What to Do Against Disruptive Business Models (When and How to Play Two Games at Once)

Increasingly, established companies in industries as diverse as airlines, media and banking are seeing their markets invaded by new and disruptive business models. The success of invaders such as easyJet, Netflix and ING Direct in capturing market share has encouraged established corporations to respond by adopting the new business models alongside their established ones. Yet, despite the best of intentions and the investment of significant resources, most companies are unsuccessful in their efforts to compete with two business models at once.

According to Michael Porter and other strategy theorists, managing two different business models in the same industry at the same time is challenging because the two models (and their underlying value chains) can conflict with each other.1 For example, airlines selling tickets through the Internet to fight back against their low-cost competitors risk alienating existing distributors (the travel agents). Similarly, established newspaper companies that offer “free” newspapers to respond to new entrants risk cannibalizing their existing customer base. By attempting to compete with themselves, Porter argued, companies risk paying a significant straddling cost: damaging their existing brands and diluting their organizations’ cultures for innovation and differentiation.2

His view was that a company could find itself “stuck in the middle” if it tried to compete with both low-cost and differentiation strategies.3

The Case for Separate Units

The primary solution proposed to solve this problem is to keep the two business models (and their underlying value chains) separate in two distinct organizations. That is the “innovator’s solution” that Clayton Christensen proposed and that has been supported by others.4 Even Porter has accepted this organizational solution.5 The rationale for this approach is straightforward: Managers at the established company who feel that the new business model is growing at their expense would want to constrain or even kill it. By keeping the two business models separate, you prevent the company’s existing processes and culture from suffocating the new business model. The new unit can develop its own strategy, culture and processes without interference from the parent company.

Sensible as this argument seems, the separation solution is not without problems and risks. Perhaps the biggest problem is that you can’t exploit the synergies between the established company and the separate unit.6 In recognition of the need to exploit the synergies, some academics have suggested an alternative: the creation of separate business units that are linked by a number of integrating mechanisms. Several studies have now identified a number of integrating mechanisms that successful companies have put in place to exploit synergies (see “How to Integrate Separate Units”).7

Why Separation May Not Be Enough

Although the idea of creating separate business units has received a lot of attention, this approach by itself does not ensure success. In fact, there are many examples of companies that have pursued this strategy and failed (such as British Airways with its Go Fly subsidiary and KLM with its Buzz subsidiary) while other companies, such as Nintendo and Mercedes, have succeeded in playing two games without creating separate units.

We have also found that competing successfully with two different and conflicting business models involves more than creating a separate unit. Several years ago, we studied the experiences of 68 companies that faced the challenge of competing with dual business models.8 Our main finding was that only a handful of companies that created separate units were successful in playing two games. Many had created separate units and still failed, suggesting that separation in itself was not enough to ensure success.

If separation is not sufficient, what else should companies do? From 2007 to 2009, we studied 65 companies that attempted to compete with dual business models in their markets (see “About the Research”). By comparing the experiences of the businesses that did so successfully with those that failed, we have identified five key questions that companies need to consider if they are to improve the odds of success in competing with dual business models in the same industry.

Question #1: Should I enter the market space created by the new business model?
Despite popular perception, the markets that get created by new business models are not necessarily more attractive than existing markets. Nor are the new customers who are attracted to the new business models the kinds of customers that established corporations should necessarily pursue. For example, consider the huge market that Internet brokerage created in the United States. There’s no question that it’s a big and growing market. But is it a market that all established brokers ought to go after? Probably not. Consider Edward D. Jones & Co. L.P., one of the leading companies in the U.S. retail-brokerage industry. As John Bachmann, a former partner, commented: “You will not buy securities over the Internet at Edward Jones. That’s going to be true as far as I can see into the future.… If you aren’t interested in a relationship and you just want a transaction, then you could go to E*Trade Financial Corp. if you want a good price. We just aren’t in that business.”9

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HOW TO INTEGRATE SEPARATE UNITS

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The decision to enter the market space that a new business model has created is not (and should not be) automatic. Before jumping in, an established company needs to assess the “attractiveness” of the new market and whether it’s a market worth competing in. Whether or not the new market is attractive will depend not only on its size and growth rate but also on the business’s competences and the likelihood it would succeed in the new market. Appearances can be deceiving. Established corporations should approach the decision the same way they approach the decision to diversify into another market. They must assess not only if the new market is attractive in general but whether, given their own bundle of core competences, it is attractive to them. That involves asking whether their competences can be applied in the new market in a unique way.10 The corporate graveyard is littered with companies that moved into what appeared to be attractive markets, only to discover that the markets were filled with mines.

Many established companies assume that the new markets are just extensions of the old market. For example, how different can the low end of the airline market and the established airline market be? Aren’t they simply two segments of the same market? The answer is emphatically no! The fact is that the new markets are substantially different from the established markets — they are made up of different customers looking for different value attributes. As a result, they require different key success factors and draw on different skills. For an established company, moving into a newly created market represents a risky diversification move and should be evaluated as such.

That doesn’t mean that established corporations can ignore an invading business model — they can’t. But they don’t necessarily have to adopt it. One potential response is to invest in the existing company to make the traditional business strategy more competitive relative to the new business model. Alternatively, the established company can counterattack the business model innovators by introducing a new business model of its own — a “disrupt the disrupter” strategy. There are several options available to a company to respond to an invading business model; adopting the new model is just one of them.11 (See “What to Do When Your Business Model Is Disrupted.”)

Question #2: If I do enter the new market space, can I do it with my existing business model or will I need a new one?
If an established corporation decides to exploit the newly created market that a new business model has created, the second question is: “Can I serve the new customers with my existing business model or do I need a new one?” The answer is subjective, and companies from the same industry facing the same disruption have answered in totally different ways. However, the importance of asking (and answering) this question cannot be overemphasized. It can save an established business an enormous amount of money and time.

Consider Internet banking and the new markets it has created in retail banking. Should an established bank try to serve the new market by adding online distribution to its existing business model? Or does Internet banking require an alternative business model? Most established banks have treated Internet banking as just another distribution method. But the Dutch bank ING Groep N.V. has taken a distinctly different approach. In creating a separate unit called ING Direct and allowing it to develop its own business model and culture, ING has concluded that Internet banking is more than just another distribution channel, something that requires its own dedicated business model.

Companies are being asked to make similar decisions in other industries. Consider the emergence of price-sensitive customers in the auto industry. To tap into the low end of the market, established carmakers are weighing whether to sell new brands to the low end using their existing business model or develop a separate business model. With the exception of India’s Tata Motors Ltd., most car companies have chosen to stay with the existing business model. Airlines are weighing a similar issue: Should they develop separate business models to serve price-conscious consumers (as Southwest Airlines and easyJet have done), or can they cater to this market segment by offering cheap seats and no frills on their existing planes? Many airlines (including Continental, BA, KLM and United) began with the former, but now most are shifting to the latter.

In making this decision, the question is: Do the new customers represent an entirely different market requiring a different set of value chain activities, or are they just another segment that can be served with the existing business model? The way most banks approached Internet banking suggests that they looked at the new customers as just another segment that could be served with their existing business models. On the other hand, banks like ING (with ING Direct) and HSBC (with First Direct); airlines like Singapore Airlines (with SilkAir) and Qantas (with Jetstar); and various companies including Tata Motors (with the Nano) and Dow Corning (with Xiameter) have all looked at price-conscious customers not just as another segment but as a fundamentally different market that required a dedicated business model.

Obviously, there is no “right” way to look at the new customers — a lot depends on how aggressive a company wants to be. Consider Nestlé S.A. To reach affluent coffee drinkers, Nestlé created a new unit called Nespresso and gave it the freedom to develop its own business model. Nespresso operates more like a luxury-goods manufacturer than a high-volume consumer goods company. Nestlé has since developed a new line of coffee makers for discerning coffee drinkers at the low end of the spectrum. But rather than create another business model, it manages the new line (called Dolce Gusto) as part of the established Nescafé division. Same company, similar products, different organizational decisions on the same challenge!

The issue of whether a new set of customers is another segment or a different market is so subjective that some companies treat it both ways. In the United Kingdom, Waitrose Ltd. treats home distribution of groceries as both a segment and a market. On the one hand, it offers home delivery through its existing supermarkets. On the other hand, a new unit called Ocado Ltd. caters to the needs of online customers using a targeted business model.

Why does a company decide to treat new customers as a totally different market rather than as another segment of the existing market? Two important considerations are the size of the new market and its growth potential. The bigger the new market, the more likely the company is to be aggressive and to attack it as a separate market. Another compelling reason to approach it as a different market is that the new market is so strategically distinct from the existing market that the business model doesn’t apply. Still another reason may be that serving both established and new customers with one business model may be so difficult that another solution is necessary.12

However, the most important factor is top management’s attitude toward the newly created market. A recent academic study found that new markets are made up of two types of customers: customers of the established companies that desert it for the new value proposition, and new customers entering the market for the first time.13 Therefore, the question that all established companies need to answer is: Is my goal to limit the cannibalization of my existing market or to exploit the new one? If the goal is to pursue the new opportunity aggressively (rather than defend against the threat), the company will likely choose to approach it as a new market that requires its own business model.14

Question #3: If I need a new business model to exploit the new market, should I simply adopt the invading business model that’s disrupting my market?
Once a corporation decides to enter a new market using a new business model, it faces a make-or-break issue: exactly what business model to adopt. The temptation is to mimic the business model of the disrupters — after all, if that business model worked for them, surely it will work for us. Our research suggests that this is a trap. By adopting the same business model as the invader, established companies end up competing with their disrupters head-on. They try to beat them at their own game by being better than them. Unfortunately, this strategy almost always falls short.

Established companies that succeed in entering the new markets do so by developing radically different business models — different from the one that the disrupters are using and different from the one it employs in its established market. They follow the same logic that disrupters used to attack them. The disrupters succeeded in attacking the main market because they used a disruptive business model. If the established corporations want to have the same success, they also need to utilize a disruptive business model to enter the market that the disruptive business model has created. In a sense, they need to “disrupt the disrupter,” as Nintendo did in response to Sony and Microsoft in the video games console market. Instead of targeting teenagers and young men as Sony and Microsoft did, Nintendo developed the Wii specifically to target families. Instead of emphasizing functionality, speed and superior graphics (as the PlayStation and Xbox did), the Wii stressed ease of use and simplicity. It was a strategy that caught the disrupters (Sony and Microsoft) by surprise and catapulted Nintendo to industry leadership.

To appreciate why established companies need to adopt a business model that is different from the one that the disrupters use, we need to remember, as Christensen pointed out, that the new markets created by the invading disruptive business model are different from the established market.15 That has a serious implication for established companies: Moving into these markets represents a fundamental new market entry and to succeed, businesses need to abide by the cardinal rules of successful market entry.

The most important rule is to adopt a strategy that breaks the rules of the game in that market.16 There are many high-profile examples that support this generalization, including Canon’s success in entering the copier market, IKEA’s entry in the furniture retail business, Southwest’s entry in the airline market and Enterprise’s entry in the car rental market.

Enterprise, which began more than 50 years ago as Executive Leasing, entered a young market that was dominated by Hertz and Avis. Rather than compete with Hertz and Avis for business travelers, Enterprise targeted the replacement market (for example, customers whose cars were being repaired). Rather than operating out of airports, it located its offices in downtowns. Instead of using travel agents, it used insurance companies and body shop mechanics. And instead of requiring the customer to pick up the car, Enterprise brought the car to the customer. In short, Enterprise built a business model that was fundamentally different from the ones utilized by its established competitors.

That suggests that if an established player (1) has decided to enter the market space that the invading disruptive business model has created on the periphery of the main market; and (2) has decided to use a business model that is different from the one it’s using in the established market, then it should design a business model that is fundamentally different from the one the disrupters employ. Although that will not guarantee success, it will increase the probability that the established company will compete with its disrupters successfully.

Question #4: If I develop a new business model, how separate should it be organizationally from the existing business model?
Once an established company has decided to enter the newly created market space by using its own disruptive business model, it must determine how separate the new and established business models should be. We found that asking “Should we separate the new business model or should we keep the two together?” is the wrong way to approach it. A more useful question is, “Which activities do I operate separately and which can I operate together?”

The logic for this approach is straightforward. Proponents of running two separate operations point to the benefits of keeping the two business models apart, the most important being that it allows the new unit to develop its own strategy, culture and processes without interference from the parent. It permits the new unit to manage its business without being swayed by people who might worry about cannibalization threats and channel conflicts. While these benefits are real, separation is by no means cost-free. Perhaps the biggest cost is not being able to exploit synergies between the two businesses. We think there has to be a balance: separate enough to avoid conflicts but not so separate as to prevent exploitation of synergies. That balance can be only achieved if the corporation thinks creatively about what activities to separate and what not to.17

This decision on the appropriate degree of separation must be made for at least five areas:

Location. Should the separate unit be located close to the parent company or somewhere else?

Name. Should the separate unit adopt a name similar to the parent name (as Nestlé did with Nespresso) or should the name be totally different (as BA did with Go Fly)?

Equity. Should the unit be a wholly owned subsidiary of the parent or should the parent own only a certain percentage of the equity?

Value chain activities. Which value chain activities should the unit develop on its own and which should it share with the parent? Frequently, companies allow the new unit to develop its own dedicated customer-facing activities while sharing back-office functions with the parent. That, however, may not always be the best solution, so companies should examine this on a case-by-case basis.

Organizational environment. Should the unit be allowed to develop its own culture, values, processes, incentives and people, or should some of these be shared with the parent? Many organizations allow a unit to develop its own culture while having some common shared values. But that also needs to be considered on a case-by-case basis.

Obviously, there are no “right” answers. Contrary to what many academics have proposed, separate units don’t need to have their own names or their own distinct value chain activities. We know of many companies that did not do this and yet succeeded in operating two different and conflicting strategies at the same time. The trick is to find the company-specific answers that enable the corporation to separate the unit but not isolate it. In that way, it succeeds in balancing unit independence while helping it with the skills, knowledge and competences of the parent company.

Question #5: Once I create a separate unit, what are the unique challenges of pursuing two business models at once?
In addition to deciding which activities to separate and which to keep the same, the business must also decide how to manage the separate unit to exploit potential synergies and achieve true ambidexterity. Several academics have explored this issue and, as a result, we now have a long list of ideas and suggestions on what companies ought to be doing.18

In an earlier research project, we explored this issue ourselves.19 Specifically, we examined 42 companies that had created a separate unit to compete in the new market. Of these, 10 were successful, while 32 failed. We compared the two groups on three dimensions: (1) the amount of strategic, financial and operational autonomy given to the unit (measured on a scale of 1 to 5, with high scores implying that decision-making autonomy was granted to the unit) (2) differences in the culture, budgetary and investment policies, evaluation systems and rewards relative to the parent (measured on a scale of 1 to 6 with high scores implying that these policies were very different) (3) whether the new unit was managed by a new CEO and (4) whether the new CEO came from outside the company or was transferred internally.

We found that successful companies gave much more operational and financial autonomy to the separate units than unsuccessful companies. They also allowed the units to develop their own cultures and budgetary systems, and to have their own CEOs. These are all policies consistent with the notion that the new units need freedom to operate as they see fit. However, we also found that autonomy did not come at the expense of synergies: The parent still kept close watch over the strategy of the unit; cooperation between the unit and the parent was encouraged through common incentive and reward systems; and the CEO tended to be transferred from inside the organization to facilitate closer cooperation and active exploitation of synergies.

Our results and those of other researchers suggest that there are many tactics that companies can use to manage the two business models effectively. But rather than prescribing a laundry list of steps companies can take, we prefer to suggest a way of thinking that managers can apply to their specific circumstances.

One of the most fundamental principles of management is that the underlying organizational environment creates the behaviors in a company.20 By “organizational environment,” we mean four things: the culture of the company, which includes its norms, values and unquestioned assumptions; its structure, comprising not only its formal hierarchy but also its physical setup as well as its systems (information, recruitment, market research and the like); the incentives, both monetary and nonmonetary ones; and finally, the people, including their skills, mind-sets and attitudes. These four elements create the organizational environment that supports and promotes the behaviors that we want in a company.

That suggests that to develop an organization that’s capable of competing with dual business models (what we call an “ambidextrous organization”), we must first ask and answer the question: “What kind of culture, structures, incentives and people do we need to put in place in our organization to promote and encourage ambidextrous behaviors on the part of our employees?” There are many possible answers. Every company aspiring to manage two business models at the same time must ask the question and find the answers that are appropriate for its own specific context and circumstances.