BUSINESS_MODELS

Not surprisingly, the invention of new business models can originate from many potential sources. What business models pioneers possess is an understanding of "deep truth" (about the fundamental needs of consumers and how competitors are or are not satisfying those needs) and the

technological and organizational possibilities for improvement over the status quo. An

established logic for satisfying consumer needs ------ e.g. newspapers for providing news ------- get overturned when new technology arises. New technology is often but not always the trigger.

In the case of newspapers, communication costs have dropped dramatically. For news, the permanently important question (the deep truth) is how society will gather and distribute the news of the day. First it was the town crier, then the newspaper. Today the Internet is increasingly important. The business model usually changes along the way when the underlying technology changes; but technological change is not always necessary to reshape the business model.

The entrepreneurs who can figure the logic out and build distinct organizations to address customer needs better is likely to be knowledgeable about customers, and to think fundamentally about user needs. They must also understand technological possibilities and the logic of organization. Put differently, the business model articulates the underlying business or industrial logic of a firm's go-to-market strategy. Once articulated, the logic can be tested and the assumptions clarified. Articulating the business model and testing its logic is necessary for a disciplined approach to making money with a business.

V.Business Models. Business Strategy, and Competitive Advantage

Developing a successful business model is insufficient in and of itself to assure competitive advantage. Gross elements of business models, once implemented, are often quite transparent and easy in principal to imitate. Indeed, it is usually just a matter of a few years if not months before a new business model, once an evident success, draws forth imitative efforts. Business models are usually "shared" to some degree by several competitors.

11

As described, a business model is more generic than a business strategy. A business model explains the value proposition to the customer and architecture [structure] of revenues and of costs for an enterprise - basically, the benefit it will deliver to customers, how it will organize to do so, and how it will capture a portion of the value that it delivers. A good business model will provide considerable value to the customer, while enabling the enterprise to receive monetary consideration for value delivered.

Selecting a business strategy is a more granular exercise than designing a business model. An essential element of competitive strategy analysis is to figure out various "isolating mechanisms" that can be used to prevent competitive advantage from being eroded through imitation. These considerations need to be evaluated and integrated into business model design, even though it's an analytically separate question.

As mentioned, many features of a business model are easy in principal to imitate. For instance, leasing vs. owning is an observable characteristic of business models that competitors can replicate. The "newspaper revenue model" i.e. low cost for the newspaper, use of advertising (including classifieds) to help cover the costs of generating content is easy to replicate, and was implemented with little variation in hundreds of geographical "markets" throughout the world.

Accordingly, having a differentiated (and hard-to-imitate) yet effective and efficient architecture to an enterprises' business model is important. Both Dell Inc. and Wal-Mart have demonstrated the value associated with their business models (Webvan and many other dotcoms demonstrated just the opposite). Their business models were different, superior, and required processes that were hard for competitors to replicate, at least in the US. They have also constantly adjusted and improved their processes over time.7 As Michael Dell (2008), founder of Dell notes:

"This belief - that by working directly with customers we could get them technology faster, provide a better level of service, and provide better value - was

6Outside the US, new entrants could adopt key elements of the model and preempt Wal-Mart, as Steven Tindall did in New Zealand with 'The Warehouse".

7Indeed, a critical element of Dell's success is not just the way it has organized the value chain, but also the products that it decides to sell through its distribution system. The initial products were personal computers, but now include printers, digital projectors, and computer-related electronics.

12

the basis of the business — the fundamental busines s system was quite powerful and delivered lots of value to our customers - we screwed up lots of things, but the one thing we got right was this core business model, and it masked any other mistakes . . ."

Dell's competitors were incumbents who would have difficulty replicating Dell's strategy as selling direct to customers would upset their existing channel partners and resellers. Dell has no such constraints as it was the new entrant.

Over time, Dell developed capabilities around deciding which products to build beside desk top and lap top computers. Of course, the whole strategy depended on the availability of non captive suppliers able to produce at very competitive prices.

As Magretta (2002) points out, discount (big box) retailing had been around long before Wal-Mart; what Sam Walton (Wal-Mart's founder) did was "to put good sized stores into little one-horse towns which everybody else was ignoring" . Once in place, the small towns selected by Wal-Mart couldn't support another similar sized store, so that a difficult to replicate first mover advantage was created. Wal-Mart promoted natural brands at deep discounts and supported by innovative and lean purchasing logistics and IT systems.

Business model choices define the architecture of the business, and expansion paths develop from there on out. Once established, enterprises often encounter immense difficulty in changing business models. Witness the difficulties that American Express and Discover Card have experienced in trying to morph to hybrid models where they simultaneously issues cards themselves and look to third parties (banks) to do so for them as well. Trying to harness banks who are competitors with respect to the issuing function (they also likely to be issuers for both Visa and MasterCard) as partners to issue American Express and Discover cards is incongruous when their main competitors Visa and MasterCard are not hobbled by these relationship conflicts i.e. Visa and MasterCard do not compete with their issuing banks in issuing credit cards. Rather,

8Michael Dell (2008).

9Sam Walton, founder of Wal-Mart, quoted in Magretta (2002), p. 6.

13

they provide network services only10. Visa and MasterCard are thus likely to be preferred partners over American Express and Discover who compete with the very banks they seek to partner with to issue their cards.

The selection of any business model involves significant strategic choices - - - does one outsource manufacturing? Does one disintemediate existing distributors? Which customer groups does one target? Clearly, spreadsheet analysis can help one refine a business model; but business model choices typically involve important decisions based on incomplete information. These decisions aren't easily quantified and modeled. Strategic choices which today we think of as business model choices predated the use of modern computing. Swift and company's model of delivering cattle to a central location for slaughter and processing rather than driving them to point of sale did not require detailed computer modeling of spreadsheets to determine its viability

----even when such techniques are available, they are rarely able to yield grand insights in and of themselves.

In short, innovating with business models will not, by itself, build enterprise-level competitive advantage. However, new business models, or refinements to existing ones, like new products themselves, often result in lower cost or increased value to the consumer; and if not easily replicated they can provide the opportunity to generate higher returns to the pioneer, at least until these features are copied. Developing and implementing business model innovation that either helps enhance the value proposition to the consumer, or enhances value capture opportunities (and hopefully both) is important (and possibly cheaper) than technological innovation. The issue is explored in more detail in the next section.

In this section, consideration is given to factors that affect the ease or otherwise of imitation. At a superficial level all business models might seem easy to imitate. A business model as such is unlikely to enjoy intellectual property protection. In particular, a new business model is unlikely

See de Figueiredo and Teece (1996) for an analysis of some of the ways to mitigate the hazards of competing with ones suppliers.

14

to qualify for a patent - - - even though certain business methods underpinning it may be patentable. Descriptions of the business model may enjoy copyright protection; but that is unlikely to be a barrier to copying the basic "idea" that lies at the core of a business model. What then is it, if anything, that is likely to impede copycat behavior that quickly erodes the business model pioneer's advantage? Three factors would seem to be relevant.

First, implementation of a business model may require systems and processes that are hard to replicate. For example, while at some level Dell Computer's direct-to-user (consumers and businesses) business model is obvious (you simply disintemediate wholesalers and retailers), Gateway Computer (which implemented a similar model) did not achieve anywhere near the performance levels of Dell. This has been attributed to the inferior implementation of processes. Likewise, Netflix pioneered delivery by mail of DVDs using a subscription system; Blockbuster video responded with a similar offering. Netflix held onto its competitive advantage in part because it was not handicapped by Blockbuster's cannibalization concerns, and because Netflix had patents on the "ordered list" by which subscribers indicated online their preferences for movies to view".

Second, there may be opaqueness by outsiders with respect to (1) how a business model is implemented and (2) what elements of the business model are in fact the source of customer acceptability. Rumelt has referred to this as "uncertain imitability" (Lippman, and Rumelt, 1982).

Third, even if it is transparently obvious how to replicate the pioneer's business model, incumbents in the industry may be reluctant to do so because by doing so they would cannibalize existing sales and profits. When incumbents are constrained in this way, the pioneer of a new business model may enjoy a considerable period of limited competitive response. Notwithstanding these constraints, competition is likely to be vigorous because other new entrants, unconstrained by the incumbency and anticannibalization proclivities, might enter also.

Blockbuster may have infringed Netflix's patents as Netflix alleged in a patent infringement lawsuit which was settled in 2007.

15

Consider Netflix's entry into DVD rentals outlined earlier. In order to respond to competitive inroads into its rental of DVDs through Blockbusters stores, from Netflix, in April 2002 Blockbuster purchased assets from NetLearn, including the assets of DVDRentalCentral.com. DVDRentalCentral.com was a subscriber-based, online, DVD rental service. Blockbuster subsequently renamed the business FilmCaddy and operated it separately from the rest of the Blockbuster business. Blockbuster shut down FilmCaddy when it launched Blockbuster Online.

On August 11, 2004, Blockbuster Inc. launched (in the U.S.) its new online DVD rental service (Blockbuster Online) that allowed customers to rent unlimited DVDs (3 out at a time) for a monthly fee. Blockbuster Online's initial plan included no due dates or extending viewing fees, and also gave subscribers two free in-store movie rentals each month. On November 1, 2006, Blockbuster Inc. coupled its online business with its in-store capabilities by launching Blockbuster Total Access, which allowed online customers the option of returning their DVDs through the mail or exchanging them at more than 5000 participating Blockbuster Stores for free-in-store movie rentals.

Clearly, Blockbuster was endeavoring to respond (defensively) to Netflix by offering an ancillary online DVD rental service. Most elements of the Netflix business model were relatively easy for Blockbuster to copy, although of course Blockbuster suffered from cannibalization of its in store rentals by its online rentals.

While Netflix did a lot of work to establish the online market, Blockbuster used its brand equity and its network of physical stores to try and capture value from the model Netflix had created. At minimum, it was intent on minimizing damage to its in-store franchise. Its guiding principle in responding was to offer all the functionality of Netflix plus several distinguishing features that Netflix couldn't easily match - - - such as those associated with the use of its retail store footprint. However, the Blockbuster stores also complemented its online strategy, as customers could choose to return rentals to these stores. Netflix did not have a retail presence and was not able to respond directly to this element of the Blockbuster offering.

16

However, Netflix did have some limited patent protection. Netflix had two patents (numbers 7,024,381 and 6,584, 450) which provided some protection to the Netflix business model -------- in particular, the use of an ordered list from which movies are selected to be shipped to customers. The patents do not cover online rental of DVDs per se; but they did cover methods by which user's pay a flat fee in order to have a maximum number of movies out at any one time and methods in which users can return a fixed number of movies within a fixed period of time.

In short, Blockbuster implemented almost a straight copy of the Netflix business model even with a website that was very similar --------- the stars, the recommendations, the box shots, the

dynamic queue. By doing so, they achieved reasonable success, and undoubtedly blunted Netflix's growth compared to what it would have otherwise been. Blockbuster Online was a good defensive move for Blockbuster.

VII. Business Models to Enable Profiting from Technological Innovation

Technological innovation by itself does not automatically guarantee business or economic success. Far from it. This was a theme in the author's earlier work (Teece, 1986) on "Profiting from Innovation" (hereafter "PFI"). Notwithstanding the recognition by scholars that technological innovation without a commercial strategy is as likely to lead to the destruction of creative enterprises as it does to profitable creative destruction, purely technological innovation continues to be lionized in western society. Indeed, even when executives think of innovation, they too often think exclusively of technological innovation.

However, business model innovation and good implementation coupled with strategic analysis is necessary for technological innovation to succeed commercially. Otherwise, even creative companies will flounder. Quintessential examples of firms that succeeded at technological innovation but failed to get the business model and the technology strategy right included EMI (the CAT Scanner) and Xerox (the personal computer) . But there are a plethora of other examples too.

12 See Teece (1986).

17

Eli Whitney invented the cotton gin13 but died a poor man. Even Thomas Edison with his portfolio of 1000+ patents and personal fame from inventing a durable electric light bulb, electricity as a system, motion pictures, and phonographs failed commercially on many fronts. For example, he abandoned the recording business after arguable failing to get the business

model right ---- he insisted that Edison disks be designed to work only on Edison phonographs14. In short, getting the technology strategy and the business model right is necessary in order to achieve commercial viability if one is to profit from innovation, and build sustainable competitive advantage.

Figuring out how to deliver value to the customer and capturing value while doing so are key issues in designing a business model. Because of imperfections in the market for knowhow, capturing value from the production and sale of knowhow is inherently difficult (Teece, 1981). Capturing value from knowhow often requires a business model where knowhow must generally be bundled with products and complementary assets must be used in order to realize value to the innovator15.

To help managers figure out appropriate business models and technology strategies, the PFI framework adopts a contracting framework (Winter, 2006) and recognizes two extreme modes (models) by which innovators can capture value from innovation: (1) the integrated business model, in which an innovating firm assumes the responsibility for the entire innovation process from A to Z including design, manufacturing, and distribution. Clearly, companies that have the right assets already in place are well equipped to do this; the PFI framework also indicates when there is a necessity to do so ; (2) the other extreme case is the outsourced (contractually licensed) business model. The pure licensing approach is one that has been embraced by a

Whitney's invention (1793) greatly increased the ease with which cotton could be separated from the pod. In addition to not getting the business model right, the early Edison phonograph suffered from poor sound

reproduction, a recording that was too brief, and cylinders that survived only a few playings.

1 An application of the PFI framework can be found in biotech. Pisano (2006) carefully analyzes the sources of failure in the market for knowhow in the context of the biotech industry. This analysis enables one to figure out where intellectual property monetization through licensing is likely to be viable, and where it's not, and where some kind of vertical integration is indicated. Using PFI, one can map business model selection to type of innovation.

The PFI framework can be thought of as an effort to delineate important features of business model choice, and to predict the outcomes from doing so. With respect to licensing versus internalization (i.e. own use), the answer yielded by the framework is calibrated according to the strength of the appropriability/intellectual property regime, i.e. one could license and expect the licensing model to work only if one had strong intellectual property rights. If one doesn't, the owner of complementary assets might well capture value at the expense of the innovator.

18

number of companies, like Rambus (semiconductor memory) and Dolby (high fidelity noise reduction technology). In between there are (3) hybrid approaches involving a mixture of the two approaches (e.g. outsource manufacturing; provide company owned sales and support). Hybrid approaches are the most common, and require strong selection and orchestration skills on the part of management (Teece, 2007).

One well studied situation where there is a value capture problem of serious proportions is investment in basic research and the production of scientific knowledge. Basic research is hard if not impossible to charge for, despite the fact that it generates high value for society. As a consequence, very few firms invest in basic research. Spillovers (externalities) are large, and profiting from innovation is difficult. There is simply no viable for-profit business model for capturing value in a world of open science and rapid dissemination of scientific knowledge through journals, conferences, and professional contacts. Not surprisingly, most basic research is not done by business firms, but by universities and government funded laboratories.

Investment in scientific research is an example of what economists call "public goods"; public goods define a circumstance in which the economic activity in question generates positive externalities. Very often there isn't a (private) business model available to support value capture, and government funding is required. Viewed in this way, the concept of the "business model" can be integrated into almost two centuries of economic thought about the design of institutions and the role of enterprise and government in civil society. Good business models design can be thought of as a response to what would otherwise be a market "failure". A good business model should fix potential market failures. Another way of putting it is that enduring market failures with respect to innovation speaks to the inability of entrepreneurs to come up with business models to enable the innovator to capture a significant position of the value created for society.

Business firms, and in particular small startups, too often offer for sale "items" of technology, such as devices, or a discrete technology component. Without more, this may not represent a customer solution. A business model based on simply selling a component or an "item" may not

19

enable the innovator to capture a significant share of the value generated by the technology, unless that item has ironclad patent protection and is critical in an important application that is already recognized.

The problem is quite general. When value delivery involves employing intangible (knowhow) assets, pricing and value capture are difficult because of the nonexistence of markets. As illustrated in section III above, with the Internet, many services are simply provided for "free" as a way to build brand and to indirectly promote a related value added service. A mixture of revenue approaches is usually required when trying to sell on the Internet. For instance with the proliferation of illegal digital downloads of recorded music, recording companies are insisting on (and sometimes achieving) so called "360 contracts", whereby the recording studios not only participate in revenues from recorded music but also in revenues from branded clothing, performances, and other public appearances. Basically the recording company participates in all sources of revenue - hence the term "360 contract".

To summarize, the traditional revenue model used by innovators to capture value from technology involves selling products that have intellectual property embedded within them (Teece, 1986; Somaya and Teece, 2007). The most common way to capture value from innovation - so common that it is rarely noticed or reflected upon - is that the consumer buys (and pays for) knowhow bundled with the purchase of products. The latest cell phone, digital camera, or automobile doesn't come with a price for the product and an unbundled price for knowhow and/or intellectual property.

However, the traditional bundling model is now starting to change at least at the intermediate product level. As technology markets evolve and become more sophisticated, capturing value is possible either by naked license or by the sale of products and intellectual property, or both. In short, different models of value capture are becoming available as (intermediate) markets for knowhow and intellectual property become thicker.

20