WCM Educational Recap #7: Tech Strategy — The Transition to the Digital Economy

Recapped by Sarah Johnston

Tech Strategy

This week, we looked at the overlap between business and technology, including aggregation theory, disruption, and M&A within the industry.

What is a Value Chain?

A value chain is a series of business activities used to create and deliver a product or service from start to finish; for example, a product may be transferred from the supplier to the distributor before reaching the end-user. The term supply chain is used when discussing movements between firms. There are two ways to make outsized profits in this value chain:

• Gaining a Horizontal Monopoly: Heightening scale and power by acquiring competitors in the same part of the value chain.
• Vertically Integrating Backwards: Gaining a competitive advantage by acquiring a firm elsewhere or developing capabilities in-house.

Scarcity governs the offline economy; the firms distributing the scarcest resources hold the highest power due to a surplus of users compared to suppliers.

Differences in the Digital Economy:

1. Distribution: Digital goods are free to distribute, which neutralizes the advantage pre-Internet distributors leveraged to integrate with suppliers.
2. Transaction Cost: Transaction costs are zero, which takes power away from previous suppliers; aggregating demand, rather than monopolizing supply, generates success within the digital economy.

What are Aggregators?

In the digital economy, companies controlling the demand for abundant resources are the most valuable. Aggregators own and attempt to scale the user relationship. Superior user experience is imperative for supplier success, as suppliers can be commoditized; successful aggregators attract the most users by offering superior service. All aggregators have three key characteristics:

1. Direct Relationship With Users: Aggregators provide a personalized relationship with users; this could be payment-based (for example, Amazon), account-based (Netflix), or use-based (Google).
2. Zero Marginal Costs For Serving Users: Goods are digital and delivered through the internet, and transactions are handled automatically; thus, there is no marginal COGS, distribution costs, or transactional costs.
3. Demand-Driven, Multi-Sided Networks: Aggregators attract customers with a superior experience, thus building their platform and increasing demand as the number of users augments. Customer acquisition costs decrease over time.

Example of Aggregation:

Netflix provides a superior user experience by allowing the user to make a personalized account and offering access to shows and movies from multiple different networks. Netflix’s convenience and strong user relationship, in turn, decreases the value of said networks.

The Law of Conservation of Attractive Profits:

Breaking up a formerly integrated system — commoditizing and modularizing it — destroys incumbent value while simultaneously allowing a new entrant to integrate a different part of the value chain and capture new value.

For example — Airbnb captures value by commoditizing property and providing additional features that heighten convenience, such as reservations, transactions, and messaging.

Integrators vs. Aggregators:

An integrator is a company whose different aspects leverage and integrates with the rest of the company’s value chain, thus keeping the customers locked in its ecosystem.

• Content: Aggregators are content agnostic, whereas integrators are predicated on differentiation. Integrators’ content and services are unique and reinforce their brand.
• Value Capture: Aggregators provide leverage, while integrators capture margin from its differentiated content or services.
• Monetization: Aggregators seek to serve as many customers as possible, whereas integrators seek to monetize customers to the highest possible extent.

Platforms vs. Aggregators:

Platforms provide an interface on which other applications, processes, or technologies are developed. Some differences between platforms and aggregators include:

• Value Chain: Customers buy directly from the aggregator, whereas platforms facilitate a relationship between third-party suppliers and end-users.
• Network Effects: Aggregators internalize their network effects and commoditize their suppliers, while platforms externalize their network effects to create a mutually beneficial ecosystem.
• 3rd-Party Suppliers: Aggregators act as an intermediator between users and 3rd party developers, whereas platforms facilitate relationships between users and 3rd party developers.
• Economic Value: Aggregators capture the majority of the value within their ecosystem, while platforms capture the minority.

Aggregation Theory: Key Takeaways

1. Always consider the industry value chain, then how and which components of the value chain will be disrupted through innovation.
2. Modularization vs. Commoditization: Consider how suppliers will compete — do they have control over the customer relationship?
3. Value Capture: Aggregators capture the majority within their respective value-chains; conversely, platforms, while capturing the minority, can base their value around the ecosystem they create.
4. Consider Incentives: Internal network effects when the business scales point to an aggregator, while external points to a platform.

What is Disruption?

Disruption refers to an innovation that shifts the market’s standards by providing solutions to issues the current industry has failed to address. Not all innovation is disruptive; most technical advancements within an industry are sustaining innovation, which improves the performance of an established product. Sustaining innovation does not significantly affect the existing market, whereas disruptive innovation creates a new market by providing a different set of values and thus overtaking an existing market.

Disruptive innovations are not just breakthrough technologies that make good products better.

The Theory of Disruptive Innovation:

Disruptive innovation is the transformation of an expensive, complicated product into something affordable and accessible, allowing many more people to use the product or service.

There are two dilemmas regarding disruptive innovation:

Incumbent Size: Market leaders have a huge customer base and economies of scale in addition to high growth expectations; conversely, the new entrant can start small, remain flexible, and focus on a niche. These characteristics are beneficial, but there are concerns surrounding whether the innovation will be profitable or desired.

The S Curve: After many product iterations with minimal value, iterations begin to see exponential value increase, resulting in an S-shaped time-performance curve. The dilemma lies in the overlap between sustaining innovation to maintain market leadership and exploring the niche concepts of disruptive innovation — leaders must make sure that innovations are profitable and scalable before investing.

Theory 1: New Market Disruption:

The disruptor develops and dominates a market, which expands and moves closer to the incumbent. Eventually, both products serve the same target market — for example, tablets shifted from an entertainment device to a work tool with the same capabilities of a laptop after the rapid development of the S-curve. Now, more people buy tablets because they are more powerful and cater to the market of laptop users.

Theory 2: Low-end Disruption:

The disruptor serves a niche market the incumbent deems “inferior,” eventually moving upstream as it becomes more widely used. Customers are initially overserved, meaning they consume a product but don’t need all the services.

Characteristics of Successful Disruptive Innovation:

1. Enabling Technology
2. Innovative Business Model
3. Coherent Value Networks

Obsoletion: A cheaper, single-purpose product is replaced by a more expensive, general-purpose product; obsoletion is often a precursor to disruption.

Technology M&A Landscape

There are two types of integration:

Horizontal Integration: Increasing production of goods or services at the same level as the supply chain.

Vertical integration: A company gains ownership and control of multiple levels of its own supply chain.

Most acquisitions fall into one of two categories: scale or scope.

Scale M&A:

• Buyer seeks to increase their presence in a particular market and achieve greater economies of scale
• Buyers usually target a competitor in a related sector or new geographic market
• Mainly bottom-line focused

The goals with scale M&A are to rescue expenses, build a capital base, and expand research and development.

Scope M&A:

• Buyer seeks to expand their scope by moving into a new territory
• Buyers are less concerned with cost and more established
• Mainly top-line focused

The goals with scope M&A are to acquire new capabilities, expand breadth, and diversify the business.