The Problem With Legacy Ecosystems

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This article originally appeared in the Harvard Business Review and was co-authored by XSeed Capital Partner, Robert Siegel, co-founder and CEO of Box, Aaron Levie, and general manager of, Maxwell Wessel.

As automation and digitization transform the economy, well-resourced incumbents in industry after industry are losing out to upstarts. Traditional retailers that have entered the e-commerce space appear no match for digital-native Amazon. Electric-vehicle sales at the world’s most storied automotive companies consistently trail Tesla’s. And even after substantial investments in technology, no taxicab consortium has been able to fend off Uber’s attack.

Why is it that so few of the powerhouses of the 20th century are leaders in the new data-driven world?

The three of us have been exploring that question in a course called “The Industrialist’s Dilemma” that we teach at Stanford University’s Graduate School of Business. Part of the answer has already been suggested by Clayton Christensen and other business scholars. All companies’ internal systems—their metrics, resource allocation processes, incentives, approaches to recruitment and promotion, and investment strategies—are set up to support their existing business models. These systems are generally well established and extremely difficult to change, and they often conflict with the needs of digital business models.

But the CEOs we interview in the classroom pinpoint a different challenge—one that arises because of how value is created in a digitized economy. Many of the most successful business models of the 21st century are built on being able to reach into peoples’ lives, using software that generates information on customer habits and patterns of usage. These digital relationships provide a new level of intimacy, allowing firms to personalize their offerings and better orchestrate how they serve customers.

Most older companies, however, struggle to take advantage of the opportunity to extend their relationships with customers, because they’re constrained by their existing value chains. A network of partners with fixed ways of doing business presents an external challenge, even if the internal challenges that go along with business model reinvention can be overcome.

Firms that have had relatively stable relationships with suppliers, competitors, collaborators, and customers for many years can’t easily shake up those networks. But doing so may be essential for long-term survival. To better understand why, let’s take a deeper look at ways in which the digital era has changed how we create and capture value.

Software Transforms Customer Relationships

Uber’s success is not a story about big data. It’s a story about small data obtained directly from customers in a new way. Uber realized that it didn’t need to amass and analyze vast amounts of information about taxi usage; it simply had to capture the most meaningful piece of information about users at exactly the right time: where a potential rider is locatedwhen he or she needs a ride. And the company knew it could learn that if it had access to the customer’s cell phone. Afforded such access, Uber could make a rider’s experience easier and more convenient than taxicabs did.

Many of today’s most iconic companies share a similar story: Their success is built on an ability to reach further into a customer’s world than competitors do (or than anyone could have 20 years ago). The clearest examples are in the realm of connected devices. Tesla equips its cars with sensors and software to understand how customers drive and to offer them autopilot functions. Nest sells “smart” thermostats, smoke detectors, and video cameras that keep tabs on what’s happening in users’ homes in order to improve energy efficiency and safety. General Electric is reaching into its customers’ industrial sites to monitor assets in real time, providing service alerts and changing maintenance schedules according to data gleaned from embedded software.

But it is not just connected products that enable companies to extend their relationships with customers. Consider Netflix: By instrumenting its apps to detect everything from where customers are geographically to when viewers stop watching a movie, the company is able to understand people’s preferences intimately. The streaming-media giant uses this knowledge to provide timely recommendations and to source—or even create—content that people will love.

23andMe, a provider of genetic testing, also takes customer relations to a new level. Instead of simply sending test results to doctors and hospitals, as most labs do, 23andMe maintains a connection with clients, periodically sending them questionnaires, creating a community through online forums, and pointing people to relevant information about their health and genetics. Such ongoing engagement allows 23andMe to conduct innovative research while spending far less than competitors and continually gaining insights to share with clients.

The ability to connect more personally with customers creates immense opportunity for companies to capture data about the market, supply new products and services, and build extremely defensible network effects and feedback loops. But transforming a customer relationship is not simple; it often requires doing things differently up and down the value chain.

Disrupting Partnerships

Most corporate strategists fail to grasp that software alone won’t transform their business model. Each of the aforementioned companies leverages software in innovative ways, but each also changed how products are distributed and serviced—and even how input materials are sourced.

Let’s return to the example of Nest. Cofounder Tony Fadell told our class that an early differentiator for the company was that it chose to market its first product, the Learning Thermostat, directly to homeowners for do-it-yourself setup, bypassing the typical distribution and installation channel—professional contractors. Why does that matter? Nest’s team knew that only a small fraction of thermostats were ever programmed to adjust a dwelling’s temperature depending on the time of day, the day of the week, and the season—the process was just too complicated. To deliver on the promise of a thermostat that would actually program itself, Nest had to enable the device to learn the customer’s temperature preferences and schedule. And for the software to work best, the team needed to create user profiles, ensure that the thermostat was connected to a home’s wireless network, and confirm that the customer had the Nest mobile app on his or her phone.

Approaching product sales and installation differently made this possible. Without contractors in the supply chain, Nest could develop a user-friendly product from which customers could easily derive value. The company’s decision to abandon the traditional distribution channel committed the team to building a strong retail strategy and a consumer-facing brand. But it disadvantaged professional installers and challenged the existing ecosystem.

As the case of Nest shows, when companies use digital technologies to form new relationships with customers, software development is only part of the process. Sometimes this is because companies seek to change customers’ behavior at various points in the customer journey. Sometimes it is because delivering value involves using the data collected to supplant former partners. In either situation, business models and channel strategies must change in unison—requiring tough decisions that can upset long-standing partners.

The Need for Interdependence

In some circumstances, the shift from an industrial to a digital setting has even more radical consequences for partnerships than what we saw in the Nest example.

To understand why, we need to take a brief detour, to look at what scholars understand about how transformative innovations emerge and evolve. Clayton Christensen, drawing on the work of Alfred Chandler and other business historians, has observed that the need to restructure the extended value chain is common when major innovations are introduced—not just because business models are often in flux, but also because innovative product designs are still emerging. Early in the life of a new product, the inventors don’t have a deep understanding of how to optimize different components of an innovation relative to one another. The first automobile manufacturers, for example, needed to maintain tight control over research, design, and manufacturing. Changes to one part of the car often meant changes throughout the automobile. For that reason, product development required an interdependent network of partners.

Over time, as more standard design architectures emerged, companies developed a sophisticated understanding of how the different components worked together—how transmissions relate to batteries, for instance, and how batteries relate to electrical systems. Components and subsystems could then be modularized. Today traditional automobile manufacturers have the luxury of allowing innovation to occur at the subsystem level; next-generation products will plug in easily to most car platforms. Such broad scope for independent partner activity is typical of mature technologies and mature industries.