There are few people whose impact on entrepreneurs and business in general you hear about as frequently as Clayton Christensen. Clay’s body of work includes co-founding a publicly traded company, being a Rhodes Scholar, writing one of the most influential business books of our generation, fighting cancer and a stroke that forced him to relearn to speak, teaching thousands at the Harvard Business School, and raising five children. He has accomplished gigantic things, not to mention he stands 6 ‘8″ and today is also his birthday so please wish him well.
When I heard he would speak at Startup Grind 2013, excitement and then panic raced through my bald head. Luckily one of the very best in the business, Mark Suster of GRP Partners was gracious enough to come and represent the startup community at the interview. Mark has written a great recap of his conversation, but it seems appropriate to followup with this audience and share the entire interview from a few weeks ago.
The Innovator’s Dilemma as you might know outlines how companies with historically successful products and market share will be disrupted and beaten unless they are innovative again and again. Clayton also recently co-authored How Will You Measure Your Life? which explains how like in business you need to plan in order to be successful in your personal life or you run the risk of failing your family and betraying your values. Read or watch the fascinating interview below.
MARK: Welcome to StartUp Grind! I thought we would start with the disruption of education. Because you’re a professor and I thought that would put me on more comfortable grounds.
MARK: We’ll come right back to venture capital, I promise. What are your feelings about education in America – the doubling over the last few years of consumer debt over education, and the fact that technology might just make what you do much more available at a lower cost for more people, which in itself matches I think your definition of disruption, and what’s going on with Udemy and Stanford and other places. I’d love to hear that.
CLAYTON: Boy, it’s a great question. I wrote my first piece about the disruption of the Harvard Business School in 1999. Because you could see this coming. I haven’t yet done the one about the disruption of the Stanford Business School. But what’s important about today versus ten years ago is, there are certain industries in which there isn’t a technological core that allows somebody to start at the bottom and go to the top. So like, hotels don’t have a technological core. Holiday Inn comes in at the bottom of the market, but they can’t go upmarket except if they emulate the Four Seasons. So they can go up, but they have to emulate the people they’re trying to compete against. They can’t disrupt them, because there isn’t anything about their model that is extendable upmarket. In so many others, computers and steel, there’s a technological core. So, for 300 years higher education was not disruptable because there was no technological core. If San Jose State wants to become a globally known research institution, they have to emulate UC Berkeley and CalTech. They can’t disrupt them. But now online learning brings to higher education this technological core. And people who were very complacent now are in deep trouble. The fact that everybody was trying to move upmarket and make their universities better and better and better drove these prices up to where they are today. So what do you do about it? I’ll just talk about the Harvard Business School and how hard it is. Because – and this is in most industries – online learning, or the technology itself, is not intrinsically sustaining or disruptive. But how it gets deployed makes the difference. So right now, the Harvard Business School is investing millions of dollars in online learning, but it’s being developed to be used in our existing business model. We’ll sell it to other universities and we’ll sell it to other universities to use in their existing business models. But there is a different business model that is disrupting us, and that’s online learning. On-the-job education. So Intel University, GE Crotonville. This model of learning is: You come in, we’ll spend a week teaching you about strategy, and then you go off and develop the strategy. You come back for two weeks in product development, and we send you – you know. You use it and you learn it and you do it while you’re employed. It a very different business model, and that’s what’s killing us. And it’s truly what’s going to kill us.
MARK: I know you think a lot of VCs don’t read your work. I’m very public about how The Innovator’s Dilemma not only influenced the way I built my startup, but the way I think as a venture capitalist. I called it something different, because I couldn’t call it the same thing you called it: I called it Deflationary Economics. I was going to call it Suster Theory, but I didn’t think that would go down too well. I think about Fred Wilson, a venture capitalist in New York City, and he publicly has also said that the most influential work on him was The Innovator’s Dilemma in thinking about how he invests. And I think particularly with the Internet as you get much larger markets and therefore you end up trying to sell things with lower costs, with less margin, with less specification to a much bigger industry, it lends itself very well to what you’re talking about. Thinking in terms of education, and I’m thinking Harvard, Stanford, Yale, Princeton, not even the business school but education. It strikes me that something we need to think about is if employers en masse valued students who got lower-cost education that was taught in a different way with different sets of tools and came more job-ready because they were actually learning by doing rather than learning from “chalk-and-talk,” I wonder if we’d see that shift happening faster and it might be good for our country in terms of debt and stuff
CLAYTON: I agree. It would be wonderful if they would do that. Because the job to be done is the employers want people who can – who have the skills to do the job. Universities don’t understand that job. The students are here to learn what we think they should know. And we invest and we subsidize their education in fields for which there are no jobs. I really do think that the more we can link the employers with the people who, online, provide the skills, it really will just cause the world to flip. The scary thing is that fifteen years from now, maybe half the universities will be in bankruptcy. Including the state schools. But in the end, I’m excited to see that happen. So pray for the Harvard Business School if you wouldn’t mind.
MARK: I think – not in a terrible way – this is actually good for society. I also wrote a post – I went to University of Chicago Business School – but I wrote a post talking about how I think for most entrepreneurs, business school doesn’t prepare them well for entrepreneurship. I think it prepares people well to go look at Bain Capital much more than being entrepreneurs. And that’s how I think universities need to adapt. You have, on your staff, also: There’s a gentleman who teaches entrepreneurship there and I’m struggling to remember his name, who does a great job at actually teaching from blogs and other things in his course. Talk about internationalization of innovation. Is this something you have a point of view on? The fact now that you’ve got China and India and, we heard earlier, Brazil and other places – and the role that education may or may not play in the U.S.’ competitive advantage.
CLAYTON: Boy, it’s a wonderful issue. And it plays it out in scary ways. So as a general rule, when a new industry takes root, and the first products emerge in a wave, almost always the architecture of the product will be proprietary and interdependent in character. The reason why that those are most successful have proprietary architectures is the product isn’t good enough in the beginning for what people need. If you try to start out with an open architecture, the modularization of the architecture takes so many degrees of freedom from the engineers that they have to make a product that’s not as good as the best, and when the best is not good enough, you can’t win that game. That’s why we lost Palm. They went open too early. So you see RIM is the most dependent proprietary architecture and the iPhone is not as closed, but still very proprietary. And then what always happens is the product becomes more than good enough for what mainstream people need. Then coming from below, it becomes more open and modular in character. And when that happens, then the people who have the proprietary architecture are just kind of pushed to the ceiling and the volume goes to the open players. So in smartphones, the Android operating system and the consummate modularity now allows hundreds of companies in China and Vietnam to now assemble these things. So it pulls in global competitiveness that isn’t nearly as intense when proprietary architectures are the norm. Just one other thing about it: Just like I pray for Harvard Business School. I pray for Apple. They always have won with the proprietary architecture. And because of their advantage, you ask them, what’s the core of the company? They say it’s the design and the interaction with the customer. It’s right there, where they have the advantage. Manufacturing isn’t really our core competence. So you just give that to the Chinese. But then what happens to them is, as the dominant architecture becomes open and modular, the value of their proprietary design becomes commoditized itself. Because now this is just open and it may not be as good, but almost good enough. Then what happens in manufacturing is – one of my colleagues visited a plant in China where they formulate logic circuitry in an iPhone. This thing is 37 layers thick. Each layer 80 microns in diameter. Vias, the holes that go up and down, are two microns in diameter. And the precision has to be, when you’re doing a via down from the top and it’s got to go to level number 17 instead of 18, this is very precision work. And the machine that makes this costs $120 million. And it drills over two million holes per hour. This is sophistication. And there is nobody in America that could make this anymore. So what we face is commoditization of the design through modularity, and then where the money is made is in sophisticated manufacturing. And it really is quite scary.
MARK: Did you read Andy Gross’ piece where he talked about this phenomenon that, because we’re not investing now in manufacturing that the advantage is moving offshore? He talked a lot about battery design for next generation cars, and because we don’t have the manufacturing for that, we’re losing competitive advantage.
CLAYTON: Yeah. It really is scary. And I don’t know – just like, if you’ve read my stuff, I’m ashamed I haven’t read Andy Gross’ piece. But the root cause.
MARK: You should just read my blog I summarize all this stuff for you.
CLAYTON: The root cause is the professors at business schools. Because, for example, we teach our students that the way they measure profitability is a return on capital employed. That’s a common measure. And so if I’m going to be measured by that, this is a ratio. And sure, I could get that ratio up by developing new products that generate attractive profits to go in the numerator of that ratio. Aw, what the heck, if I just outsource everything, then I get assets off the denominator of the ratio. Either way, the ratio goes up. So because the way we teach people to measure things, it causes us to outsource that job. And there are other ways to measure – but I think the cause…we are at fault.
MARK: So I want to do something tangible that I think a lot of people in this room spend a lot of time thinking about. Over the last ten years the concept of “freemium” has taken root. And I think also my industry propagates that, which is: Don’t charge people. Get as many users as you can. It’s somewhat of a land grab and you’ll find third-party ways to monetize like advertising. Obviously there is huge disruption itself in that in terms of cost going to zero. How do you feel about that for entrepreneurs and how should they think about that?
CLAYTON: Well, dang. As a general rule, if you have a product that doesn’t get the job done that a customer is needing to get done, then often you have to offer it for zero. Because if you ask for money for it – because if it doesn’t do the job well, they won’t pay for it. So go back in the early years of downloading music. You’ve got Kazaa and a bunch of people – it was free, right? But it was an open, modular system at the beginning, and you had to be a teenager to be able to use this stuff. Adults couldn’t. And Apple came along with a proprietary interdependent architecture. And because they were proprietary and interdependent they could take it all the way from iStore all the way through. People were so delighted to have something that did the job well that they were willing to pay!
MARK: But let’s talk about a specific example. For the most part as a VC I encourage my companies to monetize. I believe in testing markets, I believe in proving the value. I don’t say “job to be done” but I use the exact same words which is, “understand customer intent.” Understand customer behavior. Because, for me, I don’t want to see products and features. I want to understand the psychology of “why.” Because I don’t believe something fundamentally will become big if there’s not an underlying reason for them using it. But – Facebook could have made decisions to monetize early, and obviously, some people would have chosen to pay for that product, and it was a premium product – they didn’t. But by becoming huge, they open up the network effect to be able to monetize in many different ways over time. So do you accept that in some cases it may…
CLAYTON: Yes, yes. So, if in fact it is intrinsically a modular element in the stack, then modularity drives commoditization which drives profit out. So if this is going to happen, just sy it’s going to happen and make it happen. But as a general rule, when that happens, the pieces of the stack above and below it initiate a proprietary decommoditization layer in the stack. So when it becomes free, the whole industry doesn’t go to pot, but where the money is made very often flips above and below it. And so when that happens, rather than fighting the “freeness” you say “Holy Cow. There’s something happening above and below.” When – I had a stroke and sometimes I just can’t come up with word…the guys that make the calls – phone-free – no, I’m sorry, that makes telephone calls free – Skype. I’m sorry, it just happens to me periodically. They – what used to be a very profitable stack just became truly commoditized. But you look at all of the things that work on top of Skype now. Man, they’re generating billions and billions of dollars. And that always happens. I just say this just accelerates a natural process, and when it does, look above or below, and we can invest there or be an entrepreneur there.
MARK: So let’s talk about disruption of venture capital because to be fair to you, I don’t want to avoid the topic where I get disrupted. I actually do think lots of venture capital is starting to be disrupted. I personally don’t believe it’s as radical fast as many people are predicting. But one of the ways in which people believe venture capital will be transformed, disrupted is through crowd-funding. And the belief that you can raise large pools of money in a small way to fund companies. I’ll weigh-in in a second with my views on crowd funding but I’d love to hear your views: Is that one of the ways that venture capital will be disrupted, and if not, what other ways do you think it’ll be disrupted?
CLAYTON: Boy, it’s a great question. Let me say – I will say this after this is over – you are asking great questions. And it takes a lot more brains to ask good questions than it does to give good answers, so…there’s something about crowd-funding that doesn’t feel right to me. IF in fact the creation of new businesses were all the way to the edge of rule-space, then crowd-sourcing would work. Because people could just go down a checklist and say “this fits, this doesn’t, here’s your money.” But it’s somewhere between intuition and pattern recognition, and I just don’t – it just doesn’t feel right to me.
MARK: So the biggest problem I have with crowd-funding is it takes me back to the 1990s, when you had the – I lived in Europe for a time – when you have the emergence of AIM, the alternative market in London, you had the Nuemarkt in Germany, you had the Nouveau Marche in France, of course the NASDAQ in the U.S. And we saw tons of unsophisticated people pouring money into companies that – they didn’t understand what determines the value of business. Like my Mom calls me and says, “Honey, should I invest in Facebook?” And I’m like, “Not a chance! You don’t know the first thing about it!” Now, at least with public markets, we have regulation that forces disclosures. With the private markets, people are going to invest in things for which they don’t understand including the sophisticated structures of capital such as liquidation preferences and voting rights, and…
CLAYTON: Yeah, I’m with you 1000%. I’ll tell you where I think there is a – I don’t want to say vulnerability, but opportunity – sorry, I might get it a bit wrong here. But my sense is, for venutre capital, historically, you might have ten good investments. Two of the ten will be really home runs. A couple more are reasonable, and five or so you don’t get penny out. There are a couple of problems with that basic model. The two that win have to be really big wins to cover what went – you know. But because you don’t know which of the ten are going to make it, every time you come up to bat you actually have to go for home runs. Doubles you can’t consciously go after doubles or singles – it’s just the nature of it. And then you’ve got – we’ve got to get liquid at some point, and I can’t see how it can have a liquidity event. It’s hard to put it in if I can’t get it out, right? So, there are just a lot of people out there. Or there are a lot of ideas out there – that are singles and doubles. It’ll become a $40 million nice profitable investment. Just not the kind of thing you could ever take public or sell to a big company. Venture capital can’t go in because it can’t get out. They’re not big enough to be one of the home runs.
So there’s a new technology that’s emerged in the Boston area which must mean it must be suspect in some way that it hasn’t shown up here. But they’re calling it royalty capital. The money doesn’t come in as debt or equity, but it comes in as a license, just like you can license IT and stick that on the balance sheet. You get a license to use their capital. Then, they don’t pay a royalty on this license until there’s revenue. As soon as revenue starts, there’s a royalty rate they give off to the people that gave the license. The faster the ramp, the more the royalty comes down. The way you negotiate it at some point – when the royalty accumulated to 3x the value of the license – then we just say it’s paid in full. And you don’t have minority shareholders, you know? You pay it off with pre-tax money, rather than post-tax money. And the liquidity process is a process, not an event. So that most of the companies that get funded this way actually get some out of every investment. Even those that fail pay some of it out. And so it’s possible to invest – to invest in companies that won’t go public, and…yeah.
MARK: I don’t want to run out of time without having a chance to ask you one more important area, which is: When I was 20, the most important book for me was The 7 Habits of Highly Effective People, Steven Kelly, because it talked about how you live your life. It talked about what you make habits, what’s important to you, how you derive happiness, how you make decisions. I have not yet read your book – how you measure your life, and I don’t know if it’s in a similar vein. But I’d love for you to give us – it’ll be the next book I read – I’d love to hear the overview of it.
CLAYTON: We designed it in three sections. The first one is, how can I be sure that I’m going to be happy with my career and successful in my career? The second one is, how can I be sure that my family and the close relationships I have with my family and close friends are a source of joy for me throughout my life, rather than a source of heartache? The third one is, how do I be sure I stay out of jail? And this is the architecture – this reflects the architecture of the last class in my semester. And what we asked the students to do is – it’s a whole semester of studying the theories from my research. And then we ask them to put the theories on my cassette of lenses, but instead of studying a company, look in the mirror. Can these theories teach us things about these three issues? And I’m not kidding you. Holy Cow! When we look at ourselves through these lenses, it’s really very scary. So for example a shocking number of my classmates, when they graduated from the Harvard Business School, every one of them planned to have a marriage that was just filled with joy and happiness. And a shocking number of them went out and got divorced two or three times. They find themselves – their children are being raised by someone they’ve never met on the other side of the country. And their family situation is a source of real pain. Not a single one of my classmates had a strategy to go out and get divorced and be unhappy. And why that happens is the same reason, like when Cisco disrupted Lucent – there wasn’t anything in Lucent that said, “you know, we should go out and go into bankruptcy and drive the company into the ground.” But that’s actually what they did. And so the theory of disruption helps you think through the decisions you’re making in your marriage. But this is the one that really applies: Look at yourself through the lens of “jobs to be done” and ask yourself – it’s since happened to me, my whole life – married life – I tried to be a good husband. But I do for Christine what I think she needs from her husband. And if I give what I think she needs from me and she’s not appreciative, I get, “Why don’t you like what I just gave you? I know this is what you need.” You know? If instead, I try to look at it from – what are the jobs that arise in Christine’s life? For which she might hire a husband. And I’m telling you. I would never hire Clayton Christensen. But understanding the jobs that she needs to do really allows me to say, “Gosh, I guess I need to be the kind of person that she would want to have.”
MARK: So, uh, you want to be sure you don’t get fired, I guess, is the answer. But no, I’ve been writing a lot and talking about happiness and motivation and interrelationships. The most stressful period of my life was running a startup and it was very unhealthy. And I try to make sure that the people I invest in understand that they don’t actually realize how much stress they’re under and how unhappy they are, and how unhappy they make those around them. If you’re not going to deal with that while you’re going through the journey, you’re going to have some pretty unhappy years. You may know, in our industry, there’s been three suicides in the past six months. You know, they may be related to the stresses. It may just be coincidental to individual psychology and chemistry, but I think we as an industry need to be more open about talking about these issues. Again, for me, very young in my career to have someone like Stephen Covey openly talking about this, and happiness – I think’s a wonderful thing. So I look forward to reading your book.
CLAYTON: I hope it’ll be useful.