by creating their own internal barriers to innovation. Instead of innovating, most industries being disrupted turn to litigation.
To compete with Tesla’s direct sales to consumers, GM, Ford, and the rest of the auto industry either have to shut Tesla out of selling directly to consumers or they have to abandon their own dealer networks and sell directly as well. It’s an untenable and unsustainable position as consumers find car salesmen to be one of the least trusted groups. To defend their dealer network, car makers decided to litigate instead of innovating.
Taxi companies needed to start copying Uber’s business model but instead they turned to lobbyists and legislation to convince cities that deregulated ridesharing was a bad idea.
Hotel chains burdened with even a greater capital investment in their physical buildings are doing the same thing.
Corporations using existing business models have people, processes and revenue goals that can’t be changed overnight. These incumbents tend to have short-term goals and incentives (stock price, quarterly earnings, year-end bonuses) and often fail to recognize that more money can be made on new platforms and new distribution channels. In each case litigation versus innovation is seems obvious choice.
What can a company do?
The introduction of new technology has always been disruptive to existing markets, particularly to those who sell through well-established distribution channels and have extensive capital equipment and fixed investments. But today, as disruption happens faster, and is funded at enterprise scale, companies need to figure how to create a portfolio of innovation. They can do so by first identifying technology trends with innovation outposts located in technology centers; second, by investing in early-stage disruptors; third – buying disruptors and keeping their innovation culture and people; while fourth, creating an innovation culture internally that disrupts their own business model before others do.
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