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VCs risk outpacing consumers

When leading companies shoot past the ability of their customers to keep up with new technologies, they lose out on smaller opportunities.

The venture capital industry is ripe for disruption: just like other leading mainstream companies have been for years, according to HBS professor Clayton M. Christensen.

As a keynote speaker at the Angel/Entrepreneur conference recently sponsored by the Harvard Business School Association of Boston and Capitalyst, Christensen said he believes exciting opportunities await those who come up with ideas for other forms of high-tech start-up financing.

When mainstream venture companies become huge financial institutions, he suggested, they become increasingly inflexible in their mandate to chart fast growth. "This is not an indictment of them," said Christensen, author of the managerial bible, "The Innovator's Dilemma: When New Technologies Cause Great Firms to Fail." "This is an absolutely normal progression of economic institutions as they become successful."

In his remarks, Christensen shared his views on how the lessons he's gleaned from his research--both for "The Innovator's Dilemma" as well as studies conducted more recently--might help angels, or private investors, venture capitalists, and entrepreneurs get around one of the heartbreaking paradoxes of success.

Every market entails a trajectory of continuous improvement, he began. In large part, the trajectory is limited by how quickly customers can learn and how quickly their lives and needs can change. At the same time, he said, the pace of technological progress almost always outstrips the ability of customers to use any particular new technology. Many successful companies, therefore, tend to overshoot the mark.

"Microsoft can innovate faster than your life can change," Christensen observed dryly.

When leading companies shoot past the ability of their customers to keep up, he said, they create the potential for a disrupter to take hold: to fill a ready niche and quietly, over time, expand and invade the market.

And as each company gets big and successful, it loses its ability to pursue small opportunities, he added. A company that has $40 million in revenues, for example, that needs to grow at 25 percent next year, has to reach out and find another $10 million in revenue. A company that's $40 billion in size, in order to grow 25 percent, has to find $10 billion in new revenue, Christensen said.

"And there just aren't any small, emerging, high-growth or high-potential markets that are $10 billion in size in any given year."

"That's another reason why it's so difficult for established companies to make the transition and become a leader in an emerging disruptive technology," he said. "The only thing we know for sure is that nobody knows the right strategy as the disruption takes root."

A healthy fear of success
Sounding a further note of caution, Christensen described the disquieting display of hubris that he'd witnessed a year ago by a newly successful entrepreneur. At the conference in question, Christensen explained, a number of entrepreneurs stood up one by one and talked about their businesses and how successful they were.

If a business model appears unattractive to the established players and isn't a sustaining technology to anyone else, go all out. "I remember one fellow stood up and announced that he had started a company 11 months earlier...and they had pulled in $75 million from blue chip venture companies: Kleiner Perkins was one, Greylock was another. And the...valuation was over 700 million dollars.

"And as he beat his chest, the other entrepreneurs in the audience stood up and applauded," marveled Christensen. "I remember listening to that applause and thinking, 'My gosh. If I were you, I would be scared to death.'"

Hewlett-Packard lost ground in the disk drive race, Christensen suggested, because it made what appeared to be very smart decisions based on its great size.

As a case in point, he explained, a group at the company wanted to launch a little disk drive called the Kitty Hawk. It was only 1.3" in diameter, and its proponents thought there had to be emerging markets such as the market for digital cameras and other devices that would need such a small drive. Their idea was "floated" up to senior management, he said.

"There was financial protection in their business plan, that in the first year it would generate $10 million in revenue, in the second year $20 million, in the third year, $30 to $50 million.

"And it was such a piddly small business that management killed the idea," Christensen continued. "The entrepreneurs were so convinced that there was a market for this, however, that they sharpened their pencils and came up with new projections. The new projections were to generate $100 million in the first year, $200 million in the second year..." Preferring these new projections, management approved the plan.

The entrepreneurial team was stuck, though, because in order to even try to generate huge revenues, the team had to forget about "all the little emerging applications" that had once seemed so interesting. In fact, he said, their mandate to get big fast forced them to "cram" the technology into existing markets that didn't particularly care for it. And so it failed.

"Ironically, the revenues the venture did turn in were $10 million in the first year...(but) management killed it because it had fallen so short of where the expectations were."

Tips for aspiring disrupters
Just like other industries, computers and brokerage among them, the venture capital industry itself is also ripe for disruption, he said. While odds always favor the incumbent when a "sustaining" technology is introduced, Christensen offered some strategic advice for potential disrupters, both entrepreneurs and angels.

As new investors begin to evaluate business plans, he said, they should rely on certain litmus tests. One is that the right strategy is unknowable in advance. "Have a strategy to learn, rather than a strategy to implement," he advised. If a technology enables "the larger population of less skilled and less wealthy people to do something that historically they could not do or that only specialists could do," it also has high potential for success, he said.

And if a business model appears unattractive to the established players, and clearly isn't a sustaining technology to anyone else, go all out.

There is great opportunity for institutions and innovative business models to coalesce and emerge as real disrupters, he concluded.

"What role angel investors will play, what role individuals will play, what role corporate venture capital will play in disrupting the traditional venture capital industry, I don't know," he added.

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