When Your Business Model Is in Trouble

An interview with Rita Gunther McGrath. by Sarah Cliffe

Columbia Business School professor RITA GUNTHER McGRATH studies strategy in highly uncertain, volatile environments. She spoke recently with HBR executive editor Sarah Cliffe about how to recognize an oncoming crisis—and seize opportunities to get ahead of competitors.

HBR: Why is there so much interest in business model innovation right now?

McGrath: I see three main reasons. The first is the increasing speed of everything. Product life cycles and design cycles are getting shorter. When the pace of change gets faster, people realize that they need to look for the next big thing. The second issue is inter-industry competition. Competition is coming from unexpected places. Who could have anticipated that the iPad’s success would put all kinds of display devices—like electronic photo frames—out of business? And the third trend is disruptions from business models that offer better customer experiences instead of simply products. Traditional toy retailers are struggling, but Build-a-Bear gets people to pay good money to provide free labor and make their product themselves. Maxine Clark, the entrepreneur who thought that up, was brilliant!

Which industries are facing the biggest disruptions?

You’d do better to ask which industries are not being disrupted. Oil and gas are probably stable. Some consumer packaged goods are, too. But if you don’t have strong barriers to entry or you’re up against shifts in technology or regulation, you’re going to face new kinds of competition. It’s just so easy for someone to come after you once you’ve demonstrated that a market exists.

What are the signs that a business model is running out of gas?

The first clear stage is when next-generation innovations offer smaller and smaller improvements. If your people have trouble thinking of new ways to enhance your offering, that’s a sign. Second, you hear customers saying that new alternatives are increasingly acceptable to them. And finally, the problem starts to show up in your financial numbers or other performance indicators.

There’s always very early evidence that a business model is in trouble, but it usually gets ignored or dismissed. That’s because at most companies the people at the top got there because of their success with the current model—so they have very few incentives to question its durability. So you get a denial reaction initially, followed by desperate attempts to eke just a little more time out of the existing model. The recognition that things must change happens only when it is far too late, and then change is much more painful than it had to be.

Are there any business models—like the experience providers you mentioned—that are on their way up?

Some business models are more powerful than others. Basically, you should look for models that create customer stickiness or loyalty or barriers to entry. Anything that gets automatically renewed gives you a certain amount of stickiness, especially if the customer has to work to change providers. Anyone who has ever tried to move from one cell phone service to another while holding on to their phone number has experienced this—it’s a time-consuming hassle. One reason companies are so motivated to get you to manage your accounts online with them is that once you do, it takes serious work to discontinue the relationship. Anything where your service is embedded into the clients’ service, so that clients depend on you to provide critical steps in their processes, is sticky. IBM, for example, gains this advantage when it takes over portions of a client’s computing processes. In those models customers aren’t going to abandon you unless you get arrogant or greedy. Then there are the platform models. Microsoft is a classic example. It doesn’t just sell application software—it makes a lot of money licensing software platforms to other organizations. Platforms allow you to charge more and to hold on to an advantage for a long time.

What models should be avoided?

Those where the customer buys something once and is done. Also—and this is a bigger problem than you’d think—make sure you have a revenue model! People are starting businesses that give away a lot for free. Sometimes that’s OK if you can experiment at low cost or you have patient venture capitalists. But you really want a model with a clear path to monetization.

Say you’re meeting with a company that wants to reinvent its model. Who should be in the room?

Wait, back up. First you need to have processes in place that cause you to challenge the existing assumptions in your model. For example, Andrea Jung ran Avon very successfully, but then it got into big trouble. One of her advisers suggested that if things were going so badly that she was about to lose her job, maybe she should fire herself on Friday afternoon and rehire herself on Monday morning, and then look at everything in the company with fresh eyes. This led Jung to make some very tough choices—cutting 25% of her own handpicked managers, changing marketing programs, and reversing course on investments she had previously advocated.

So the first step is to build mechanisms that cause you to reexamine your assumptions. One question I encourage people to ask is, What data would lead us to make a different decision? Be sure you’re not getting only information that confirms your preexisting beliefs. Then you can think about what nontraditional information to seek out. You need to get unfiltered information by talking to customers directly and by going through the experiences they go through. You want to get out of the room, in other words. Do your own version of Undercover Boss and see what insights you can get. I’ll never forget an experience I had with classroom participants from a wireless telecom company that was regularly criticized for poor network coverage. When I asked them, “Why are your senior managers not bothered by this?” they said, “We know where their offices are, what routes they take to work, and where they go on weekends. We make sure the network is working in those places.” This insulation from reality can be deadly. You need direct contact with the truth.

Once you’ve done all that, then you can bring together a diverse group—people who know something about the technology, people who understand customer needs, people who have a longer view of where things might be evolving—and develop hypotheses about the areas where you should experiment.

How do you choose among possible experiments to invest in?

You need a portfolio of opportunities. I believe in investing in several options: Some will pay off, and some won’t. Some of them might be mutually exclusive. Verizon, for example, knew that landline telephones were disappearing. A lot of companies would have just milked that business for the cash cow that it was, but Ivan Seidenberg took out investments in four or five mutually exclusive networking technologies and let them run until it became clear which one would be dominant. Then he invested heavily in that technology and shut the others down. Most companies don’t do that. Instead, they fund the one project with the best numbers.

What’s the right pace for change if you’re still making good money from your existing businesses and you’ve got this portfolio of new investments?

That’s one of the most difficult issues—I wish I had a clear answer for you. The best attempt we’ve made is to calculate what we call bare-bones net present values: Make some guesses about when the cash flows from new businesses will come onstream. Then figure out how to get cash out of your declining businesses or find another way to benefit from them. For instance, you can license technology to others who still have an interest in it. You can continue to run the business but outsource its operations to a lower-cost provider. That transition period is tough, but it’s good to spend time thinking through the issues.

I’m guessing that shareholders aren’t especially patient with the messiness of those transitions.

You’ve got that right. If a company needs to get out of a business—take write-offs, get rid of assets—the Street doesn’t like that. But private equity firms like it a lot. A fair number of firms going through a big business model change right now are partially or wholly in the hands of private equity players, and I don’t think that’s an accident. Some of the more-enlightened companies I’ve spoken with have talked about recruiting investors who are willing to be patient.

Do family-controlled businesses have a better record of patient investing?

Without a doubt. Bose recently released a product called VideoWave, which creates a high-end home theater. The company spent five years developing it. That’s a long time to wait for new revenues. But the people at Bose think that because they had the patience to get it right, the premium-price advantage and the business model will last. They can invest in deep science because they’ve maintained private ownership for a long, long time. They’ve looked at the stock market and said, “Nope, not for us.”

I suspect we’ll see a different approach to investment coming out of this wave of business model changes. Think about it: Do the capital markets operate in a way that encourages companies to make the right kinds of decisions as they face large-scale change? I’m dubious.

Anything else companies can do to turn threats to their models into opportunities?

When companies don’t respond to business model challenges, it’s usually because of internally generated problems like the lack of incentives I mentioned earlier and too much distance from the customer. I would encourage managers to think about what internal issues they should be tackling right now. Because when everything’s fine, when your model is chugging along and you’re doing your day job, it’s easy to ignore those issues. Organizations have powerful inertia. It’s like kids. At night, can you get them to go to bed? No. In the morning, can you get them to wake up? No. They want to keep doing whatever it is they’re doing. Organizations are just the same.

Originally published in January–February 2011. Reprint R1101F