business models | aperture

Strategy in the Post-fixed Costs Economy

October 2020

Evaluating strategic options in a world where businesses have never been easier to start, but never been harder to scale

We’ve talked often about the diminishing importance of supply-side economies of scale. In its simplest expression, digitization flips the industrial age equation. What was scarce in the industrial age was supply; what is scarce in the digital age is demand (attention).

In the industrial age, to scale supply meant mass production to spread the fixed cost of large capital investments over large volumes. And the industrial age was an age of mass produced, relatively standardized goods. This applied to goods and services provided by the private sector, but also to state-provided services, such as education and public services.

Since the advent of the internet, this is changing. We first noticed the shift in industries where both supply and distribution could be digitized (e.g. media) because supply became abundant faster and this highlighted our limited attention sooner. But it’s becoming increasingly apparent that all industries are being disrupted as software has eaten the world. More and more physical goods have software components to them, making supply more digitized. Where supply cannot be digitized, distribution nearly always can. And where supply-side economies of scale remain important, they can be borrowed.

Renting scale and the end of fixed costs

AWS was not originally intended to be a platform on which third-parties would run their businesses. But, thanks to Amazon’s business model, it was possible to open up that infrastructure service to others. In doing so, Amazon created a massive and highly profitable business which contributes 65% of group operating profits.

But, as big as the impact has been on Amazon, the broader societal impact has been truly dramatic.

Before AWS, companies had to make large upfront investments in computing hardware – a significant barrier to entry. Even buying hardware was a major source of risk: buying too much could bankrupt a company while buying too little could cause a major bottleneck to growth. And so, AWS removed both risk and cost for new businesses. As a direct consequence, it also contributed to the creation and success of hundreds of thousands of new businesses.

This boost to global GDP over and above the value captured by Amazon itself is difficult to calculate, but it’s certainly very significant. It’s probably not an overstatement to suggest, as Charlie Songhurst does, that AWS has been the single biggest factor in the rise of angel investing.

But AWS is not the only internet era platform. From Shopify to Stripe, examples abound of platforms that share their scale economies to remove the cost and complexity of doing ecommerce – allowing companies to form and start trading faster, with reduced risk and at lower volumes than would have ever been possible.

And not all internet-era platforms are providing digital services. As Rita McGrath, Columbia Business School Professor, discussed on a recent Structural Shifts podcast, by helping establish prices and create trust, digitization is making more and more non-digital assets tradeable on marketplaces. As she put it:

“What we’re seeing with the advent of the digital economy is that more and more transactions can be conducted in markets that used to require a firm.”P

Uber was a pioneer in this regard, but we now see this “uber of x” phenomenon everywhere – even in the enterprise market. At aperture, we are very much an embodiment of this, providing strategy and go-to-market as-a-service that enables companies to avoid the fixed costs and risk of underutilization and underperformance in these functions.

In effect, it’s becoming easier to rent all services, physical and digital. All become liquid and on-demand. Capex gives way to opex or, as Younes Rharbaoui says: we have entered the post-fixed costs economy.

“Signs of a post-fixed costs economy are all around us: companies switching to full remote, increased reliance on independent workers & freelancers, on-demand software where cost matches usage, are all creating lean financial structures for growth.”

And, of course, like many other secular trends, the impact of the pandemic has been to accelerate it. If COVID-19 drew a binary distinction between online and offline services, lifting the former and sinking the latter, then it was disproportionately brutal in its treatment of those offline businesses with high fixed costs – oil companies, airlines, hotel chains and so on. From now on, all fixed cost investments will be more heavily scrutinized and, where they exist, variable costs alternatives will be more actively considered. Even Warren Buffett, a regular character in aperture blogs, is starting to consider the wisdom of some high fixed-cost business models.

The fact is, if fixed costs were already becoming passé, they definitely will be in the post-pandemic world – ushering in a faster transition to a new, internet-era economic structure.

Platforms, aggregators and the long tail

For the best explanation of the difference between platforms and aggregators, we recommend this classic essay from Ben Thompson. In it, he uses the Bill Gates platform definition, namely that: “A platform is when the economic value of everybody that uses it exceeds the value of the company that creates it. Then it’s a platform.”

On this definition, the business we have already mentioned – AWS, Stripe, Shopify – are all platforms. They make the large investments in fixed costs – datacenters, fulfilment centers, payment networks, etc. – that mean their clients don’t have to. They make it cheaper and simpler to do business.

It’s this commoditization of supply and associated end of fixed costs that’s now starting to give rise to a long tail of providers. Thanks to lower and variable input costs, it’s possible to make money at lower volumes than in the past, which in turn means a higher number of providers can co-exist.

Take newspaper publishing, for example. The massive costs of producing and distributing physical newspapers gave rise to significant economies of scale and produced an oligarchical market structure. Compare that with today, when a platform like Substack allows independent writers easily and cheaply to publish, distribute, and monetize paid newsletters. These writers can make a living with only a small audience, allowing potentially tens of thousands of them to co-exist – and giving rise to a broader phenomenon, the “Passion Economy”, where more of us can pursue our craft or our talent and make a living from it.

However, the difference between the long tail as it’s conceived now and the original theory, is that supply is abundant, not demand. The constraint on all digital-era businesses is demand and the gatekeepers of demand – the most profitable actors in the digital ecosystem – are aggregators.

In a world of abundant supply, aggregators help match buyers and sellers. They are in a position to do so because they provide interactive content that rises above the noise to command our attention. When in possession of our attention, they can monetize it by charging advertisers to reach us. This has become the biggest cost for many online companies, accounting for 40% or 50% of the investments they make in growing their business.

As Clayton Christensen predicted in the Law of Conservation of Attractive Profits, as one part of the value chain commoditizes, the value is captured elsewhere. As platforms helped generate an economic surplus, aggregators increasingly captured that value – especially Google and Facebook.

While it has become cheaper to start a business, a sharp increase in customer acquisition costs more than offset these savings.

More precarious

But it’s not just high customer acquisition costs that prevent long tail companies from rising to a size where they exploit scale effects. There are other factors at play.

First, the falling costs of starting a business is a double-edge sword. If one online retailer can set up on Shopify, so can any other. Platform companies are lowering the barriers to entry for everyone, making it harder to defend a business than in the past.

Second, if a business model has network effects and a company can grow large enough to exploit them, this market leader becomes more powerful than an industrial-age leader. This is because, unlike supply-side economies of scale, demand-side economies of scale are subject to increasing returns to scale; the more they exist, the stronger they become. And so, where the industrial age gave way to oligopolies with clearly defined industry boundaries, the internet age gives way to winner-takes-most aggregators, large-scale platforms, and a long tail of suppliers operating across the economy in general.

Third, there’s also one important supply-side economy of scale which makes size important even in the absence of network effects – and reinforces them where they exist. This is the ad score. Basically, the bigger a company gets, the cheaper its relative cost of customer acquisition becomes because it pays a lower cost per lead thanks to a higher ad score (the algorithm that advertising platforms like Facebook and Google use to calculate the likelihood of a customer clicking on an ad).

Effectively, the post-fixed cost digital economy is one where is it simultaneously cheaper than ever to start a business, harder than ever to defend and scale it, and where the returns to scale have never been more important.

If it was hard to cross the chasm from startup to large, scaled business in the industrial era, in the digital age it is harder still.

So where to next?

Let’s look at strategic options for new entrants, from where to play to how to scale.

Where to play

Marc Gruber, a professor at EPFL and former podcast guest, wrote a book on “Where to Play”. At the risk of grossly oversimplifying the narrative, it argues that companies spend too little time thinking about which market opportunity to pursue – assuming a good product eventually finds a market – and instead provides a framework to select the right market before commencing activities.

Like Marc, we believe it makes sense to invest the time upfront to consider carefully where to play, even more so in the post-fixed cost economy. Marc’s book provides the methodologies for this choice, so we limit ourselves here to explaining the rationale.

In a digital world, where returns to scale are bigger, incumbents will be harder to displace. Therefore, it follows that any startup should focus either on creating a new market or, more likely, on market blind spots: the niches where consumers are underserved or overserved.

Underserved and overserved markets

In the digital age, underserved markets are likely bigger opportunities than in the past because geographical limitations are removed. A micro market in one country might be a big market when addressing all countries collectively.

B2B marketplaces are a classic example of this phenomenon.

While there are B2C marketplaces for seemingly everything, many entrepreneurs overlook B2B marketplaces because they seem less scalable. They think that it will be difficult to build a big business if your buyers and sellers are very specialized; that there won’t be a generalized pull effect. Buyers of fish are unlikely to be drawn to a specialist marketplace for, say, cement and building materials. But when you are dealing with a global B2B vertical, a two-sided network is more than sufficient to build a massive business: the wholesale fish market, for example, is worth USD150bn!

Another reason B2B marketplaces are sometimes overlooked is because it can be a long game. Many of the businesses we work with are patiently helping incumbents digitize their offering as a precursor to enabling one-to-many transactions. But their ultimate goal is to become a platform for enabling a many-to-many marketplace.

There are also plenty of opportunities to target overserved customers. As Gary Pisano discussed on another episode of Structural Shifts, companies often push so far with innovation with an existing product or within an existing business model that they overshoot customer demands and leave themselves open to disruption from new entrants providing more user-friendly products or offering more convenience. He gives the example of subscription-based razor blade services like Dollar Shave Club disrupting the overengineered and expensive Gillette razors (“I can only shave so close before it’s scary!”). But this concept of overshooting is especially prevalent in B2B software where, in order to meet the enterprise buyer’s demands, traditional companies have overshot the demands of the end user creating the opportunity for disruptive innovation. This idea is brilliantly expressed in the following excerpt from an a16z article:

“Since effective top-down sales require a highly choreographed (and costly!) dance between pre-sales and the customer, product teams are incented to add more nobs to the product so these teams can sell more value and extract more dollars. Vendors get crossed off the list in vendor discovery if their product doesn’t check all the right boxes for the enterprise buyer, even if many of the boxes don’t actually deliver any value. This often creates a vicious cycle where more complex products give rise to longer sales cycles for more dollars, which then incentivizes even more complex products. For any user of legacy enterprise software, it doesn’t take long to realize that designing a seamless user experience is by no means a top priority for the vendor.”

Direct to consumer

Targeting underserved and overserved customers is what Clayton Christensen refers to as “disruptive innovation” and, as he tells us in the Innovator’s Dilemma, disruptive innovation is about simpler and cheaper products, but it’s also about marketing:

“disruptive technology should be framed as a marketing challenge, not a technological one”

This is even truer today than when Christensen wrote it because digitization opens up new routes to customer. As a result, product, monetization and customer acquisition have to align seamlessly around these new distribution opportunities.

The big trend is direct-to-consumer.

In the retail space, this mostly refers to the phenomenon of avoiding any intermediation – retailers or wholesalers or even any physical retail footprint – to sell directly to the consumer.

In the enterprise space, direct-to-consumer is different. Historically, it was not worth going directly to end users because they didn’t have much influence – or budget. Therefore, it was necessary to go through procurement teams and the choreographed dance of RFI, RFPs and workshops mentioned above.

But what is changing now is that technology products are not just sold directly, but are consumed directly. This makes software-as-a-service a much more disruptive phenomenon than people think: it’s more than a cheaper deployment method, it is a way to circumvent the central buying function and reach the end user.

In this context, it’s clear SaaS companies should have products marketed to end users, simple enough for them to consume without heavy configuration, and priced so they won’t appear on the central procurement team’s radar (e.g. freemium models to test and deliver value ahead of the paywall).

Slack is the example many cite. It markets directly to end users, who can try it for free. Once it has taken hold in an enterprise, it spreads virally thanks to strong network effects (even across enterprises). All the while Slack reaps the benefits by having a pricing structure that reflects usage.

Some argue that it’s harder to make this bottoms-up, direct-to-consumer approach work in areas like fintech, where regulation is important and IT security teams have more muscle. But we see it happening everywhere.

One fintech example that we came across recently, in the context of our upcoming wealth management report, is Hydrogen.

Hydrogen offers a classic bottoms-up approach: a user can provision for themselves a free sandbox environment from the Hydrogen website, pre-integrated with the services they’ll need (like Plaid). The customer only begins paying once they cross certain thresholds, such as API calls. In addition, that also take a jobs-to-be-done approach to solving end user problems by offering discrete services as no-code plug-ins to existing applications, meaning an end user can add a service like tax optimization in minutes.

Avoiding the aggregator tax

Going direct to underserved or overserved consumers is the new playbook for disruptive innovation, but it doesn’t mean companies can avoid the aggregator tax. In fact, costs just get reallocated: in retail, CAC is the new rent, while in enterprise, CAC is becoming the new senior sales rep.

Nonetheless, while unavoidable, businesses can minimize the aggregator tax.

One way is to invest in brand.

A lot of startups seem to believe investing in brand is a luxury. We don’t agree. Marketing is like a pump: first, you have to fill it, if you want to draw it down. Sure, you can generate some leads from well-targeted paid campaigns, but it’s not a sustainable endeavor and you’ll end up paying more to aggregators over time. Instead, you want to run paid campaigns into a customer demographic that’s heard of your company and thinks positively about it, which will improve your ad score and lower your ad cost.

You should also invest in data. Going direct to consumers means you know more about your customers than your industrial age predecessors ever did. It’s critical to capture this information in order to:

– build proprietary routes to customers

– learn more about your users to better target and to aid self-discovery through recommendations

– learn how consumers use the solution so you can constantly improve the utility of the product, everything from ease of purchase to completeness of solving user’s problems.

You must leverage the power of networked buyers. At the most basic level, your product should be differentiated enough that customers will want to advertise it on your behalf. That customer advocacy might come in the form of a positive review or post, but as former podcast guest Julian Lehr highlights, it may also come in the form of signaling.

In addition to advertising, the networked customer can be an acquisition channel.

Wherever possible, you should try to build into your solution the viral features that make the product better when it’s used together with others (e.g. messaging), that lead to customers acquiring other customers. And, even when it’s not possible to build these viral features into the product, it’s possible to build them around the product. A Nike running shoe has no inherently viral features, but the community it has built around its products, the millions who share fitness information, definitely does. And it’s not just consumer brands that can create communities. Consider Salesforce, for instance, which has a community of over 2 million organizing events and sharing content. This attracts others, but also binds together the users in a way which makes it hard to leave the community (by choosing a different product).

Don’t just rent commodities, rent luxuries

If you’ve read this far, it probably won’t come as a surprise that we advocate for renting commodities. Don’t buy your own servers, for example, or write your own accounting software. This will keep operating costs low and variable.

However, we also advocate for renting specialist skills. It allows more cost flexibility and avoids underutilization, but it also reflects a structural shift.

The best people increasingly don’t want to work for a single company. They like the variety and the speed of learning that comes from working across multiple companies and projects. And, platforms are emerging that go further than just matching companies with freelancers – platforms that put together, manage and take responsibility for (the output of) interdisciplinary teams. Effectively, they give businesses greater flexibility and quality at scale and specialists the security and freedom to keep learning.

Achieving internet escape velocity

Brett Bivens, a venture capitalist at TechNexus, came on the Structural Shifts podcast earlier this year to talk about his theory of “Internet Escape Velocity”.

Essentially, internet escape velocity is what happens when a company successfully executes the strategy playbook described above. That is:

– it identifies an underserved or overserved niche

– it leverages internet distribution to reach those customers directly

– it unleashes a growth loop by combining the reinforcing properties of product, distribution and monetization, and

– it uses data and marketing to avoid the aggregator tax

At that point, it hits internet escape velocity, becoming capable of crossing the chasm of precarious long tail supplier to become an aggregator itself, using the pull of its loyal customer base to pull in more suppliers or to launch new own-label services. Brett uses the example of Spotify, which he describes as follows:

“over time, as they expand and gain leverage, podcasts are a higher margin business, social products are a higher margin business, marketplace products are a higher margin business for them. And so, by owning the consumer demand via the lower margin streaming business, they have the opportunity to expand into those areas.”

When a company hits internet escape velocity, it also has the option to invest in fixed assets. As we showed in a paper we wrote with Dave Galbraith in 2016, internet-era companies tend to become asset heavier over time as they seek to entrench their position and deliver better customer fulfillment. But the critical point is that they invest after they achieve a sustainable route to customers. Assets grow like the roots of a tree, downwards from distribution rather than upwards from production.

If, however, a company that hits internet escape velocity doesn’t want to invest in fixed assets, the good news is that it’s never been easier to rent supply in the post fixed-cost economy.

Banking myths: Business models are metal cards | Low LTV #17

Debunking Banking Myths with aperture

What we’ve learned from doing the Structural Shifts Podcast

What the world looks like when seen through “a great series of conversations with people who are building the future”

In the break between seasons — season 2 starts again on September 24th — we thought we’d take stock and reflect on some of the things we’ve learnt from making our podcast.

When we started Structural Shifts (initially without a name, that came from episode 14), it was just an excuse to reach out to and chat with people whose life and work we found interesting. What surprised us was two-fold: firstly, that people liked it and recommended / introduced other people we should interview, making the whole endeavour sustainable; and, secondly, that many of the evergreen topics we set out to explore bubbled up to the top of the people’s agenda and consciousness.

The fundamental transformations that used to quietly shape our world — over years or decades — suddenly became topics for mainstream conversations. The acceleration everyone’s talking about — we felt it too and it has influenced how we make and develop the podcast.

It’s safe to say that doing the podcast has taught us valuable lessons.

“I found this podcast borderline post-modern, and refreshingly frank. A profound look into what’s next. Love every bit! The guests, the music, the format.” — Simone Cicero, Co-Creator of Platform Design Toolkit

A crisis can be clarifying

The worldwide lockdown had wide-ranging effects, some of them even on the positive side. For example, it enabled us to interview thinkers we greatly admire, but who are geographically remote — like Rita McGrath and John Hagel — as well as to grow our audience.

In a world already hungry for meaning, the pandemic triggered a pressing need for strategic thinking. First, it made people pause and reflect on what truly matters — for their lives, work, for the planet.

Then, because institutional and private reactions to the pandemic left many disillusioned, they became determined to gain a stronger understanding of big topics — fintech, internet business models, geopolitics, the climate, the future of work.

We had profound, unhurried conversations with people who are thinking and doing things differently. Their thoughtful observations, distilled from decades of practice and reflection, challenged our received wisdom on a range of topics — from innovation to marketing — as well as encouraged us to entertain contrarian viewpoints.

Instead of a just-do-it mentality, the pandemic reinforced the timeless value of reflection and flexibility, reflexes that all our podcast guests share. If you keep an eye out for it, you’ll notice that in every episode we publish.

Good questions are catalysts for change

Good podcasts depend on two key ingredients: interesting guests and good questions.

Our listeners increasingly took care of introducing us to great thinkers, some of whom — like Brett Bivens or Julian Lehr — we caught on the rise to becoming big stars. And we concentrated on trying to get the best out of the conversations.

In the past six months, we’ve spent a lot more time on research. As our audience grew, so did our sense of responsibility to get the best out of every conversation. Many weekends and late nights were spent reading the books our guests had written, which made us well-prepared — and hopefully improved our the return on our listeners’ time.

Our goal was also, for ourselves and our listeners, to delve into diverse topics such as the ethics of technological change or building a safety net for the self-employed. A risk because many podcasts listeners like to keep digging into a given topic like investing, we hoped to create the context for the cross-pollination of ideas, frameworks, and viewpoints that can serve both professional and personal pursuits.

As the inner workings and implications of the networked age leapt into view for the entire planet, we developed an even keener focus on asking questions that help us have better, more stimulating conversations. Questions are essential to decode, deconstruct, and rebuild our vision of the world as it is — and as it might become.

The case for techno-optimism is one of our favorite examples of such a conversation, providing signposts to use when engaging in mainstream conversations around key topics in tech and their society-wide impact.

“A great series of conversations with people who are building the future. Each one is like having a dinner conversation with a smart friend who has come back from a voyage. I listen when driving or jogging — the miles just melt away and I arrive with a refreshed mind.”

It’s easier to connect when you share purpose and focus

Another thing we noticed while doing the podcast, especially in the past 6 months, is that people who share the same principles tend to resonate (or “click”) more easily when having conversations remotely.

It was surprisingly easy to delve into complex topics with them because everyone was eager to dive in. Maybe you’ve also noticed how small talk takes less and less time in online meetings as we have more of them.

This desire to have important conversations, to support clarity and good decision-making translated into our guests sharing personal perspectives more openly.

What’s more, it was easier to connect with new guests who dedicated even more time than before to share their expertise and experiences. We’re grateful for every minute they spent with us!

Capturing attention in a roaring world is a big challenge

As Herbert Simon predicted, a wealth of information gives way to a poverty of attention.

Our response to this has never been to compete on giving information, but to focus on carefully curated insights. A great fan of craftsmanship, we meant for the conversation — except for maybe the couple we did on previewing the post-pandemic world — to be timeless; as relevant now or in two years’ time as they were the day they were recorded

We also found that the lockdown period — or more specifically the extra time that many people gained through not travelling and commuting — opened up more demand for the long-form product we offer.

“Always insightful and informative. It is a relaxed conversation with people who have had interesting experiences and something to say. Ben Robinson, brings out the best in each guest.”

The Structural Shifts podcast remains one of our favorite projects, in which our enthusiasm for the topic and our guests’ generosity combine to help you see farther — and more clearly.

Helping ourselves and our network to move from scalable efficiency to scalable learning and, in do doing, to prosper in our networked age is why we do the podcast.

We hope it helps you achieve the same.

“I really love this podcast series. There’s not much content like this coming out from Europe. Should serve as an example to others” — Bozidhar Hristov

Our thanks to all of our guests and listeners and to Sarah Mikutel, our podcast editor. In series 2, we’ll be back with more mind-expanding conversations, covering the token economy, the future of finance, the end of globalization, the startup community way, the new precariat and much more…

Changing the Business Model of the Internet (#12)

Structural Shifts with Andy YEN, Founder and CEO of ProtonMail

This podcast was recorded at Fongit — Switzerland’s premier innovation incubator. Ben Robinson is joined into the conversation by Andy Yen — Founder and CEO of ProtonMail — and we discuss the inherent trade-offs that the current Internet present to the users, the importance of privacy and security but also how to compete against Google head-on via business model innovation.

Ben Robinson (Ben): Welcome to the Aperture Podcast. For this episode, we’re at Fongit and we’re with Andy Yen, founder and CEO of ProtonMail. Andy, welcome to the podcast.

Andy Yen (Andy): Yes, thank you. Thanks for having me.

Ben: Andy, I want to start with the idea of trade-offs, which is sort of inherent to the Internet because I mean, it’s become such a sort of integral part of our lives. I mean, it’s completely embedded in our lives. Nobody could imagine living today without the Internet, but the Internet was kind of started on the model of everything being free and that’s come with all sorts of negative externalities. So, I’ll start by asking, have we paid too big a price for the Internet?

Andy: I think it’s the opposite. We haven’t paid a high enough price for the internet. We live in the world where we’re used to getting things for free, but as any economist will tell you, there’s no such thing as a free lunch. Nothing is free. Everything has a cost, and in fact, if you look at the internet today, if you use it for free, if something is free, then you’re actually the product that is being sold and repackaged and actually you don’t bid it out to the highest bidder. So because of that, I think we’re not paying enough for the Internet and we’re paying in ways that we probably don’t understand and we probably shouldn’t be paying, namely today we mostly pay for our Internet services with our privacy in our personal data and that’s a price I think most people don’t realize and understand.

Ben: No, I think you’re right. I think most people would just think these services are free, full stop. And I think also with this idea of surveillance capitalism and the surveillance state and so on. What’s so bizarre, about this state of affairs, is that whenever people thought in the past, in 1984 about dystopias they thought that it would be really intrusive. So the state would be monitoring you in an active way, but actually what we’re doing is we’re surrendering our own privacy. Whether it’s a conscious choice or an unconscious choice, it’s a choice that we’ve made. So, do you think we can ever turn back the clock on that?

To understand regulation really, we need to look at history and kind of understand history. Governments have been in the business of regulating businesses since essentially the beginning of time.

Andy: Well, I would argue that people haven’t actually made a conscious choice, because let’s take an average person. When you agree to a Terms and Conditions, you don’t actually read it. You don’t know what you’re consenting to. In fact, we have no idea. If you imagine a 13-year-old child on social media, cause that’s the age in which you’re allowed to go on social media now without parental consent.

Ben: So there is actually now some notion of parental…?

Andy: Well there’s always been a notion of certain minimum age. It’s not really adhered to and respected. It’s not really verified.

Ben: I didn’t even know that was the case.

Andy: Yes, by law, it’s supposed to be 13 in most countries. If you take a teenager going on Facebook or social media for the first time, I would actually say they don’t really understand what it is they’ve consented to. They don’t realize the implications of giving up their data forever. They don’t realize that at the time that they’re posting a photo on Snapchat or on Instagram that this data could come back and haunt them for decades better. This is not what you think about in your first social media experience. So we haven’t really surrendered. We haven’t really consented. In some ways we’ve been sort of tricked into doing this and I think that’s an important distinction, because consent must be informed and without information, you cannot willfully consent to something.

Ben: And what role should the government play here? Because I didn’t even realize there’s a minimum age. But clearly somebody, somewhere has set a minimum age because they understand that anything like drinking or having a gun or whatever… there are some… you want a person to have a certain level of education and to understand the implications of what they’re doing. So there have clearly been some small efforts here to try to safeguard the consumer or the individual, and we’ve seen Europe issue GDPR, again sort of top-down pieces of legislation to try to safeguard the individual. We have these cookies, laws and things. Is it possible in the same way as you know, I asked you if we could turn back the clock and change customer behavior? I don’t think we can, but can we protect customer behavior through legislation?

You vote with your wallet in many ways and that decides the future of any industry. If consumers decide that electric cars are the future, then that’s the future. If customers decide that they want to have more privacy in the future, then that’s where things are going to go.

Andy: Well, the customer behaviour point we can revisit later, cause I’m not sure I entirely agree that we cannot change customer behaviour. Let’s talk about a little bit about government regulation. To understand regulation really, we need to look at history and kind of understand history. Governments have been in the business of regulating businesses since essentially the beginning of time. If you look at, for example, finance. That’s another industry that is quite widespread, known for some pretty bad abuses, things like that. The first Stock Exchanges appeared maybe in the 17th century, but the first legislation really only came after the Great Depression. It was the Securities Act of 1933. And then onward, even that wasn’t enough. We had a financial crisis in 2008 and then more regulation came afterwards. So what that really shows is regulation and governments in particular, it takes time.

Ben: And they’re also reactive as well.

Andy: Yes, reactive as well. So you cannot say, let’s rely on government regulation to keep us from going off the edge of the cliff because historically, that has never been the case. They regulate after you got to the edge of the cliff, and if you want to take action before then, I think it needs to come from the private sector. It cannot be government driven. Government will not drive the change in this area, because they historically never have done that.

Ben: And what about the consumer? Because you see a different kind of model in China, for example, where there’s an expectation from the consumer that they do need to pay for a lot more services in China, so some of the things that in the UK, US and so on are free, like this podcast. In China, there’s an expectation you pay for podcasts. So do you think the role of the private sector working together with the consumer is to try to actually create a price for using the Internet?

Andy: Well, I actually think China is not a very good example here, and I’ll tell you why.

Ben: Yes. I think it also has very strong trade-offs.

Andy: Yes. In China, there’s surveillance capitalism and surveillance in general. You are not fooling or tricking anybody. Everybody in China know they live in a surveillance state. They are aware the government is spying on everything that they do. They have the ability to read all their personal information. This is kind of a known fact. They live with it. And in fact, I would say that they have a much higher awareness of the risks of surveillance than Western society, because in China you write the wrong thing online, you end up in jail. Here we don’t have that sort of pressure and that’s not part of our everyday reality. So in fact, they’re not being tricked because they know exactly what’s going on. Whereas in the Western world, in fact, most people have no clue. It’s not part of their daily reality. So that’s why you cannot compare with China because the level of awareness is completely on a different level.

Ben: And so just to revisit that idea of it won’t be the government that solves this, or at least proactively or in advance of whatever the next scandal is, so you’re saying it’s more the role of private companies and possibly I would argue private companies in alliance with the consumer. So how do you think that will play out?

Andy: Well, ultimately when you look at an industry and how it evolves, it always comes down to consumer choice. Consumers will make a decision and their decision translates to how they pay for things, their wallet. You pay with your wallet. You vote with your wallet in many ways and that decides the future of any industry. If consumers decide that electric cars are the future, then that’s the future. If customers decide that they want to have more privacy in the future, then that’s where things are going to go. My view and the reason that we’re doing ProtonMail and working so hard in this space is we actually view privacy as an innate human need. It’s something that everybody has a need for. Whether you realize it or not is another question, but you do have that need. You have your passwords on your accounts. You have curtains on your windows. You have locks on your doors because we have an innate need for privacy and that need for privacy so far hasn’t translated to the Internet yet, but it will. It’s just a matter of time.

Google’s business model, Facebook’s business model, this is not something that can be hidden forever. People will eventually figure it out.

Ben: And do you think it can happen without education because maybe we can go back and discuss customer behaviour. But in order to change my behaviour, I have to realize there’s something wrong with that behaviour or at least the risks associated with that behaviour. So you can have a situation where suddenly the private sector allows us choice. For everything, we have two versions — the free version and the paid version and one gives us privacy. One sacrifices that privacy and we make that choice. How do we make the consumer aware and make that informed choice? Because at the moment as you said, they’re not making a conscious choice because they’re not aware of those inherent trade-offs.

Each time there’s a scandal, there are always spikes in new users, but you don’t build a business or change an industry based on spikes. What you need is a strong underlying trend, and that trend is not going to be based off a scandal. That trend will be based off of user awareness and user knowledge and user sophistication, and that really comes naturally.

Andy: Well, there’s a couple of things there. First of all, to make a choice, there has to be a choice, and until ProtonMail came along, there really wasn’t a choice. You wanted email; you’ve got it from a service that was going to invade your privacy and mine your data. That was it. So what industry and private sector can do is a) we can provide that choice. That’s the first step. Once you have the ability to make a choice, then it’s just a matter of time in some sense, because Google’s business model, Facebook’s business model, this is not something that can be hidden forever. People will eventually figure it out, and the reason their awareness today is higher today than it was, let’s say 10 years ago is because the technology is newer. Back then, people didn’t really understand it. Now they do. And in 20 years, of course, more people will understand.

Now certain things like education. Certain things like data breaches and scandals, these things will accelerate that trend, but knowledge tends to spread and the information will get out and that’s why it’s really just a matter of time. So what we are controlling an industry is providing the choice and then seeing what we can do to accelerate that shift.

Ben: And then do you see in your own business, in adoption and so on a positive correlation with the things that you were just saying, like scandals, you know. So after Cambridge Analytica, did you suddenly see a spike in demand and interest for ProtonMail?

We are trying to change the business model of the Internet

Andy: Yes. So each time there’s a scandal, there are always spikes but you don’t build a business or change an industry based off of spikes. What you need is you need a strong underlying trend and that trend is not going to be based off a scandal. That trend will be based off of user awareness and user knowledge and user sophistication, and that really comes naturally. The first time you go on Facebook, your first thought is not how do they make money, but after seeing some ads that are suspiciously like what you’ve searched for and hearing some stories from people who have used the service and know more and maybe friends who are well educated, you slowly begin to know. So that knowledge permeates out into the society, but it takes time. It’s not overnight.

Ben: You yourself used the term change an industry, and the industry you’re trying to change is a very big industry. And so implicit in what you’re doing is that you’ve got just massive ambition, and also you are really early with this. In preparation for this, we watched your TED Talk and you were saying things back in 2014 that people have only really started saying recently about these sorts of negative externalities of a free Internet. And so a) how did you get into this? And b) how do you arrive at wanting to sort of take on Gmail and Google and the biggest corporations in the world? I suppose most people would have thought this is a great business, but it’s just so big and scary that I’m going to do something smaller. So how did you arrive at this and how do you manage with a business that has such ambitious mission?

We think the Web today is not really reaching the full potential of what it was created to do.

Andy: Well, I think what you mentioned earlier, and I think back in that TED Talk, we are trying to in fact change the business model of the Internet. Because the only way that our mission succeeds is if you build a new business model, and the business model cannot be around advertising. so that’s of course very ambitious cause it’s trying to disrupt an industry that today is maybe over two, $200 billion a year. So that in fact is the mission, and I don’t think you’d go into this with that in mind. You don’t go into a job and say, okay, I want to disrupt a $200 billion industry. Some people maybe go in that way, but the way that I went into it and the way that our team went into it was we saw a need. It was a need that we think is important. Not just…because there’s a business here, but really because of the social impacts. Democracy relies on freedom of speech. Freedom of speech relies on having privacy. It’s all connected. So we solved the social angle that was very, very important. And that’s what made us decide that we needed to pursue this. And I think a lot of that comes from the history of the company. It was founded at CERN. It’s created by scientists in fact. The World Wide Web was also created at CERN, so we had a connection to that.

Ben: You had a kind of symmetry there.

Andy: Yeah, and we saw how the Web had transformed. It was invented to foster communication. It was invented also to build a better world, and we think the Web today is not really reaching the full potential of what it was created to do. It’s become in many places actually a tool of oppression. And for us, the key thing is we need to try to reverse that trend somehow by providing choices and options and tools for people, and that is really what drove us into the business. After coming in, I guess we’re not stupid, we realize that it’s quite challenging, of course, as you say, but we think this is something that’s very important to do, success or fail. Someone needs to do it. And I think that’s the reason why most people go into Science, because you do it because somebody needs to do it. And we thought that calling to go out there and do it.

The encryption needs to be fully automatic, fully transparent and invisible to the user. And that is really, our goal, and in many ways our main innovation.

Ben: So I’m guessing you’re a physicist?

Andy: Yes, that’s correct.

Ben: Yes. So you’re a physicist, and that’s how you ended up at CERN, and how you go from CERN to creating software to change the Business Model of the Internet?

Andy: I think the joke is that it’s all Math at the end of the day.

Ben: Correct.

Andy: So, in fact it is all math. It is all logical reasoning. So the great thing about physics is basics. You can kind of go into essentially any field out there. What physics does, it doesn’t teach you any specific skill so to speak, but it teaches you how to think. So in fact, quantum physics to new technology was not a huge jump.

Ben: And tell us how it works, and by extension, the business model for it. How you make it pay?

In ProtonMail there’s a strong network effect, because if you want to protect the entire network, you want to get your friends and family to use the service. And that’s something that has been driving the growth because if you want to protect your whole community then you also get them on the same system. And we see more and more of that as we continue to grow and scale.

Andy: The business model is a freemium. So that means you can use it for free. But if you want more advanced features and services, then you have to pay for it. So, in essence it’s quite similar to Dropbox and it’s either you pay for the service or the service is going to sell you to pay for itself. That’s the model that we picked for the service. It works by using something known as end-to-end encryption, and what end-to-end encryption does is it encrypts data on your device before it reaches our server, and the beauty of that means that all the data that we store on you is encrypted in a way that we actually can’t access. So, this guarantees you two things.

One is privacy because if we can’t get your data, we can’t sell it to third parties. It’s as simple as that, but also it gives you security kind of for free, and that’s because the data that we store is encrypted. If we were to get hacked or breached, a hacker cannot steal from us something that we don’t have. So, really security and privacy go hand in hand. There are actually two sides of the same coin. And that’s why I think it’s really important because it’s not just for privacy. It’s also for security and cyber-crime today is one of the biggest challenges that we’re going to face in the 21st century. So, it sort of solves both of those problems at the same time.

Ben: Yeah. And what I like about it, to revisit that point from earlier is, doesn’t really require any behavioural change. Instead we carry on doing what we always do, which is emailing many people at once, big attachments, all the things that are a little bit risky, but this time they’re encrypted. So if you like, you’re not asking people to change behaviours that have grown up with the internet, you’re just protecting that individual from exposing themselves to the risk of hacking.

Our mission is to make privacy accessible to anybody in the world that wants and needs it. And we subsidize that through people who do pay us.

Andy: Yes, yes, exactly. And I think that’s really, really important because if I go out on the street and ask anybody, would you like more privacy and security? No one’s ever told me “No” to that question. It’s always, who do I give up? What do I sacrifice? What’s the trade off? And our mission, if you want to sum it up in the sentence, is to make that trade off zero. So we know we want to reduce all the technical hurdles, reduce all the user interface hurdles and make it as simple and as easy as the services you already use that don’t have encryption. So the encryption needs to be fully automatic, fully transparent, invisible to the user. And that is really, our goal, and that’s actually in many ways actually our main innovation.

Ben: And so if you send me an email, which you have, from ProtonMail, it comes into my email server displayed in a way that’s like every other email?

Andy: Yes, yes, that’s correct. Now in that situation, obviously my inbox is encrypted. Everything on my side is secure, but if you’re not using ProtonMail, you are using Gmail, then of course Google will get a copy of your email. And that’s why in Proton there’s kind of a strong network effect, because if you want to protect the entire network, you want to get your friends and family on to use the service. And that’s something that has really been driving the growth because there’s obviously still value in protecting your own data, your own inbox. But if you want to protect your whole community of people on contacts, then you also get them on the same system. And we see more and more of that as we continue to grow and scale.

There’s sort of like a hidden transfer of wealth there, but that is in fact needed to create a more equitable and just world.

Ben: So really pleased that you raised that because I was because I was going to ask you about Customer Acquisition Cost and the speed of adoption and so on. So, there are two things, based on what you said that really would suggest to me that this would have very low customer acquisition costs. One is the freemium model. And so the first question is what percentage of users eventually become paying users? And then the second model is to what extent are the network effects really driving user adoption?

Andy: Well, we know that the largest segment of growth, so the single biggest reason that people use ProtonMail today is actually word of mouth referrals. So network effect is in fact the biggest driver of growth. So that’s that then I think freemium is also important, but for us, freemium is really going back to the mission of the company. Our mission is to make privacy accessible to anybody in the world that wants and needs it. And you can only do that by offering the service for free. I’ll give you example. We have a VPN service as well, and the country that has the most users of Proton VPN is actually Iran.

Ben: Okay.

Andy: They’re under sanctions. So in fact, they don’t have credit cards. They’re not tied into the banking system. They have no way to pay us, and if the service wasn’t free, then those hundreds of thousands of users in Iran would get cut off. So that’s why for our mission to succeed, in fact, we must make it free to make accessible and we subsidize that by people who do pay us.

Ben: So there’s actually… I don’t know if you’re familiar with this term… shared value transactions. But it’s this idea that the heaviest users or in this case, the most demanding users maybe pay for all the features that are then offered to everybody, and you only need a small number of those people to become paying users for the whole model to work. So what’s the conversion rate on freemium into premium in your case?

I think a lot of people pay for the service really to support the ideals of the company and what it stands for. And they pay because they know that privacy matters. They care about it.

Andy: Well, it depends a lot on country. And the way a service like Proton works because we’re so global is in fact you essentially have the First World subsidizing the Third World.

Ben: So it’s like probably what the model for climate change.

Andy: Exactly. I think that’s actually a good thing because in fact, there’s sort of like a hidden transfer of wealth there, but that is in fact needed to create a more equitable and just world. So I think that’s actually a good feature. And conversion rates of course are much higher in Western Europe and the US. They’re much lower in places where people cannot afford to pay, but we’re okay with that because overall, we have a model where it’s sustainable, it’s profitable. So that means it can continue to grow and it’s a cycle that fuels itself and that’s what we need to have a business that can survive and be stable.

Email, I would argue is actually the most meaningful passport of the 21st century. In the 20th century, your identity was tied with your passport. That was who you were. That was how you verified to the world who you were. That was how you accessed all the services that the world could offer you. Today, everything’s moving online, and every online service that you sign up for is actually linked to your email.

Ben: What is the trigger point to go from freemium to premium?

Andy: It’s very hard to say. It depends on the person.

Ben: Sorry, to ask it in a different way… it’s a set of features that I sign up to that then makes it premium, right?

Andy: Yes, that’s exactly right. So paid accounts have certain features which are not available…

Ben: Such as?

Andy: Well, you can have additional storage, additional features like auto-responder on emails. So it’s a subset of features and storage that you need you don’t get on the free account, and that’s what is driving conversion. But I think a lot of people pay for the service really to, I think support the ideals of the company and what it stands for. And they pay because they know that privacy matters. They care about it, and if they don’t pay, they simply won’t have the privacy anymore. Someone needs to pay something if you want to have this option. So it’s really about keeping a private option available to the world and I think that’s very important.

Ben: And then do you have many businesses that adopt ProtonMail for all of their employees?

Andy: Yes. So today there’s probably between 20,000 and 30,000 businesses who are using the service. They obviously all pay, and for business the value proposition is very clear. You can go to a cloud but still keep control of your data. That’s important to a lot of banks and financial industry customers. But then secondly, is your communications within the company are secure and private by default because every employee will be automatically security-encrypted.

Ben: Because when you laid out the binary choice earlier between either having privacy in your email communications or not having privacy in your email communications, and you said you had this sort of free options like Gmail or the paid options like yours. There’s a third actual option, which is you use your corporate email account, but in which case the corporation you work for can see everything that you’re seeing and doing. Right? So I’d argue that there are actually three choices for individuals. Would you agree with that? But in this case, I guess the corporation allows you free access to email that’s secure and where they can’t spy on you.

the best way to protect data is to not have it in the first place

Andy: So actually, I would argue against that… because what is email fundamentally? Email, I would argue is actually the most meaningful passport of the 21st century. In the 20th century, your identity was tied with your passport. That was who you were. That was how you verified to the world who you were. That was how you accessed all the services that the world could offer you. Today, everything’s moving online, and every online service that you sign up for is actually linked to your email. It’s your online passport, and the idea of using your corporate email account doesn’t actually work because that would be like say, your employer is your identity. It’s not true. So that’s why for that reason, you know, that’s not really an option for most people.

Ben: It’s so true because that’s happened sort of insidiously, which is so many services just say sign up using Gmail, sign up using Facebook. And again, unconsciously you don’t think about the ramifications of that. But you’re right, it’s become way more linked to our identity than…I mean, you saying that it’s made me realize, wow, that’s true, and I hadn’t even thought about that myself.

Andy: Yes. So Gmail isn’t just, let’s say controlling your data. They’re also controlling your identity in some ways. And you don’t realize that when you set up for it. But that’s what is happening. And that’s why we feel it’s very important to have an independent identity, which is built on the idea of privacy and security at its core and respecting your rights online.

Ben: Some people make an argument … I obviously know where you stand on this, but some people say the genie’s out of the bottle. We can’t go back and reclaim our privacy. So almost more logical would be to make everything transparent and if everybody could see everything, then there’ll be less abuses of our rights. Where do you stand on that? How do you challenge the logic and the soundness of that argument?

Andy: Well, I would ask that person that tells you that for their email password and see they give it to you.

Ben: Good point. And so I can imagine that many people for many reasons — because they want to challenge what you’re trying to achieve in your mission, I imagine you’re the subject of attempted hacks a lot. How do you counter that?

Andy: Well, the best way to protect data is to not have it in the first place. So the way that we counter that is simply by encrypting as much as we can so that we don’t have anything that can be stolen from us.

Ben: But if they solve — I don’t know exactly how it works — but if they can figure out the encryption keys, then they can get access to the encrypted data.

Andy: To this day, not possible to break the encryption that we use. This of course maybe won’t be the case two decades from now, but we encrypt data in a way that even the strongest supercomputers in the world theoretically should not be able to crack the data. So it is for all intents and purposes inaccessible to a hacker.

Ben: And so that’s one risk. I think so you’ve convincingly argued that you were ahead of that risk. And I suppose in the same way that the sophistication of hackers will grow, the sophistication of the technology you use will also improve. So it’s a race, but for now you’re ahead. The other big risk I guess is coming under pressure from governments to just hand them the data… Because a bit like Apple says you know our devices are encrypted and safe and so on, and then the US government says we want access to it. Have you come under that kind of pressure? How do you deal with that?

Of course encryption and security technology can be abused, but there’s a very strong benefit which is: we need to secure our data and secure our future because the future is data and the future is online. And the social benefit from that outweighs the risks that may come as a result of this technology.

Andy: Both the answers of course is Yes. Like any major tech company, we do come under that type of pressure. We’re based in Switzerland. Switzerland has very strong privacy laws and a strong history of protecting privacy. So that is obviously a very strong advantage. But the technology also works. If you do the technology properly, in fact, there was no way for us to decrypt the data, so it’s mathematically not a possibility.

Ben: So you couldn’t, even if you wanted to, decrypt the data you have on your servers?

Andy: Yes. That’s the point of intent encryption, is that it’s encrypted before it comes to us and we don’t have a way to decrypt it.

Ben: So your argument is simply, no matter how much pressure you apply, we simply can’t respond to your desire.

Andy: Exactly. But there’s also a third aspect to this, which is that the opinion of governments has shifted quite a bit from 2014. In 2014 it was, okay, encryption is a major threat to national security. Now the conversation is we need more cyber-security because they’ve seen the hacks and the scandals and the issues of the past five years. So in fact, governments that were maybe pushing and trying to pressure us in 2014, some of them are now our customers.

In 2010 Mark Zuckerberg basically said that privacy is no longer a social norm. He comes out this year and he says privacy is Facebook’s main focus now.

Ben: Really? I was going to ask about users. We’ll come back to it.

Andy: Yeah. So this kind of shows a shift in how the attitude has changed because people realize that in fact we’re not just providing the privacy but also security, and security is the key to securing the 21st century digital economy.

Ben: Yeah, and again, coming back to this point, I just think it’s Canute-like to sort of say, okay, let’s roll back what we’ve put in place and instead it’s much better to say what we’ve got in place that’s secure. And that’s what I really like about everything that you’re saying. The mission — obviously everybody buys into the mission — but also, it’s a mission and a business that doesn’t require… it doesn’t introduce loads of friction into our lives basically, because we’ve got used to friction-less experience using the Internet.

Andy: And the other way to look at this is Does encryption come with certain risk? Of course, it does. It’s not black and white. Yeah. Is it possible that terrorists could use something like ProtonMail? Of course, but we also know that they also use Facebook. They also use Twitter. They also use buses and planes. You cannot possibly ban everything a terrorist could possibly use. The way you address this question, the way you look at it is you say, what is the overall social benefit? And when it comes to trains and cars and planes, of course they can be abused, but there’s a very strong benefit there as well. And it’s the same for encryption in security technology. We needed to secure our data and secure our future because the future is data and the future is online. And the social benefit from that outweighs the risks that may come as a result of this technology.

Ben: So we’ve started to touch on a couple of times, but now, if you don’t mind, delve into a bit like who uses it? So I imagine, millions of individuals like me use ProtonMail, but I’ve read on your website, you were talking about the activists that use it. You’ve said governments sometimes use it. I guess terrorists could use it as you said. So who uses it and what do they use it for? First of all, give us a sort of breakdown of the demographics of the kind of people that use it, and then is there anything about their usage that makes you uncomfortable as a CEO?

Andy: As a web service and a email provider, the users are basically anybody that would use Yahoo, Gmail or Microsoft. It’s the same spectrum of people.

Ben: Is it though, because I guess particularly, I don’t know…I mean, we’ll come back to numbers of users if you could share that with us, but I imagine particularly beginning, the early adopters were people who were hot on this idea of privacy in a way that others weren’t.

From the beginning of time the Internet was actually not free. If you look at things like Hotmail and Yahoo, in the early days those services were not fully free. The free Internet and free Internet services is a relatively modern invention in history of Internet. It really came in the mid-2000s. So it was paid first, it became free and now is shifting back towards being paid again.

Andy: I think in 2014 that was true, but today with more than 20 million users, it’s really kind of come into the mainstream and everybody will have a reason to use a service like this. People that want privacy and security. It isn’t just the paranoid guys or the government people or the journalists or the activists. That’s a need that actually even your mother might have. In fact, I would say, of course, we may not have as many mothers using ProtonMail, compared to let’s say, you know, Gmail. But that demographic is represented. So we capture actually the full spectrum globally, but it’s really people that have a higher awareness. What links them together is not what the field, they work in their backgrounds or where they live, but relieve their level of awareness of how the internet works and their level of concern for privacy and security.

Ben: And that 20 million number, that’s staggering. The first time I ever heard you speak was at an event here at Fongit and I was blown away by what you’re saying, the ambition of what you’re doing. But even then, which is I think just a few months ago, the number wasn’t anywhere near 20 million. So that would suggest to me that you really are seeing these network effects kick in. It’s like exponential type growth.

Andy: Yes. The growth is pretty rapid right now. It’s really because of awareness. People are just more and more aware today than they were in the past. If you go in 2014…, 2010, Mark Zuckerberg basically said that privacy is no longer a social norm. He comes out this year and he says privacy is Facebook’s main focus now.

Ben: So do you believe him?

Andy: Of course not, but the fact that guys like him have shifted tone so dramatically in the past decade really shows where things are going, and that’s why I think if the awareness is up and we want to be ready, we want to have the service that people can rely on, and we want to really be part of the change that we want to see in the world.

Ben: And do you see more users or greater adoption in countries where their privacy is potentially at greater risk? And do you see — and I suppose you don’t even know that much about the demographics — but do you see, just to go back to this topic of activists cause you yourself were talking about this in one of your blogs, is it people and places where their privacy is more at risk?

Andy: I think adoption is certainly higher in those communities. Among journalists and activists, it’s very, very popular. A lot of people are using it. But if you look at our VPN service in Iran, that’s a huge user base there as well. So of course, if you have a need and if it’s something that your life depends on, you’re going to use it right, and you’ll use it may be potentially more and preferentially more compared to somebody else who isn’t at risk. So there is of course a correlation.

Ben: Where do you stand on freedom of speech? Because activists are using your platform to defend their freedom of speech and to defend their freedom of protest, and somebody like Mark Zuckerberg, let’s bring him up again. I suppose he would make any argument that would absolve him from taking any responsibility for protecting freedom of speech. Where do you stand and what are the limits of freedom of speech if we can’t see what people are saying?

Andy: I think freedom of speech is obviously something that’s very important. It’s the cornerstone of modern Western democracy right now. Can freedom of speech be abused? Sometimes. There’s hate speech, there’s hate crimes, there’s far-right and far-left people who can abuse services like this. Email though, which we do is inherently a private conversation, and what you say in private, in fact is protected. Now if you use technology like Twitter or Facebook or even ProtonMail to let’s say, espouse far-right hate speech, then that is actually against the law. That’s against the law in Switzerland and we as a company would adhere by Swiss law. And I think on topics like this, it’s important for tech companies to really follow the law. We cannot take on the role of judge, jury, executioner, adjudicating and passing judgment on these types of issues. We must adhere and respect the legal framework.

Ben: And so just again to get back to the idea of the legality of some of these things and therefore government’s role in regulating the Internet, do you remember the law that was passed in the Clinton era that essentially absolved lots of these internet companies from taking responsibility for any of this stuff, from having any responsibility for safeguarding the truth on their platforms? Do you think it’s time to change that law then? Because if you’re saying that ultimately your responsibility is to adhere to legal frameworks, do those legal frameworks therefore need to be upgraded for the internet age?

Andy: Well, ProtonMail for example as a mail service because mail is private communications, is a complete separate category from other social media where it’s publicly view-able. So this discussion for example, wouldn’t really apply to a service like ProtonMail, which is private communications. Now the law — I do know the law you are talking about, what this basically says is platform providers like Facebook and Twitter cannot be held liable for the content that is posted by their users, because the user is actually the author of that and my personal view is, in fact, I think that law is in fact correct because you cannot…it’s probably in many ways almost impossible to force platform providers to really police everything that is said and posted on their platforms. I think it’s actually impossible. Where I think there does need to be some more strengthening is that if something posted is false, defamatory, or malicious, there needs to be ways to probably legally compel the take down of such information after it’s proven to be false, defamatory or malicious.

Ben: Do you think they have a responsibility themselves for that kind of fact checking?

We have a ‘don’t cut any corners’ type of philosophy. The trade-off of this is we are probably higher cost than our competitors. We probably develop products more slowly than our competitors, but I would argue that we also provide a product that is higher quality, more secure and more private than our competitors. You must make trade-offs all the time, and in any sort of project, any sort of business, you need to decide where in that space you want to position yourself.

Andy: I would say there’s a moral responsibility to do that, if not a legal responsibility

Ben: I’m not sure morality and ethics is high on the list of some of the people that run these platforms.

Andy: I would say they’re more concerned about their profit margins and their bottom and top lines, and spending time checking content and responding to legal requests is probably not very cost efficient. So yes, most of the platform providers probably hide behind this law and say it’s not our obligation, but I do think they do have an obligation to remove data that is just false and wrong.

Ben: Do you think it was a sort of necessary step that we needed some sacrifice of our own privacy in the beginning to get the Internet moving? Would you argue it was a necessary precondition to widespread adoption for us to be giving up some of our privacy and now has come the time to solve, now it’s adopted in our lives to then just tighten up?

Andy: Yeah. Well the Internet was never really free to begin with. You pay for your internet service; you pay for internet protection. In fact, from the beginning of time the Internet was actually not free. If you look at things like Hotmail and Yahoo, in the early days those services were not fully free. The free Internet and free Internet services is a relatively modern invention in history of Internet. It really came in the mid-2000s, so it was paid first. It became free and now is shifting back towards being paid again.

Ben: So you argue it needs to just go full circle?

Andy: Yeah, yeah.

Ben: Where do you stand on net neutrality?

Andy: I think it’s important to protect it. I think we need it. Without net neutrality, you essentially give big companies certain advantages that smaller people cannot compete with.

Ben: Yeah. So you would argue it was a mistake to make that change?

Andy: Yes. I think net neutrality is important for the future of the Internet. That’s my personal view.

Ben: So are you campaigning for it to be reintroduced?

Andy: Well, I’ll give you an example. In the UK there’s a new law that allows ISPs to censure various websites if they believe it’s adult material, and our VPN service — Proton VPN — was mistakenly categorized as adult by some ISPs. And the ISPs are very hard to get in touch with and not very responsive, and in fact, the only way to solve this issue is to make an official complaint under EU net neutrality rules. So that’s an example of a small company being able to compete in a market because of net neutrality. So in fact I think it is very, very important and without that, you don’t have innovation. If we didn’t have this legal recourse to do this, then we’re at a disadvantage because a big company like Google will never get blocked because they are too big.

The network effect moat protects us in the encrypted space, but that’s maybe the 2% of the market that we’ve captured so far overall. The opportunity is the other 98% of Google users who are not on the system yet, and to go after them, you must innovate. You must be better. You can’t just be more secure and more private.

Ben: Want to talk a bit about the scaling journey you’ve been on. So you’ve got 20 million customers, which is …again, I’m staggered by that number and I guess you’re adding tens of thousands a week or whatever the number is. What have been the challenges along the road to scaling this business to that extent, and what trade-offs have you had to make because clearly you want this to be the most secure, but that costs lots of money. Clearly you want this to be as economical as possible for the users, but that’s a difficult thing to achieve and to produce a really high quality. So what trade-offs have you made and what have you learnt in scaling a business to this level?

Andy: It’s no different than any other business actually. There are three levers that you can control. There’s cost, there’s time which is related to cost to some extent, and there’s quality. If you want high quality and high security, invest more time and as a consequence of investing more time, you are investing more money, and all businesses to some extent are automating these three levers and depending on the company you go to, they are could be on very, very different sides of the spectrum. For us, security and privacy are our core business. Quality is very important. So we’ve optimized the business in such a way that we care about quality first and costs and time are sort of secondary. So we have a ‘don’t cut any corners’ type of philosophy. The tradeoff of this is we are probably higher cost than our competitors. We probably develop products more slowly than our competitors, but I would argue that we also provide up a product that is in the end, higher quality, more secure and more private than our competitors. You must make trade-offs all the time, and in any sort of project, any sort of business, you need to decide where in that space you want to position yourself.

Ben: And who do you see as the competitors? Cause presumably you would put people like Gmail in a completely different category. They are not a direct competitor.

Andy: I think today in fact the competitor is Gmail, cause if you look at where most of our new users are coming from, they’re coming from legacy email services. They’re coming from Google, Microsoft, Yahoo, even AOL sometimes, so they are in fact our biggest competitor. And if you want to think about the future, that’s the target that we need to aspire to go after.

Ben: But is there another secure email service offered on a freemium basis? Is there anybody else who has exactly the same business model as you out there?

Andy: Oh yeah, of course. After we entered the space and opened up the space, a lot of people came in as well. This is sort of normal for any other space, and I think that’s actually a positive thing. It’s good to have more competition, more activity and more attention on your space because that drives innovation, that drives growth and competition’s always good in my mind. Us being sort of the first movers into this space and being by a significant margin the biggest player, that’s something that is quite durable because there is a network effect here..

Ben: Any business with network effects tend to be ‘winner takes most’ markets. That’s right.

Andy: And I would say communication apps in general also follow that sort of trend. So that is inherent advantage for us being in this space. But at the same time, we’re also not the ones who just kind of sit on our hands and say, we’re happy. We want to push innovation in the space. We want to continue maintaining our level of quality and we want to keep doing new things and doing things better and better. So that remains our key focus because we must do that if you want to take down the real competition, which is Google.

Ben: Yeah. I think what you’re saying is interesting because when you have got a business that is underpinned by network effects, the temptation is just to sit back and let them kick in, because it becomes such a strong moat. But what you’re saying is you’re not resting on the network effects moat. You’re also pushing the innovation moat as well.

Andy: Yes. Because network effect moat protects us in the encrypted space, but that’s maybe the 2% of the market that we’ve captured so far overall. The opportunity is the other 98% of Google users who are not on the system yet, and to go after them, you must innovate. You must be better. You can’t just be more secure and more private. You also need to be maybe easier to use, faster. You have to look nicer. It needs to be more stable. You’ have to compete on all these other things that people care about as well.

Ben: Yeah, they do. And would you argue today that your service is it’s the most widely used? Would you also argue it the most secure?

Andy: I would say so, yes. What I also want to say is there’s no such thing as a hundred percent security. By definition it doesn’t exist. Any system can be compromised and can be hacked. All we can do on our side is adhere to best practices, don’t cut any corners, do things as carefully as we can and engineer the cryptography in as strong a way as we can. So these were things that we try to do. It’s a reason that we use cryptography that’s open source and open standards which have been embedded by the community. So we do our best to check every single box, but I think it’s irresponsible and not honest to claim that things are 100% secure because they by definition cannot be 100% secure.

Ben: So I would imagine that everybody that’s listening to this now wants a ProtonMail account. I want one. How do we get one? And if we’re a business, how do we port all of our existing email addresses onto the Proton network?

Andy: Well, if you are a consumer, you just go on the website, get an account. That’s it. If you’re a business, we have an importing tool and we also have a customer support team who is there to help you with the migration. And we’ve migrated probably hundreds of companies just in the past month. It’s something we do all the time and we’re also improving these tools so they’re getting better and better every single month. Our whole ride is to make it easy.

if you can leverage the potential of all of Europe into one company, then in fact you have access to a bigger talent pool at a lower cost and you have more raw materials here than in the US

Ben: Just to get back again cause I think we talked about this scale of the ambition for the company, which is great, but what was the sort of Eureka moment where you were like, okay, that I’m going to stop trying to discover whatever you guys are doing at CERN and if you want to tell us what people do at CERN, that might be also be interesting, but how do you go from that to something like okay, I’m going to launch a secure email system service?

Andy: Well, I think as scientists we have natural curiosity. So there really wasn’t an Eureka moment in the sense that you thought about the problem and said okay, let’s do that. It was more like; this is something that I, myself would like to have. I like to have email that is secure and private, and if you’re a scientist, I guess the benefit of that is you can actually build your dreams.

So we just actually went out and built it ourselves cause we had the know-how to do it. And after we did that, we simply released to the public. We said, okay, we built this. Now you can come and use it. And when we released it, we discovered that a lot of people had the same desires and same wishes as us, when it came to security and privacy, and this was something that we didn’t expect. We didn’t anticipate, we didn’t project or foresee. It was just let’s do it for the sake of the science. Let’s do it for the sake of having technology, and then, as they say, the rest is history.

Ben: The last thing I want to talk about, so when I saw you speaking at the Investor Day here at Fongit, I mean I was struck by the ambition, keep talking about this. But the other thing that I found really sort of heartening was that a business with this potential scale is a) in Europe, because we don’t have many platform-type companies in Europe and b) in Switzerland. And so I think you’ve talked a bit about why you’re in Switzerland, because you worked at CERN centers in Switzerland. There’s an inherent advantage because Swiss privacy laws are very robust. But are there other advantages to being in Switzerland? Have you at any point thought okay, this is such a big business now. I think we need to take this to California?

Andy: Yeah. Of course, we get asked this question quite a bit. Investors in particular ask this question so why Switzerland and why Europe?

Ben: I’m very pleased that you’ve chosen Switzerland and Europe, so, I’m not challenging you…

Andy: I think it’s an important question. I can start from a couple levels. What is the most important thing for a tech company to survive and thrive? I would say the most important raw material, if you will, of our industry is raw talent, and if you consider Europe, not Switzerland but Europe as a whole, this is a population here of around half a billion people. That’s a bigger population than the US and it’s a highly educated population.

So if you can leverage the potential of all of Europe in one company, then in fact you have access to a bigger talent pool at a lower cost and you have more raw materials here in fact than in the US, so that is from a high level why it makes sense. And I think the fact that we want to do it in Europe and leverage its potential also explains Switzerland in some ways because Switzerland is maybe the most cosmopolitan country in continental Europe. It’s the place where you can bring Germans, Poles, Spanish and French and Romanians wherever into one place, and they can all feel at home and feel welcome here, and it’s only by leveraging all of Europe that we will succeed.

I think Switzerland also has various, in addition to the strong laws, it also has a lot of support structures for startups like us. There is Fongit where we are based, which is offering a lot of support in the office space, organization, management in helping us to operate the business. There’s State of Geneva, which is very open providing whether it’s funding, advice, whether it’s tax breaks or other sort of support. These support structures make it a lot easier for us to run the business and focus on growth instead of worrying about other things. So I think it’s this combination of factors that made it so that we were able to succeed in Switzerland and continue to grow within Europe.

Ben: I don’t know if you were there, but Neil Rimer from Index Ventures, he gave a presentation on where he thought Switzerland was at in terms of attracting and retaining great digital-age businesses. And even if you weren’t there, the slide was circulated on social. You may have seen it, but he basically had pluses and minuses and I think there were more minuses than pluses, and you’ve talked about many of the pluses that he talked about. We haven’t addressed the negatives. So he was talking about the high cost of living, the difficulty sometimes getting visas for people. Have you encountered those kinds of problems? I guess the high cost of living, for sure.

In Zurich, you’re in a talent pool that is much more conservative, much more risk averse and much more corporate in a certain sense, whereas Geneva, I would say people here are more willing to take risks. They’re more of the startup mindset, and that’s another reason why we build our base here and I think we are now more successful than we would be if we would have gone to Zurich.

Andy: So actually, on the visa and permit side, having a close relationship with the State of Geneva has essentially solved that issue for us. So we’ve never had any issues there. I would say cost is in fact a problem. The cost of living is very high. Geneva is better than Zurich in the sense that you’re close to the French border, so you can sort of reduce the cost of it that way. This is why I recommend actually Geneva over Zurich, which is not a popular opinion in Switzerland, but that’s my opinion. But I think you can’t build a business like this just in Switzerland. You also need to leverage other offices, other locations in Europe, and that’s what we’ve done. We have other offices in other locations throughout Europe which allow us to bring the overall cost basis down even further.

Ben: Where are your other offices?

Andy: So we have offices in Prague. We have offices in Vilnius in Lithuania, and also in Macedonia. So these locations help to kind of lower the average costs in Europe. Then I think the other thing is when it comes to costs, yes, Switzerland is expensive, but you have to look at the alternatives. If you’re not building a tech company here, then the only logical place you would actually go is San Francisco. If you compare Swiss costs with California costs, in fact, we’re quite a bit cheaper here.

Ben: Really?

Andy: Yes.

Ben: I am slightly surprised cause so housing, wages, these things are now more expensive in California?

Andy: Yes.

Ben: Okay.

Andy: Yes. So it’s completely shifted in the past five years. I think in 2014 they are about the same. Today we’re maybe around 30 or 40% lower in Geneva compared to San Francisco.

Ben: Wow!

Andy: Yeah.

Ben: And I also liked the fact that you’re challenging the received wisdom of Geneva over Zurich. That’s cool. Earlier on today as I was introduced to some of the members of your team and the first thing that you observe is it’s very multicultural. The second thing is these guys are very young. Very smart and very young. The third thing you observe is there aren’t actually that many of them. So would you also argue that to create a platform business today, you don’t need hundreds of thousands of people that you might need to create a really large industrial age business? So that also perhaps gives an advantage to places like Switzerland where you can get very high-quality talent and you don’t need hundreds.

Andy: I think to scale you do need a lot of people. There’s no way to get around the need for people. But it is true that if you hire very smart people, very talented people, and that you leverage the newest technologies, it’s possible to do a lot more with the same amount of people that would have been possible even one or two years ago. So, in fact it’s true. You don’t need that many people to run a pretty massive business, but you still need people. It’s still your main raw material and the fight for talent is still going to be the main thing. And the other reason I say Geneva instead of Zurich is also kind of mindset and competition. The competition is all for talent and in Zurich you’re fighting against some very big established players and…

Ben: Including your nemesis…

Andy: Including Google, yes, but not only that. It’s that you’re in a talent pool that is much more conservative, much more, I would say risk averse, and much more corporate in a certain sense, whereas Geneva, I would say people here are more willing to take risks. They’re more of the startup mindset, and that’s another reason why we build our base here and I think we would actually be maybe more successful than we would be if we would have gone to Zurich.

Ben: Last question. We’ve talked about the company journey. What about your personal journey? So you’ve gone from scientist to CEO of what is now becoming a really big business. What has that transition been like for you?

Andy: Well, I think in terms of what I do on a day-to-day basis, obviously there’s a big transition because I had to learn new things, figure it out, learn from mistakes obviously, and also do things that maybe I wasn’t trained to do in my schooling. So that’s obviously a transition. But I think what is also very important is yes, you need to change and evolve, but it’s also important to stay the same in many ways, to hold onto your core ideals and remember and keep in mind what is important. And I think for our business to succeed, we must also keep in mind always that’s our main focus. Why are we here? Why do we get up in the morning? It’s not to create a huge fortune. It’s not to become the next Google.

We don’t want to become what we’re fighting. What we want to do is we want to stay true to our ideals — freedom, democracy, privacy, security, serving the world, serving the community and serving the users first. And that’s something that I think my role now in the company is to make sure that we retain that for as long as possible and to make sure that the new people that come in understand that that is what makes us different. And that is what makes us important and able to carry out the mission that we want to do.

Ben: Wonderful. No better way to finish than that, with your description of why this business is so important and why it’s so different. I think it’s inspiring and I’m delighted that you’re based here in Switzerland. Andy, I just wish you all the best with your mission, and I hope the trajectory carries on being as exponential as it’s been. And I thank you very much for coming on the podcast.

Andy: Thank you.

Strategy is dead. Long live strategy! (#5)

Structural Shifts with Markus Menz, Professor of Strategic Management at the Geneva School of Economics and Management

Together with Markus Menz, Professor of Strategic Management at the Geneva School of Economics and Management —part of University of Geneva — we explore the role of corporate strategy in the networked age.

February 2019: “Spatially dispersed corporate headquarters: A historical analysis of their prevalence, antecedents, and consequences” — co-authored by Markus Menz, along with Sven Kunisch and Julian Birkinshaw
2017: “Determinants and consequences of corporate development and strategy function size”, Markus Menz and Fabian Barnbeck
1937: “The nature of the firm” — Ronald Coase

You can follow Markus on LinkedIn.

Ben Robinson: For this episode we are talking strategy… Our guest for this episode is Markus Menz, who is professor of Strategic Management and Vice Dean for Development at the School of Economics and Management at the University of Geneva. Markus, welcome, Thank you very much for joining us.

Markus Menz: Thanks for having me.

Ben Robinson: How long have you been teaching in the area of strategy?

Markus Menz: I’ve been teaching strategy for more than 10 years now. I actually joined the University of Geneva in 2015, so now about four years there. Before that I was teaching on the faculty of the University of St. Gallen. I was teaching strategy there for six years and before that I spent a year at the Harvard Business School, I did research there… and prior to that I did a PhD at the University of St. Gallen.

Ben Robinson: Ok. I guess, I guess since you’d been in the profession for 10 plus years, you… like us, have seen lots and lots of change in how strategy works. Maybe you can kick us off by just giving us some kind of definition of how you see strategy, how you would define it.

Markus Menz: I mean, strategy in general, I would still say is very much the same than, than 10 years ago, at least when it comes to the, that’s a more general definition. I can give you an idea of what I understand a strategy and what I usually, explain as being a strategy. Strategy is to me still, and there are referred back to let’s say as the old days of strategy to Michael Porter and others, who said, strategy is about making clear cut choices.

I think that’s still true for today. Strategy is about making choices and it is about deciding, what to do as, as an organization, as a firm, and what not to do. And that’s the harder part of that question actually. And to me that’s still relevant, even though nowadays it may have changed how strategy is being done, what the topics of strategy are about. And of course, also who is involved in strategy these days. But the core question to me is still the same of question of strategy. It is about making choices and deciding where to compete and deciding how to compete and making choices where not to be active. And this leads to what I would refer to as a fundamental trade off between being strategic on the one hand and being opportunistic on the other end. And we’re gonna discuss this probably a bit further later on, but to me that’s very complicated.

Ben Robinson: Do you think that line, is that where the line has changed in strategy? Cause I think the way you, the way my Michael Porter defined strategy, the way you are defining strategy, where it’s about choices and in particular the bit that people forget… choosing what not to do. These were, these are almost timeless concepts, right? Strategy defined like that we’ll look, we’ll always be relevant. But, so I guess the question is more in this self dichotomy between what is operational and what is really strategic. Is that where the line is changing? You know, I guess another way to express it would be, is his strategy becoming more about how to compete and less about where to compete?

Markus Menz: That’s a fascinating question to me and what is relating for me is the challenge to define what kind of time horizon strategy concerns. And well traditionally strategy is being defined as being concerned with the long term and Alfred Chandler said it’s about, the development of the company’s long-term goals… and to subsequent allocation of resources to reach those goals.

[min 5]

And, I mean this was done based on a study of industrial enterprises back in the 1960’s. So, it is something that was true back then. That strategy is concerned with the long term and what the long term means. I would say to me strategy is still about making choices that matter for a certain time horizon. But the question is what kind of time horizon do you consider. And that depends very much on the context you are in and the context has changed and therefore also the time horizon of strategy has changed to me.

Ben Robinson: But do you subscribe to the view of that just simply planning horizons have shortened? Or do you also believe that the companies can operate with more than one time horizon? I mean, the reason we ask that is because, you know, we we’re a big fan of this sort of zoom in zoom out theory. If, you know, you can plan on a horizon of say, five years or 10 years when you’re making very big decisions about product strategy for example. But, on a more operational basis, you’re maybe trying to optimize on a sort of nine to 12 month window? So I guess the question is, have time horizon shortened or have they bifurcated or multiplied?

Markus Menz: I mean, referring to the first point, we do have evidence for that. The time horizons have generally shortened strategy. So, we did, for example a regular studies. Where we surveyed chief strategy officers over the leading 500 companies in Europe. And those senior strategists indicated to us, over the past couple of years, that the strategy horizons have shortened from close to five years to a bit more than three years. This was something that we could figure out in our surveys. But of course, and I can come back to your second part in a minute. But of course this very much depends on the context again and I see as a deciding factor still what kind of industry sector you are in. So what is your investment horizon, for example? Are you in a software, environment? Are you in a industrial environment, for example, or in a service business? So it’s very much dependent on that.

Ben Robinson: Does the data that you’re referring to, do you see noticeable differences depending on the sector? Like it does TMT companies have a shorter horizon than manufacturing companies?

Markus Menz: Yes, they do… there’s a variance across industry sectors. Definitely so, it depends on the industry sector. And then the question is, that’s the second part of your question. Well are there different time horizons to consider, from what I can see, I would say yes and I would say, that a greater alignment or unification between operational tests and short term strategic or tactical decisions, has become visible on the other hand. And it refers to the longer time horizon, I still see that there is a need for companies to have a long term vision. Or I mean you could use vision as an analogy here for, for strategy. But I think that’s still very decisive to decide where the company should, should be heading at. Not just over the next six to 12 months, but in the long term.

I mean you, when you use this dichotomy, I’m of course, I’m asking myself what is it with the time in between and how to operate between those time windows. That’s a challenge that I see is to align the two.

Ben Robinson: But yeah, I think, and I don’t know if you have evidence to this effect, but it seems to us that the, as you say, but keeping a very long term time horizon, strategy is a constant. The idea that the business model shouldn’t change every 12 months… but the execution part becomes a rolling consideration that, you know. And then the time horizons can be whatever you want them to be, but that’s just a rolling consideration versus the constant that sits above it. Because you wouldn’t want things like brand strategy, business model changing every day, you know?

Markus Menz: No. But the challenging part here is to ensure that the rolling part, that the operational part doesn’t run across, your long-term vision. And what I see, for example, very often in organizations is that they — in larger organizations — is that they have two different ways of doing strategy. The one is a classic strategic planning process or where they have, I don’t know, a three to five year planning horizon window or even longer than that depending on the industry. And then they have more, this… well, which I would, I shouldn’t say opportunistic, but which I would call maybe the more spontaneous strategy process. Which builds on very specific strategic initiatives that they launch depending on the opportunities that are arising. And, and they adept those initiatives relatively fast and those two processes are usually aligned. But of course you need to ensure that they stay aligned over the course of the development of the organization.

[min 10]

Ben Robinson: Those longer term strategic planning exercises… I think we could argue whether they’re becoming obsolete. But I mean, it seems very much the case that they still happening at least according to your research.

Markus Menz: Yeas, at least when it comes to larger organizations and also when I talk to startups for example, or fast growing businesses. What I see is that they typically, they have still a vision. I mean it’s not as explicitly formulated or articulated and yet they don’t have necessarily a dedicated strategic planning process, but the team has a clear idea of where to go and what to focus on. And on the other hand, they usually are very good because of the scarce resources, probably they’re very good in prioritizing short term activities. So in coming up with dedicated actions plans where they prioritize for example, as the top three priorities over the next couple of months or so. And that’s a different from very large corporations where you don’t have typically those very specific priorities defined at the top level.

Ben Robinson: But I guess that leads onto the, to the questions that I wanted to ask you, which is to what extent have those strategic planning exercises evolved? Because, clearly, you know, I guess if we go back 10 or 20 years that there would have been exercises that were carried out by a small number of executives. Independently the rest of the organization and they would, and the strategic objectives would have been passed top-down, right? Very much as a directive, this is what we’re going to, this is what the plan is for the next five years, three years, whatever the number, the horizon was… go and execute. Have you seen a shift towards a model that’s closer to the startup world that you’re talking about, there. Where more people are empowered to develop strategy more people are involved in the… Or, there’s a better connection between the people who execute the strategy and the people to formulate the strategy?

Markus Menz: There have been significant changes, I would say also in the mindset of top management, how to do strategy. And you can consider a number of dimensions, for example, you can consider, first of all, why do you do strategy? This has changed. I mean it was, very often in the past, it was considered something necessary. I mean, I still remember when I consulted 10 years ago a company, a medium sized company in Switzerland, that was asking me to develop a strategy with them. But basically it was a CEO, he just wanted to have a written document as kind of a justification of what they were doing. And so this mindset I think has changed. Meanwhile top management, I don’t know any company that doesn’t consider strategic choices as, as strategic priorities and formulating them as something unnecessary.

So it’s the opposite, they consider it quite important. And so as the question is, who is doing it and why? And the who, I mean, strategy has become much more inclusive. That’s what I see in, I mean, on average and in organizations. But particularly in, also in organizations where in the past you wouldn’t expect it from. So, large industrials for example, who do surveys of their employees who involve employees and strategy development exercises. So, it seems to me it has taken maybe two or three decades of ideas that originated from IBM. For example, how to involve people in idea generation… has finally spread across companies. And this is certainly supported by the startup movement we are seeing globally, that somehow infuses new ideas of who should be involved. And this doesn’t only include employees. It also includes customers, suppliers, all kinds of stakeholders that were previously not necessarily considered in strategy exercises. I mean, strategy was something done in the board room previously, but not involving everyone in the organization. And then the final aspect is the how to… the tools. So, was a tool set you would use and and there, I mean you would assume that there should be some more change there.

[min 15]

But from what I see the tools to do strategy, of course some tools do facilitate those interactions of stakeholders meanwhile. But there are not necessarily modern or novel strategy tools out there. So I see that very often companies are still relying on let’s say traditional, could also say old fashioned, strategy tools that were fine for a certain era of strategy. But that are not necessarily useful for today’s environment.

Ben Robinson: So, you’ve raised at least two points there that we want to drill down more into. The first one is really about the purpose of the strategy team. Has the purpose of the strategy team changed from one that was charged with coming up with the strategy and overseeing the execution of that strategy. To being one that coordinates the activities of a much larger group of stakeholders within the organization? And in answering that it would be helpful is if you could share some of your, some of the insights from the report that you published about the consequences and determinants of strategy function sites. So like are you seeing that basically in terms of how well staffed the strategy team is, for example.

Markus Menz: Yeah, I mean just start with, you refer to the central strategy function in organizations. And I would say that not necessarily the tasks or general activities of those strategy functions have changed a lot. Of course they include some of the more recent developments these days. For example, coordinating strategic initiatives across the organization, overseeing sometimes new business development, sometimes you’ll see that internal venture capital arms of, companies are under the umbrella of the strategy function. So those kinds of activities have changed, but the core of their activity is still relatively similar, which includes, well aspects referring to strategy development. And aspects referring to strategy execution. So on the development side, the basic activity has changed, I would say from organizing a formal strategic planning process every year to a more coordinative task. As you mentioned, to coordinate between top management and middle management or even further down in the organization, line employees, coordinating horizontally.

This is something which is very frequently overlooked, horizontally between functions in the organization. So for example, coordinating between marketing, procurement, supply chain management functions and coordinating internally versus externally. So, internal stakeholders for example, in product management and external stakeholders, customers that are relevant or key accounts of the organization. So, this has changed more on the, on the strategic planning side. It’s oftentimes, it’s still referred to as strategic planning, but it has become quite different, how it is being done. On the other hand, the execution side yeah, is these days more concerned with strategic initiatives. It still concerns a lot of, the activities regarding how to execute the decision, where to compete. For example, it includes decisions regarding mergers and acquisitions, divestitures, alliances that are under that umbrella. So those activities are still the same. But it has become a much more, I would say, much more coordinative function than it was before.

Ben Robinson: On the subjects of where to compete, do you still think that’s as relevant a question as it used to be? Because, if you subscribe to the basic notion of the world is moving much faster and also that with technology change in particular, the clear boundaries between one industry and other industry are getting blurred. So is it really the job of the strategy team to continue to make those kinds of bets about where to play? Or is it much more about making sure that the company is fit to play? So it has, by that we mean has an excellent product, has an excellent or optimized business model, and then has real organizational agility. Are they not the sort of competencies that are much more important than deciding making big bets on where to play?

[min 20]

Markus Menz: That’s a tough question. What I see is that at least when I look at the larger corporations, they still rely very much on questions of where to compete, of course those concern the overall firm’s business model. So if you, for example, take recent examples of large industrial conglomerates in Europe, take Siemens, headquartered in Munich and what they want to become as a digital company. They’re trying to reconsider the boundaries of their business divisions in order to develop this corporate, you could say this corporate business model. But I still think that the central strategy function is concerned and should be concerned with questions of the overall firm and not necessarily of the specific, let’s say product specific business models. But rather as a corporate business model so, why does it make sense to have the different products under one umbrella? Why does it make sense to be in certain geographic markets active? And of course, if the market boundaries are blurring, if the product boundaries are blurring because this has consequences for the decisions that they make. But there should still be concerned with those choices because otherwise no one is in the organization. I think they’re the only ones really asking those questions besides the top management, the central or group top management.

Ben Robinson: Another question on the strategic function within organization may or may not be changing… cause clearly as well as the speed of change accelerating… We’re also living in a world where we have an abundance of information. I mean it’s, I think the amount of data that a strategy team works with today versus 10 or 20 years ago, it’s exponentially larger. Is that helpful? Does that lead to more precise decision making or is it at a,in some ways a distraction do you think?

Markus Menz: Well, I think it should be helpful. It should to lead to better decisions, but does it do so…. that’s, that’s a question that I would, where I would be a bit worried….

The amount of data is there, the question is how to deal with that data. And what I also observe, and this is something that also colleagues frequently note and I sees the same when it comes to to data and information technology and organizations. Very often, I mean, it’s considered, as something that must be done, that must be considered. But the question in the beginning should be, why do we need a certain data? Why do we need certain technology? And this is something that is not necessarily being asked. So that’s one aspect, one facet here you could say. The other facet this, when I look at large organizations, multinationals, sometimes there are very smart strategists working in those organizations who see a need for, developing new technology that supports eventually how to do strategy.

But the need is not shared by everyone in top management. But this is about to change. What I see now is that the top management has started pushing those topics as well.

Ben Robinson: Is data helping them to make better informed decisions… Because there’s so much risk involved in making these choices. The more that you can couch those choices in terms of data and demonstrate that it’s a really well formulated, informed decision is great. But I guess on the flip side, the more that you rely on data that potentially the slower the decision making comes. So do you, is that where the trade off is? Is it between collecting the data to make an informed decision versus continuing to make very quick decisions that are required and in a fast moving environment?

Markus Menz: I don’t think that this is necessarily a trade off. I mean, it sounds to me like an excuse that executives probably oftentimes articulate. Because what I think is required is a suitable technology. And the same applies actually when I discuss, for example who to involve in a strategy process with company executives. What they typically say is, yeah, of course we would like to involve everyone but we don’t have the necessary resources. But of course you could rely on technology that facilitates this. And I think you should start thinking about what kind of technology is suitable to deal or manages this amount of data. I don’t think that there can be too much data.

Ben Robinson: Okay, cause I guess it was another way of formulating the question which is… surely there’s an optimal point of which, you know, with, once you’ve reached 80% level of conviction based on all the data you have. Then making a decision there is preferable to waiting for 100% of the data because otherwise you’re not first mover…

[min 25]

Markus Menz: I mean the challenge for me would be not so much about the data here, but about just about making the decision. And I have the impression that many organizations rely on these days, at least, on very good data. Of course we can always improve. I mean, but maybe they’re close to the 80% already. But when it comes to the decision, the data’s not necessarily considered and…

Ben Robinson: Got it, so you’re saying it just becomes an excuse for people who are indecisive in the first place?

Markus Menz: Yes. It could be. I mean, I’m a bit worried about taking a very rational view on strategy and I experienced and therefore I also shifted to, part of my research focus towards the individuals who actually do strategy. I experienced that… this is a very much, I mean, strategy is as much depending on the behavior of the individuals involved as it is on rational choices. And therefore, yeah, we should be careful to, only rely on data. But that’s my experience and view that I developed over the past couple of years.

Ben Robinson: When it comes to decision-making, with or without lots of data, organizations, strategy teams see as are still relying on a lot of, of these tools and models. Are these same models and matrices still relevant because clearly one of the things that we’ve seen is in this new era of kind of networks and ubiquitous computing…. That the nature of strategic advantage or competitive advantage is shifting from way more from being about supply side economies of scale to being about demand side economies of scale. But most of these tools still assume, right, that a company is optimizing its strategy and optimizing its chances of success, based on internal resources and the resources that it could acquire or hire, right? So, do you think the strategy profession has adequately adapted its tooling for this kind of new modern world of networks effects?

Markus Menz: Well, let me start with a relatively mean saying, a fool with a tool is still a fool. And I think it’s not so much about the tools. The tools may facilitate a certain discussions. They may visualize certain analysis, but they’re not certainly not as the most important aspect. So, that’s just to start with. I do believe however, that those tools may be valuable if applied correctly and correctly. I mean, first of all, that you need to consider whether the underlying assumptions of those tools are still applicable or still relevant. And for example, if you take Porter’s Five Forces framework, where you try to understand the competitive forces in an industry, and potential and the threat of of potential new entrants and what you could do about it, the underlying assumption here is that you can clearly define an industry, right?

But the industry boundaries have become much more blurred these days. So there you would see an example where it’s probably difficult to apply the same tool and in the same forms these days. Another example is BCG portfolio metrics, um, where you try to map your businesses or you could say products. You could also do it with geographic markets, along two dimensions. One is market growth and the other one is a relative competitive position. And what you try to do is to get an overview of the activities of the organization. And I think this can be still relevant if you find the right criteria to define your markets, to define your products. And for example, Google is still working of that metrics. So, even a company that is considered for being at the forefront of the technology firms, one of the leading firms there is applying one of those more traditional, tools.

On the other hand you are referring to the more demand-side oriented tools. I strongly believe that there need to be more novel tools. But of course to come up with those tools requires also, at least from an academic perspective, it requires some data about the underlying assumptions about the firms or organizations that you consider. I mean, take for example, Porter’s Five forces, this was developed an industrial enterprise in the 1970s, 80s. So, we don’t necessarily have the data yet to develop those solutions. We have started doing it, but…

[min 30]

Ben Robinson: I think for me the Porter’s framework works very well for an established business. You know, like you’re relatively well established. What are the levers you could use to make this business perform better? What are the potential threats coming? I still think all of those things are relevant as long as they’re applied to an arena of activity rather than a very narrowly defined market. But I think the question is more if, you know if we believe that network effects are of much greater importance than they were historically. What strategic theory is there for example, that tells a company you should maximize the number of users because that will trigger, make way more value for the ecosystem and will enable you to become much more to deliver much more, much more value over the long term. Most models or matrices would probably want you to become as profitable as you could as quickly as possible, which would be in conflict probably with that aim of maximizing the number of users, for example?

Markus Menz: It could be in a way, I mean, you’re referring more to the tension between.

Ben Robinson: Tensions was what I was looking for, yeah.

Markus Menz: The tension between exploratory activities and maybe exploitative activity. So efficiency versus a growth for example. And efficiency, I mean, yeah, many of those tools are definitely targeted towards improving efficiency of organizations. Whereas relatively few are referring more to the growth ideas. I mean the Ansoff matrix you mentioned refers to it, the Portfolio Matrix does partly.

Ben Robinson: The problem with the Ansoff matrix is that for me there’s, this sort of implicitly assumes mass markets, you know. This idea that you could just take a product and introduce it to another mass market or, that’s what’s problematic about that. But, okay, I think you’re right. I think, you’ve kind of redrawn the question or you reframed it… About exploitation versus innovation and that’s cause I think that kind of takes this to the second section they want to talk about, which was organizational design. Because there are many ways in which to frame this question of organizational design. One might be, how do you ensure consistency and control versus autonomy and agility. But I agree with you, another one might be how do you ensure that you get maximum exploitation? Maximum efficiency at the same time as you would allow the organization to continue to innovate and you don’t become subject to threats from much more innovative players in your market. So with those two kind of, those two trade offs in mind, how do you, what what are your biggest learnings in terms of organizational design?

Markus Menz: Let me reply to your first trade off autonomy versus control, which is, let’s say one of the very classic trade-offs. Similar to this is also the classic distinction between differentiation and integration. So, you would associate autonomy with increasing differentiation whereas control with more coherent integration of the activities in an organization. Autonomy versus control is, as you mentioned alone, a huge topic and of course you can, you can think about all kinds of structural or procedural solutions that aim at resolving it. I mean, for example, you could argue that there, that you have a core business where you need to infuse more control. Whereas you have more let’s say more innovative businesses where you would like to have more autonomy and lead them separately.

If I really reflect on this and I don’t think that companies should necessarily strive for control. They should, based on what I see these days. They should strive for keeping people in the organization, teams in the organization as much autonomous as possible. And infuse control only were absolutely necessary. I think that’s true in a very general way.

And how do you achieve this? Well, of course, if you think about an organization with hundreds of thousands of employees. A huge enterprise, it’s very difficult to achieve this, solely by infusing a certain formal, organizational structure. What you need, at least to me are three things based, I mean, again, very general things. But as a starting point to think about it. The first one is culture.

You need to have a culture that allows this autonomy. That allows employees making their choices, that allows teams or units, think about a remote subsidiary… that allows a subsidiary to take choices. And without asking or getting back to headquarters.

Ben Robinson: And I guess the culture also allows for mistakes, right? Because if it’s a much more experimental world, we live in.

Markus Menz: Exactly that would be another aspect of culture. I mean you need to be open to those mistakes.

[min 35]

The second aspect that it requires, and this is closely related is the leadership. And with leadership, I mean that you have a certain leadership style in the organizations that you have a certain development of leaders in the organizations. That you have a certain characteristics towards leaders when you recruit people. And we know to look at highly successful organizations, what they care most about, I mean it is about how people are led. Again, I can only refer to Google here who became quite famous for developing, based on a huge amount of data, guidelines how people should be managed and, let an the firm. And it’s just one example of leadership

And the third aspect, it is about the people in the organization. And here, I mean not only who you have in the organization. But it is about how do you empower the people. I mean, you cannot provide autonomy to everyone without maybe educating or empowering the people to use this autonomy in a meaningful way. And, therefore I strongly believe in order to have an organization that functions well, that wants to benefit from autonomy, you need to invest in the people who are working with this autonomy.

I experienced myself in organizations when I talk to executives, when I advise to organizations or educated executives in organizations. That sometimes the people in those organizations didn’t want to have more autonomy because they had some fears. They had some reluctance that this would be something valuable for them. So you need to make sure that they have the skills and the ideas, how to use this autonomy.

Ben Robinson: A slightly more provocative question. Does this all need to still be organized within the structure of a firm? If we get back to a text you probably teach undergraduates, you know, Ronald Coase’s nature of the firm. And he argues that firm is necessary because of very high transaction costs. Therefore, it makes sense to coordinate the activities of people within a firm. Because otherwise, you know, they cost so much time and so much money each time to try to coordinate this if these people weren’t under some sort of common control and common management. Is that still the case or is that an antiquated notion?

Markus Menz: You already provided part of the answer, right? So, there are certain conditions these days in the environment that have changed compared to the times when Coase came up with his seminal ideas. And I mean, the question is, yes it is about transaction costs. It is about should we organize activities within a hierarchy? Is the market more efficient to do so? And I think what happened in the second half of the 20th century, there was a relatively strong movement towards hierarchies. Meaning, firms, corporations …whereas these days you see somehow a different development. You see that markets are becoming more and more important again. Take for example, labor markets outside of companies. Take for example companies that offer a workforce for certain projects, that, for example, allow you to recruit temporary management capabilities.

So, those are all examples that show you that there has been a shift more towards markets these days. And one of the reasons why it’s possible to, in economic terms at least, to have this shift is that the transaction costs have shifted. And it has become a much easier to communicate. It has become much cheaper also to travel maybe than it used to be. And all those kind of things have changed and the result is, and that’s what we see also in our research is.

[min 40]

The boundaries of organizations have blurred and have become less clear. So, and there are a number of trends associated with it. I mean think about open innovation. I mean this is something where you involve customers for example, in your innovation processes. I mean, this requires that there is some communication at it. It involves a blurring of the boundary of the firm, think about a temporary staff that you hire for, for certain priorities, peaks for example. I mean this is something that requires, a relatively weak boundary between the organization and the market. So, so definitely I think organizations have changed. Do we still see a firm? I think yes, firms will still be relevant, but they will change. Maybe the core of such a legal entity would be relatively small in the future and there will be a subset and network of, other legal entities surroundings this one. And supporting this one in an ecosystem, how it’s referred to today.

Ben Robinson: Do you see examples of companies that break themselves up into much more cellular structure… maybe to make themselves more agile, maybe also, to make them easier to work with a network that dissolve the groups themselves into smaller units.

Markus Menz: It’s actually a quite fascinating question, on the one hand, I mean, what you can observe these days is firms, organizations that have a size that never existed before. I mean, when you look at the largest companies these days, how huge those companies are on the one hand. So you see those giant firms on the one hand. On the other hand you see ways of new ways of organizing internally to make it possible to manage those giant firms. And one of the aspects is actually is this modularization you could say, or is it that dispersion of activities in order to benefit from unique aspects at different locations and different areas?

Yeah, and what we did, we studied specifically the dispersion of headquarters internationally and we were concerned what was the question of why do companies actually split up their headquarters and decide to have a dual headquarters? So two locations for the headquarter activities on more than two locations. So, we refer to it as dispersed headquarters. You could also say virtual headquarters. What we were not concerned with was a question of where’s they set up regional headquarters or not. Because our definition of dispersed headquarters is differently. We are not saying that they need to be necessarily regional headquarters. But we say that their central functions that benefit from unique aspects in certain locations, for example, that you have your legal entity, as a corporation, as a multinational based in Geneva.

Then you have your, maybe your finance function based in London split it also too to New York because you want to be close to your external stakeholders to capital markets.

And you have maybe your central it function you have spread around the world with a very large center of excellence maybe in Bangalore. So that’s one way of thinking about it and what we explored is why our companies are doing it. And we observed, for example, that already, and we relied on historical data here from colleagues and we observed that already in the late 1990s, 50% of the companies in our sample, it was a sample that covered Germany’s and Netherlands the UK and US. That 50% of those companies had dispersed headquarters so, more than just one location for their headquarters, even though it was referred to as a corporate headquarter.

And we explored why they are doing it and found that the strategy is decisive of that they have and besides that also the way how they interact with their businesses and functions in the organization is decisive. So whether they have a more, a central or a more decentralized approach towards managing the functions in the organization. At the same time we heard that, we asked ourselves is this a good thing or not? And we discovered it’s not necessarily a positive thing for companies to disperse those activities. I mean, it may pay off in the long run, but we also saw that it decreases the cost effectiveness of the headquarters.

[min 45]

So it increases the costs that you have because I mean, it’s again, a trade off. Should you co-locate activities at one location or should you disperse activities.

Ben Robinson: Because you might get some cluster effects and, yeah.

Markus Menz: Yeah. And do you have communication costs between the various units, think about the finance functions that you split between New York and London. And that has to coordinate with a legal entity in Geneva, then it involves quite some coordination costs here.

Ben Robinson: Just so, I want to move cause we don’t have long left. So, I want to move on to the topic of how education itself is changing. But just one last question. What’s the aspect of strategy that you’d like most like to debunk, or the, or a certain dogma that you think should be debunked.

Markus Menz: That’s a very tough question. Again, what I consider really annoying is the questioning of strategy itself.

Ben Robinson: Yep. Which always comes up, yes, “is strategy dead?”

Markus Menz: Yes, exactly and that’s, that’s something that I really don’t understand and don’t see because the essence of strategy is, as I said in the beginning of the podcast where it is about making choices for a certain time horizon in order to be able to develop an organization, a company in a certain direction. And I think this is necessary for all organizations that you cannot deny the importance of a good strategy. Of course, what a good strategy is then can be debated. But the existence or the need for strategy shouldn’t be debated at all.

Ben Robinson: Would you argue that strategy has become more or less important with everything that we’ve talked about?

Markus Menz: Well, certainly not less important. So, to me, strategy is something that is more relevant than ever. And if you think about, I mean, if you assume, and I’m saying assume because we don’t have much evidence yet. If you assume that there is a high of volatility in the market, if you assume that there’s more unpredictable development going on, if you assume that the workforce has changed, people are becoming more mobile of different preferences. If you assume this, I think strategy has become much more important these days…

Ben Robinson: I am inclined to agree. And then what’s the best way to teach strategy? So, I ask that I guess with two concepts in mind, the first one is, does it make sense to teach strategy in the abstract? Is it more important to teach strategy in a more practical sense than it was potentially in the past? And then the second part is, does it make sense for people to go to university for three years to learn strategy? Or is there a way in which we can educate people faster in a way that’s more liquid, more fluid and doesn’t involve them coming to a physical location every day for lectures?

Markus Menz: That’s a risky question for me because there’s clearly still a disconnect between how we are currently teaching strategy and how it should be taught ideally. In my ideal understanding at least, referring to the first aspect of your question, I don’t think, that strategy should be taught in an abstract way. And I also think that this is not the case anymore at most businesses… Of course you need to understand the theoretical foundations of the core concepts. And it’s still important to know what economies of scale are. It’s still important to, as it is, for example, to know what network effects are and how a networked economies work. But it is still relevant to understand those theoretical underpinnings. It’s still relevant to know the various concepts and frameworks and tools, but it is as important to be able to apply those tools…

Markus Menz: And just to give you an example of what we are doing is, we let students in the first year of their undergrads and not just learn those management tools, or strategy tools. But they also have to come up with business plans, with ideas for concrete businesses where they use those tools for and develop something based on the analysis building on those tools. That’s just one example. Or another example. I’ve worked with companies where we designed executive education management development programs. And there we usually have a mix. A blend of some input from myself on the various tools, recent developments as well as we have, a lot of group work on concrete projects that they will be pursuing later on in their organizations. So that’s something that, where we incorporate the actual doing of strategy, in how we teach strategy.

[min 50]

Markus Menz: The second aspect refers to the classroom setting. I mean, it’s still think it’s necessary to have it … when you consider a program on management and business administration that it’s three years that are necessary. For strategy alone, I wouldn’t see such a huge amount of time. What we do see at the same time, more on an executive education level is that there’s increasing demand for shorter executive education rather than the classic executive MBA or full time MBA programs. So we do see that, executives, aspiring executives, that they are looking more towards topic oriented, short term programs, like a three to four day programs or a regular online interventions where they can learn on specific topics.

For example, think about a program that develops aspiring board members in the area of digital topics. So, that will be a more specific education rather than a fully-fledged executive MBA program.

Ben Robinson: So, and it was unfair of me to position that as “either…or” because I knew, okay, there’s a lot of blended classroom and online learning and so on. Online learning does, is that as effective as classroom teaching in your experience?

Markus Menz: I mean, there are pros and cons when it comes to those two formats, I experienced myself that online learning can be quite effective particularly as it allows participants to or students to reflect more. To digest of the information and material in greater depth as it is the case with, or sometimes the case at least with in-class formats.

What I also experienced is, and I did this myself a couple of times, direct interaction can be very valuable when applied in an online format, which is not as feasible in an in-class format. So there are advantages of online learning, of course, there are also disadvantages. Students frequently mentioned the difficulty of having an engaging class discussion online. Of course, it is possible with today’s technology. But on the other hand, it’s very difficult to convey a certain spirit or atmosphere through online communication tools.

Ben Robinson: And do you believe that the institutions like yours are adapting quick enough? Or do you believe you are also at risk of some sort of Clayton Christensen type disruption?

Markus Menz: Hopefully we are, I’m confident because I see some relevance of an institution like ours. If you take the University of Geneva as a whole or the business school, the Geneva School of Economics and Management specifically… I think, there are certain facets of an institution like ours that make us unique, compared for example to a standardized online offering or even compared to another private business school. And this is of course, first of all it is a stimulating environment in which we are in. I mean, it’s not only about faculty educating, or teaching students. It is about interactions between students. It is about interactions between students and alumni for example, and the university serves as, as a facilitator of those interactions. And those are live interactions in person. And I think those are still the interactions that matter more than, than just as the online,or virtual interactions.

And secondly, I think we have a dedicated faculty that is very well known globally for their rigorous research. And so we not just teach or convene knowledge, but we also create knowledge. So we try to come up with insights that are unique and at the forefront of our fields. And we try to use this knowledge also to lead our teaching. And I think this is also something that prevents us from becoming irrelevant, as, as some colleagues claims these days.

[min 55]

Ben Robinson: So I’m going to ask you the same question again, but just about academia, is there an aspect of academia that you find really frustrating? That you would like to jettison or some aspect of academia that you find overly formalized that you’d like to do away with? For example, the nature of academic texts. What you said is very interesting, the way you said it’s very inaccessible to the lay person…

Markus Menz: That’s again, a very tough, but also to me, very interesting question. I mean, you could also rephrase the question and ask what will be the one thing you would like to change about about your profession? And I think personally if I think about academia and management specifically, not, I’m not speaking about other disciplines that I’m not that familiar with. But at about management as an academic discipline, you could also sometimes include economics here. But, but management in general, I would say there has been an increasing divide between between the academic world, and the world that some refer to as the real world. The world of practice and of those two to whom academics should actually contribute to. And the difficulty here is that some of my colleagues, I’m not saying all of my colleagues. But some of my colleagues clearly focus on their research on their fundamental research without considering its relevance.

And that’s to me relatively risky because I think we are serving one purpose and does this is improving how organizations work. How organizations are being led, being managed as these days, and if we are not concerned at all with the relevance of the questions, which can be very specific tiny questions. That are not necessarily important for the executive running those organizations. This is a huge risk because there is a risk of a further disconnect between academia and the questions that are being studied and the questions that matter for executives, and managers in the real world.

Ben Robinson: Should it be easier for business people to become academics? In this field, in particular, it’s one where if expertise comes from being a practitioner, then it would be good to blur the lines between practitioner and educator…

Markus Menz: Yes, exactly, it would be, it would be great if there would be a greater collaboration for example, or greater interaction. Just to give you an example, I mean I usually get my research questions that I study from conversations with practitioners or from newspapers, articles in and the Wall Street jJurnal, the Financial Times or wherever. So I see certain phenomenon going on and I then think myself, okay, how can I understand those phenomena better? But I also have many, many colleagues who look into the academic body of literature and ask themselves, okay, how can I, and that’s a starting point. How can I contribute to this academic conversation without necessarily considering that this conversation is, is actually something that is currently relevant for organizations.

And but of course, coming back to your question, I mean, is it needs to be closely collaboration for sure. There needs to be more interaction and maybe also more diverse backgrounds of academics working on, or studying those topics, the most fascinating studies that I oftentimes see from colleagues are those of colleagues who had a different career before they actually entered the academic profession. Yet it is quite difficult to make this career change, but this is something that is clearly enriching this conversation.

Ben Robinson: Okay. Just before we leave, so we’re gonna tweet out the links to some of the research, some of your research that we’ve alluded to during the conversation. Anything in particularly like you’d like to highlight to our audience, anything any blogs or journals or anything that you think for those people who’s super interested in strategy they might want to look into?

Markus Menz: Yeah, I still think that some of the more classic practitioner oriented outlets like Harvard Business Review, Sloan Management Review or even the McKinsey Quarterly are, are still very valuable sources for getting an overview on a specific topic or a specific aspect. I would also recommend your audience to get directly in touch with academics if they’re interested in certain topic areas.

[min 60]

I mean, they see oftentimes, for example what kind of areas of expertise in academic have on their web pages. And, and simply reaching out to them it doesn’t cost anything and it oftentimes provides them with some valuable input. And academics are usually, very open to share their insights and learnings on a specific topic. So, that would be an advice that I would, like to share here.

Ben Robinson: And if, if anybody wants to contact you, how do they do so?

Markus Menz: Well, the topics that I’m focusing on are these days primarily corporate strategy, still topics referring to corporate headquarters, centralization, decentralization and the organization of top management teams, and boards of directors. So, corporate governance questions as well and one question that I would like to particularly highlight that I’m currently concerned with is understanding how to do strategy in a way that keeps up with the modern development, both in terms of changes in the environment, but also keeping in mind technology, that builds on and copes with this complexity, but on the other side simplifies doing strategy. And if you have examples regarding that, I would be very happy to learn about them and to discuss with you, how to maybe generalize and further improve those strategy processes.

Ben Robinson: And if they, if they do, they should reach out to you through LinkedIn or your email.

Markus Menz: Yes, I’m fairly active on LinkedIn and I do have an email address… markus.menz@unige.ch

Ben Robinson: Great, Markus, thank you very much indeed. I think if I were to conclude, it would be that the nature of strategy, both in the way that it’s taught and the way it’s executed are changing. But strategy is more relevant than ever. So Markus, thank you very much for your time.

Markus Menz: Thank you very much for having me. Ben.

What is a Challenger Bank for?

The last couple of months have seen JP Morgan close its digital bank Finn, as well as BPCE close the UK arm of its digital bank, Fidor. This has led to a lot of speculation about whether it’s possible to run a disruptive business within an incumbent organisation. But, it also raises a simpler point. When does it make sense to launch a challenger bank?

The rise of the challenger bank

Challenger banks are definitely in vogue. In the aftermath of the financial crisis, regulators sought to introduce more competition into their domestic banking markets. One of the most progressive was the UK regulator, which lowered capital requirements for start-up banks as well shortened the application process, leading to a influx of new competitors. But many jurisdictions, including the UK, also introduce Open Banking legislation, which obliges banks to share customer data with third-party providers, also increasing competition.

In addition to the regulators’ efforts, technology has also lowered barriers to entry. Infrastructure services like AWS have reduced start-up costs while smartphones have opened up distribution at the same time as making possible new digital features, such as remote, paperless customer onboarding.

The result has been an explosion in the number of new companies offering banking services — 17% of all companies having been created since 2005, according to Accenture.

Different business models

But digital banks are not just banks without branches. They are offering something different. Part of this is about customer experience — they have built their offerings from scratch, taking advantage of new technology to mould their services around people’s lives. But part is also around business model.

A look at the latest Monzo annual report illustrates this well. It has over 2m customers, but it makes significant losses. It has over 2m customers, but makes net operating income of only £9.2m (£5.7/customer). The majority of its money comes from fee income, not interest income. And, despite heavy losses, it is ramping up marketing expenses (up 700%) and pushing forward with international expansion.

In this regard, Monzo — like the other challenger banks — is operating a classic digital-era business model. In contrast to traditional banking models, it recognizes that distribution is not the primary point of differentiation in the value chain; but, instead, customers are.

It is this desire to maximize customer numbers that explains why, despite a historical customer acquisition cost of less than £3, Monzo is engaging in TV ad campaigns. This explains why its investors are prepared to cover its losses and fund its international expansion. And lastly it explains why most income comes through fees, not interest income. Because this is a business where, with low customer acquisition costs, low churn (NPS is +80%) and low cost to serve (GBP30 per account at present and falling fast as scale economies kick in), the incentive is to maximize lifetime value.

Monzo, like other challengers, will seek some direct customer monetization for sure — Monzo is now offering loans — but this is likely to be levied on those who can most afford it, in the shape of premium subscriptions, ensuring that most services remain free (current account, foreign ATM fees) to attract as many new customers as possible. Instead, most of its monetization will be indirect, using the pull of its large customer base to bring in third-party fees. At present, most of its fee income comes from interchange fees as its customers spend money using their Monzo debit card, but over time other routes will make more meaningful contributions. Monzo has said that it wishes to become its customers’ “financial control centre” by introducing them to the best possible third-party financial services and, although the resulting commissions from these introductions are small at present (just £85k), this will grow as two-sided network effects materialize.

Hard for incumbents to match

For incumbent financial institutions, it is difficult to match the challenger bank model. Their businesses were created for a different age, where distribution was the choke point in the value chain. The need for a costly and difficult-to-achieve banking licence plus a network of physical branches kept out new entrants, meaning banks could push undifferentiated, expensive products to captive clients. And now it is extremely difficult for banks to change course and match challenger banks like-for-like — they don’t have the cost base, the financial incentives or innovation capabilities to do so. And so many banks are starting to launch challenger banks themselves.

However, the bank-within-a-bank model is also difficult to pull off.

Firstly, as Aperture-subscriber John Hagel so eloquently describes in this piece, you have the problem of the immune system fighting off anything that threatens the business model and revenue streams of the body corporate (what in more successful companies might be described as the Innovator’s Dilemma). This likely contributed to closure of Fidor UK and explains why the rest of the business is up for sale. But the challenge to incumbents is very real. As the following table from Citi shows, banks’ RoE is much more sensitive to falls in revenue than reduction in costs, meaning that with stubbornly high costs — and in the absence of business model change (see below) — it will be difficult for banks to countenance a strategy that cannibalizes existing revenue streams.

Assuming that the immune system can be countered — by creating a completely separate organization, with different people, processes, tech, brand, incentives and reporting directly into the CEO — then you have the problem that innovation is hard. This seems to have been more of the root issue at Finn. Built on the bank’s existing IT infrastructure, its objective was more around putting a new UX on traditional products than using the virtues of digital to create a unique offering. As a result, it didn’t manage to attract large numbers, let alone introduce viral features that leverage the power of networked consumers, as Revolut has successfully done.

The last problem is one of strategic intent. If a bank launches a digital bank because its strategy is a) to defend itself against challenger banks; b) to lower cost to serve by using digital channels; c) to improve User Experience; d) to capitalize on Blockchain/AI/IoT/Cloud or e) to change its perception among younger customers, it’s probably going to fail.

Launching a digital bank is about launching a digital era business model, which goes way beyond changing brand perception, user experience or moving customers onto cheaper-to-serve channels. As noted above, it is about maximizing customer numbers and engagement to activate demand side economies of scale. This requires clear strategic intent because, in turn, it requires organizational transformation. Launching a challenger bank can be a (faster and less disruptive) route to digitization, but it is neither an easy option nor a panacea.

Where can it make sense to launch a challenger bank?

Our view is that a challenger bank strategy has a higher likelihood of success if is underpinned by one (or more) of the following six objectives.

1. Entering new markets.

It is interesting to see Goldman Sachs’ digital bank Marcus referenced in so many of the articles on Finn. For us, it is very different. For instance, it is built on a new technology stack. But most importantly, it moves Goldman into a completely new space, consumer finance, where it does not have the cannibalization concerns that trigger the corporate immune system. This allows it to operate under very different constraints and, like other new entrants, challenge the status quo with a proposition that includes market-beating interest rates, no origination or late fees as well as customizable payment dates and payments. And it’s working: Marcus had 4 million customers and $46bn in deposits at the end of March 2019, two and half years after launch.

2. Entering new geographies.

In the same way as entering new markets allows the new business to operate more freely, so does entering new countries. It is also a less risky strategy than M&A, which made sense at a time when distribution was the barrier to entry, but now encumbers the acquirer with all of the legacy issues they inherit. And this is why the challenger-led strategy is being pursued by many banks, including DBS, which has launched digibank (“a bank in a smartphone”) in India and Indonesia with already over 3m customers — and why it is looking to do the same in Vietnam.

3. Tackling financial inclusion

Launching a challenger bank with the purpose of bringing banking to the unbanked is by definition the antithesis of cannibalization — because no one was providing these services in the first place. And, as banks like CBA in Kenya have shown with M-Shwari and now Stawi, when you combine mobile distribution with low costs and intuitive user experience, you can succeed in bringing financial services to millions of people. But, as demonstrated below, while countries like Kenya and China have very successfully leveraged digitization to tackle financial inclusion, there still exists massive scope to do the same in populous counties like Egypt, Indonesia or Pakistan.

4. Lowering the cost of capital

Another reason for launching Marcus was that Goldman Sachs can use retail deposits to lower its group cost of capital. But a business where this is more transparently the objective is EQ Bank in Canada. It is a subsidiary of Equitable Bank, which provides residential and commercial real estate lending services, and the bank uses EQ customers’ savings to fund its lending, allowing it to start to increase its net interest margin (now at 1.6%) in a low interest environment. Structuring the group like this not only creates complementarity between the bank and its challenger brand, as opposed to a cannibalization threat, but also reinforces incumbency advantages. EQ Bank can sustain its above-market deposit rates thanks to its parent’s large lending book.

5. Technology renovation

Another reason to launch a challenger bank is to attempt lower-risk and faster-to-value technology renovation. Banks sit on decades of technology debt, batch-based legacy systems built around products not people that have been continually added to over time, resulting in massive cost and massive complexity. If banks are to compete on price and on user experience with digitally-native challenger banks, then they will have to address this technology debt. But doing so is expensive and risky, which why it is tempting for many banks to start again — create a new bank with new technology.

This “build and migrate” strategy is still somewhat unproven , even though it looks like some banks like Santander, with Openbank, may be going down this route (its annual report states that Openbank is “the testing ground for our future technology platform”).

For banks considering this strategy, they should be mindful that they will have to run two IT platforms in parallel for a good while (it is unlikely that regulators would let incumbents close all branches — or indeed the bank itself — for a long time). They should also be aware that there will be customer attrition in the base business as they divert investment into the new bank and also likely attrition when they try to move across customers to the new bank. In addition, they should start small, that is, with a single product offering like savings, which will enable them to test the market proposition before committing big expenditure, get fast RoI on the initial capital expenditure and minimize the risk of rejection from the corporate immune system — at the same time as probably lowering cost of funding (or, in the case of one challenger bank we consulted, whose first product will be to lend boomer savings to millennials, increase asset yield). Furthermore, if the technological renovation is successful and the bank creates a great platform, then, as Starling, OakNorth and Ant Financial have done, it can sell this to other banks — the “make yourself the first customer” model of creating an exponential software business.

The counterargument to the “build and migrate” strategy is two-fold. Firstly, modern core banking systems are modular, meaning that progressive renovation is possible — replacing systems one by one — to combat risk and speed up time to value. In our experience, however, these projects tend to more complex than they seem and subject to the same issues as all in situ transformations, such a scope creep. A better argument for not executing a build and migrate strategy is that it is increasingly possible to achieve what banks want — improve customer user experience, launch digitally-native products, run advanced analytics and open up to third-parties — without replacing all of their back-office systems, as vendors like Additiv and The Glue are helping institutions to do.

6. Launch a new business model

In a blog we wrote last year, we set out what we thought were five viable banking business models for the digital age. However, at least three of these new business models were off limit to banks given their organizational constraints. Launching a challenger bank removes those constraints and allows banks to unbundle themselves by launching a narrowly-focused digital proposition (in terms of product offering as well as demographics) and then to rebundle themselves around this proposition. This is what fintech companies like Transferwise, Robin Hood and Zopa have done successfully and we are starting to see banks do the same — like Imagine Bank from Caixa which successfully attracted a new customer demographic with a convenient and high margin savings product and has since rebundled a whole set of own label and third-party services.

There is also the possibility to do this unbundling to rebundling via a holding company model. This represents the digital equivalent of the traditional universal banking model but where each product offering is run by a separate subsidiary. Doing this keeps each unit nimble enough to compete to respond to market shifts, permits partial customer acquisition, but also allows the overall group to achieve economies of scale (both supply-side, like IT, and demand-side, like customer data insights). In banking, the best example of this seems to be Pepper from Bank Leumi, which is building up a set of discrete product propositions.

If not challenger banks, then what?

If an incumbent bank chooses not to launch a challenger bank, what are its options?

It could choose to do nothing, essentially pursuing a mix of tactical options like cutting discretionary spend, shrinking risk-weighted assets and lobbying the regulator to slow, or reverse course on, new legislation. But, even though this might get management through to its next stock option vest, this isn’t a long-term remedy.

Another option could be to go upstream. We see this a lot in wealth management. Since HNWIs want a somewhat bespoke service and interaction with a relationship manager, then a lot of banks are moving to serve exclusively these HNWIs and UHNWIs where they think they can earn good fees for the foreseeable future. However, since many banks — as well as independent asset managers and family-offices-as-a-service focus on the same market — fees are gradually eroding. But more importantly, it leaves the banks open to classic disruptive innovation as the providers who now serve retail and mass affluent customers with digitally native services start themselves to move upstream.

In our view, for the banks that don’t want to launch challenger banks, there are only really two options. One is to become a bank-as-a-service, offering their back office and compliance to other banks and fintech providers, as banks like Bancorp in the US have done. But, this is a low-margin business. A better option is what we call the thin, vertically-integrated bank, where a bank starts to offer third-party services alongside some of its own products, capitalizing on its advantages —a bank licence, trust, the pull of a large customer base — to give its customers more choice. The challenge here is, of course, that this is a radically different business model which is likely to activate the corporate immune system.

So, the conclusion seems to be: if a company can dismantle the corporate immune system for long enough to adapt its existing business, then a challenger bank might not be the right option. Otherwise, it probably is.

Is Spotify the new MoviePass?

Have you ever wondered why the social features on Spotify aren’t better? It’s not difficult to imagine a more engaging experience if, say, it was easy to co-create playlists or you got updates on what friends and artists were listening to. One explanation could be that it is hard to build siloed social interaction — outside of horizontal apps like Facebook or WhatsApp. But my hunch is that, while Spotify wants to maximize users, it doesn’t want to maximize usage. Why? Because unlike most aggregation platforms, its marginal cost grows with usage, meaning that — like MoviePass — its best customers are actually its worst customers. That’s why it’s struggling to generate profits, why it’s struggling to protect itself from rival streaming services and why it needs to become the pre-eminent platform for podcasts.

The move to subscriptions

There is a structural move underway towards subscription-based business models. According to Zuora’s Subscription Economy Index, subscription revenues are growing five times faster than regular transaction-based revenues. Part of this reflects changing consumer behavior towards renting, rather than buying, assets. But the other explanation is that with internet distribution, digital services have become abundant. As such, it makes less sense to restrict supply to maximize profits, as companies did in the past. Instead, companies are working with new business models that take as their starting point low or even zero marginal costs of supply and seek to generate revenues and profits differently. Some seek to make the service available for free and charge advertisers (like Facebook), others seek to drive down the cost of sales to maximize output (like Uber) while others seek to aggregate abundant supply in a way that brings convenience to consumers, for which they charge a subscription price in return.

Is a subscription model right for Spotify?

Prima facie, Spotify and, to a lesser extent, MoviePass look like good candidates for subscription pricing. Abundant, there is negligible cost and no deterioration in the quality of either music or movies with additional consumption (although for movie theaters, there is finite capacity, of course — not to mention that MoviePass doesn’t access the most profitable aspect of moviegoing, which is concessions). But the common business model challenge with Spotify and MoviePass is that marginal costs increase as consumption increases. In Spotify’s case, it pays the labels and the artists every time a song is played. For MoviePass, it pays the cinema every time a customer watches a movie. As such, they are offering for a fixed cost to consumers what in their case are uncapped marginal costs. And so, their business models become a gamble that 1) most consumers will stop consuming before marginal costs exceed average monthly revenue per customer 2) they can drive down operational costs to compensate for low gross margins 3) they can open up additional revenues streams over time, like selling data to artists or movie makers or 4) they can develop superior experience that drives down customer acquisition cost (CAC) and churn over time. But it is easy to see how this is precarious — and hence why Spotify isn’t profitable — and also how elements of the model are in conflict, such as developing superior experience without pushing up consumption.

Spotify vs Netflix

For Netflix, the model works very differently. Netflix buys the rights to its content, so that it turns variable costs to fixed costs that it spreads over higher revenues, meaning high gross margins. Moreover, the content producers are in general fragmented — Disney , for instance, has its own route to market through its own streaming service — such that their power is small and diminishing vis-a-vis Netflix, allowing it to extract continuously better terms. Contrast this with the music industry where three labels control practically all of the rights and thus have strong bargaining power to negotiate advantageous terms.

Another major difference between Spotify and Netflix is that Netflix is able to constantly improve its offering by investing in original content. Where people say that spending billions on original content creates the pressure for Netflix to keep growing, this is somewhat true — they want to recoup the costs. However, it doesn’t oblige them to up the efforts to acquire new subscribers, but instead allows them slowly but steadily to increase subscription prices over time without seeing an increase in churn, meaning gross margins continue to rise, more than offsetting the increase in operating costs. The issue with Spotify is that, for now at least, it is offering a largely undifferentiated service. Sure, it has better playlists than Apple’s or Amazon’s streaming services, but all streaming services allow you to access all music. This not only limits the scope to take up pricing (in contrast to Netflix, this would provide significant churn), but it also pushes up CAC since consumers have many direct substitutes (witness for example how Spotify is giving away Google speakers to induce new subscribers), further pushing down gross margins.

Spotify as Netflix

It is against this backdrop that Spotify’s move into podcasting is so interesting. In contrast to music, the supply of podcasting is highly fragmented — there are 700,000+ free podcasts available today, including our own :) — meaning that the aggregation dynamics are completely different. In addition, the audience is similarly fragmented making it difficult to monetize podcasts through ads — today, podcasts in the US generate around $300m in advertising or $0.01 per active user per hour, 10x less than radio and 70x less than newspapers.

Spotify has made three acquisitions in this space — Gimlet Media and Parcast, which give it a catalog of high-quality podcasts and the team to be able to commission and produce more of the same and Anchor, which is a platform for amateurs to make and distribute podcasts easily. So, in short, it is building original content à la Netflix as well as providing a route to audience for the long tail of producers, on top of which is can seek to increase advertising revenues or take up subscriptions. With podcasts, therefore, Spotify is a position to become a true aggregator, gaining control over supply such that gross margins increase and able to leverage its position to deliver increasing returns to scale that would see a rise in average per user revenues at the same time as reducing churn and lowering CAC.

Spotify vs Amazon and Uber

One of the things you realize when you read this fascinating oral history of Amazon Prime is that, at the time, no one knew what it would cost to launch and what kind of a black hole in the company accounts it could create with massive adoption. Instead, you get a sense of Jeff Bezos’ drive and leadership, the company’s focus on constantly improving customer experience as well as how innovation materializes in real life.

What is interesting about Amazon Prime in the context of Spotify is that it is analogous to the Spotify model: a fixed price subscription for a service where marginal costs are uncapped. In the same way, Amazon’s best customers could have become its worst customers, driving down profitability. However, not only did Jeff Bezos see this the other way around, as a means to encourage its best consumers to consume more (“ We’re not going to take our best customers for granted”), but because of all its different business lines, Amazon was able to capture that extra consumption across its estate and turn it into revenue. This has continued to be the Amazon philosophy (“When we win a Golden Globe, it helps us sell more shoes”), but it’s not a strategic play for Spotify since, for now at least, it’s a single service offering.

The problem with the Amazon model — and the Uber model — is that it leaves a lot of money on the table. In the case of Uber and Amazon, both have low distribution costs but high other costs (drivers, fulfillment centers, logistics, etc) so the incentive is not to maximize profits by cutting supply, but instead by maximizing supply to maximize revenues (and network effects). This effectively pushes out the supply curve, which creates significant additional consumer surplus (a difference between the price paid and the price customers would have been willing to pay). A study by Freaknomics author Stephen J. Dubner estimates that, in a single year in the United States, Uber produced USD7bn of consumer surplus, with consumers paying USD4bn when they would otherwise have been prepared to pay USD11bn. This is money that would historically have gone to workers and to profits.

Spotify vs Tencent Music

There do, however, seem to be emerging business models — coming out of China — that conform to the platform dynamics of low distribution costs and high supply, but which manage to capture much of the consumer surplus generated. A look at Spotify compared to Tencent Music helps to illustrate this.

Tencent Music is a music subscription service like Spotify, but with a twist. Its best customers are its best customers.

Tencent Music operates a completely different business model from Spotify, one described by Eric Feng as shared-value transactions. For most users the service if free (less than 15% of sales are generated through subscriptions). This opens up the service to the largest possible audience (800m+), maximizing the potential for network effects and downstream monetization. This monetization comes from getting its most active and engaged users, those with the highest willingness to pay for the service, to pay more — in turn converting consumer surplus into revenue. Practically, it does so through social interaction, such as allowing users to sing karaoke together or send each other virtual gifts, gamification, such as fan leaderboards that put users in the running for prizes, as well as plenty of paid-for exclusives like live-streamed concerts or early access to new albums. As a result, 4% of its customers account for 70% of its revenues.

A new way?

When you read this excellent A16z article, you realize that these kinds of shared-value business models based on deep customer engagement are proliferating across Chinese e-commerce, from music to video to books. They offer an alternative to business models based on subscription, which aren’t the right fit for many businesses and which lock consumers into long duration contracts; an alternative to business models based on advertising, which create a conflict of interest between service provider and consumer (as well as plenty of negative externalities); and an alternative to business models based on transactions, which leave a lot of money on the table.

The question is why are these business models emerging out of China? Connie Chan suggests it’s because businesses in China thought about “content consumption in a mobile-first way”. This is certainly true, but it is also because China built its payments infrastructure to support a mobile-first world, one where business models based on micropayments can be viable. As we discussed in our first podcast with David Galbraith, the “US internet” is built on layers and layers of legacy technology that make payments extremely expensive and which effectively force companies into transaction, subscription and ad-based models.

One solution to this problem could be crypto. Crypto is almost infinitely divisible, making the most tiny of micropayments practically possible. In addition, because it circumvents the existing payments intermediaries and their fees, it can make micropayments economically viable. The problem, however, is that — for now at least — distributed ledger technology is nowhere near scalable enough to cope with the volume of e-commerce payments, which would of course multiply if transaction amounts got smaller and if micropayments opened up a larger addressable market (note, for instance, that ad spending is around 2% of GDP, creating a ceiling on ad-based revenue).

Whether the solution comes through crypto or an infrastructure upgrade, not being able to execute on micropayments-based business models is bad for business and bad for consumers. Furthermore, it is likely to give a growing advantage to Chinese vs American internet giants as they battle to colonize the rest of the world.

The Rise of the Growth Platform

As Michael Porter once said,

“The essence of strategy is choosing what not to do.”

Strategy, as an exercise in weighing up opportunity cost and allocating resources between competing priorities, has always been about making choices and this is truer than ever.

However, traditional strategic theory has not kept up with the digital age. It presents a static view of the world at a time when technology is fundamentally changing the nature of scale, the nature of work and the nature of the firm. Where sustainable competitive advantage used to come from maximizing the scale of production, it now comes via the network effects of connecting consumers with external producers. This move to networked business models raises fresh strategic questions about what not to do, both in terms of what a firm produces, but also in terms of what skills and resources it needs to employ itself. In future, the most successful companies won’t just be those with networked supply chains, but those with networked workforces.

From hierarchies to networks

There are many routes to creating a highly profitable business, but the most dependable and sustainable is to seek scale.

For the most successful industrial age companies like Ford or General Electric, this meant systematizing production to maximize output. If a firm could produce a good, say a Model T car, at greater scale than competitors, it could spread its fixed costs over larger volumes, allowing it to charge less while spending more on distribution and marketing. Achieving mass scale was a formidable barrier to entry leading to very high levels of return on capital — without necessarily having high-quality products.

In our networked world, what is inside and outside a company becomes increasingly fungible and it is clear that the bedrock of competitive advantage moves from how to scale internal organizations to how to orchestrate the most valuable ecosystem.

Today, while scale remains critical to achieving sustainable advantage, the nature of that scale is changing.

As platform companies like Uber and Amazon have demonstrated, in the age of networks and ubiquitous computing, achieving scale no longer requires firms to manufacture all of their products and services. Instead, they can source some or all of these products and services from third parties. This allows them to operate at higher scale since supply is elastic and to achieve greater quality since they offer consumers more personalized choice.

These platform models are underpinned by network effects, or demand-side economies of scale, as opposed to supply-side economies of scale. These arise not from maximizing production, but facilitating the interactions that make the platform more valuable for every participant, such as making it quicker and cheaper to get a taxi. And since network effects are not subject to diminishing, but instead increasing, returns to scale, markets move from having a few dominant players to winner-takes-most.

However, strategic theories have not kept up with this change. They continue to draw a sharp distinction between what is internal and external and ask how firms can maximize profits with existing resources or with the resources they could hire, build or buy. But, in our networked world, what is inside and outside a company becomes increasingly fungible and it is clear that the bedrock of competitive advantage moves from how to scale internal organizations to how to orchestrate the most valuable ecosystem.

This shift clearly calls for new strategic tools, but it also calls for a new approach to resourcing, one that reflects the inevitable move away from hierarchies to networks.

The changing nature of work

When competitive advantage meant maximizing output from a given set of resources, it was important to organize work into standard, repeatable tasks. These tasks were governed by strict processes and overseen by formal hierarchies. The role of senior management was to formulate strategy, the role of the rest of the organization was execute it with little autonomy to think or act for themselves.

Today, the nature of work is dramatically different, almost diametrically opposed. Ours is an information age. Networked technology has connected us and broken down the siloed and hierarchical flows of information. We have become knowledge workers whose work, where once routine and predictable, is now varied and exceptional. This requires simultaneously new ways of organizing work and also new ways of planning work.

Networked technologies have also dissolved geographical boundaries and unpicked the fixed form of work. We don’t just do different work, we can work from where we want, at the hours we choose and on the tasks we select. In other words, work has become more global, more varied and more liquid.

In its new form, it makes much less sense for work to be organised in hierarchies and we could argue whether it needs to be managed under the umbrella of companies at all. More and more people are choosing to become freelancers and, when you look at their motivation, it owes a lot to self-empowerment. They want to be free from the constraints of companies which not only set their hours, but in their pursuit of productivity, put limits on their learning and self-actualization.

The new strategic imperative

The big shifts in the nature of work and the nature of scale are taking place against a backdrop of accelerated change which has seen the longevity of S&P 500 firms shrink by a factor of 5 since the 1930s.

In response, firms have started to shorten strategic planning horizons, but what is really needed is to split strategy in two. Long term considerations like value proposition, business model and purpose seldom change and should only do so in response to major structural shifts. However, for shorter term considerations, it is important for strategy to become more closely aligned with innovation. That is to say, strategy should pivot from a function that makes well-informed yes/no decisions to one that creates the conditions for maximum agility so to impose as few of these constraints as possible. This means devolving autonomy. This means embracing a culture of experimentation. But, above all, it means embracing the power of networks.

Traditional resourcing decisions were anchored in an old paradigm. They assumed that the best people wanted to work for companies and that companies were the best place to manage them.

Some might argue that firms have already capitalized on the changing nature of the workforce. But outsourcing, nearshoring and offshoring were aimed at exploiting wage arbitrage — doing the same work, but with cheaper workers. There was no attempt to use the networked properties of the internet to revolutionize the way work was done.

Furthermore, the scope of any outsourcing or offshoring decisions was constrained by management theory that said companies’ internal resources must be focused on “core” areas, those with the highest strategic and operational importance. But what constitutes a core activity will change over time. When a firm is starting out, everything is core. It needs to establish its culture, its product/market fit, its business model. But, once these are established, its focus should shift to how to scale as quickly as possible and this means looking to external networks to alleviate the constraints and lower risk. It is only once a firm crosses the chasm and becomes its market’s winner-takes-most that it should it think about bringing back in house some of these activities — either to deepen its moat (like Amazon having its own logistics network) or to reduce its reliance on third-parties (like Dropbox choosing to move off AWS).

And so a new approach is needed. Traditional resourcing decisions were anchored in an old paradigm. They assumed that the best people wanted to work for companies and that companies were the best place to manage them. They were conceived for a world of slower change when the opportunity cost of either being too slow to hire or hiring the wrong people was less material. They assumed all core activities had to be performed by internal resources. And they didn’t take account of the power of network effects.

In the knowledge economy, having the best people matters more than ever and establishing flows of information between independent yet interdependent individuals is critical to ensuring that they grow. As such, management place artificial and damaging impediments to fast growth when they seek to hire all of these people within their company.

The rise of the Growth Platform

Some digitally native platforms have emerged to let companies tap a broader talent pool on an on-demand basis, but these have limitations. In the case of platforms like Uber, they work against the self-empowerment of workers by subjugating them to management by algorithm, making them interchangeable commodities and internalizing all of the network effects. Platforms like Upwork are much better in that they allow for differentiation, empowering workers to be more selective about what they do as well as earn a better return on that effort. But in not sharing risk with the end client, these platforms add much less value than they otherwise could, creating an opening for a new type of business model, what we call the Growth Platform.

Growth Platforms are more capital intensive and take longer to scale than aggregation platforms, but they add much more value and are critical to the next phase of the digital economy. AWS is a growth platform, using the strength of its balance sheet to give firms access to cheap and liquid computing power and sharing network effects through the AWS Marketplace. WeWork is another example, taking the upfront risk on large real estate investment that it parcels out and makes it affordable to smaller firms, while plugging them into its network effects around community and optimized design.

However, up until now, we had not seen a growth platform for creative people and skills. Platforms that pair companies with the right teams of go-to-market people and creatives, to form a partnership that maximizes value and transfers risk from both sides. Companies get immediate access to the best go-to-market talent, but also the infrastructure to make these people perform at their best. The people don’t just get to work with fast-growing companies, but also job security with optionality as well as the ability to constantly learn.

The platform should then supercharge its value-add through network effects. The teams are external to the companies they work for, but in substance they’re very much part of it, adapting to the culture and working towards the same goals. They’re external only as condition of achieving network effects. By operating at increasing scale, these platforms accrue the network effects that enable it to better match not just requirements with people, but people with people, assembling the fluid and interdisciplinary teams to let companies adapt to greater complexity and pace of change. Furthermore, it accumulates the domain expertise, market knowledge and the ecosystem of partners that allows for continual and compounding rates of success.

Removing the constraints

Until now, firms had a binary choice: hire all of their own people or outsource. One allowed for control, the other speed. Similarly, the best people had to choose between working for one company or becoming a freelancer. One gave security, the other freedom.

Now, owing to network effects and the changing nature of work, these constraints are disappearing. By plugging into growth platforms, firms achieve control, speed and quality — at scale. And people gain freedom, security and the opportunity to keep learning.

We’re now in a new paradigm, then, where mutual success depends on firms choosing what not to do and workers choosing what to do.

Firms need Business Model change, not Blockchain

When Jimmy Song, a venture partner at Blockchain Capital, took to the stage at Consensus two weeks ago (wearing a black cowboy hat), he launched an attack on the blockchain-is-the-answer-to-everything mentality. He said,

“When you have a technology in search of a use, you end up with the crap that we see out there in the enterprise today.”

Jimmy was clearly trying to be provocative and burst the bubble of blockchain fanatics, but he has a point. It’s not so much about blockchain per se (although this may be where the worst offences are committed) but about the focus on technology in general. Every day we are bombarded with articles about the need to digitize or about how [Blockchain/AI/APIs/Cloud/Mobile/IoT] will transform or disrupt such and such an industry. But we forget that technology in the absence of new business models never changed anything.

It wasn’t the internet that transformed retail or music. It wasn’t the smartphone that created Uber. Instead, it took business model change which exploited new technologies. In retail, it was the Amazon business model of one-click checkout, marketplace and next-day delivery. In music, it was the iTunes model of unbundling music to let us buy individual songs and then the Spotify rebundling model of all-you-can-listen streaming subscription service. And Uber didn’t just use the smartphone to let people order cabs (as many of the incumbents did), but instead uses the power of GPS to allow anyone with a car to become a taxi driver, transforming supply in the course of transforming user convenience and experience.

And so in banking we can safely predict that it won’t be blockchain or APIs or AI that transform the industry. Instead, it will be new business models empowered by those technologies.

Implementing technology without a clear plan risks making matters worse

In fact, we could probably go further and say that implementing new technologies without a clear idea of the future business model may make matters worse because it could well entrench existing practices.

The reason for this is that these new technologies will be implemented in support of existing business models rather than in pursuit of new ones. This means — as we have seen so often in banking — that digital technologies are used to digitize analogue products, rather than reinventing them for the digital age. But, it means more importantly that these technologies will be used to double-down on scale.

The industrial economy was all about scale. Once a company had come up with a winning product, the challenge was to exploit economies of scale as fully as possible. This allowed unit costs to be minimized and allowed firms to undercut rivals, seeing them gain more market share and scale and thereby locking in their leadership position. So all investments were aimed at maximizing scale — mass marketing, mass production, mass distribution — and business were organized into centralized, hierarchical structures to make this possible.
But these investments in scale in the digital age are quickly moving from sources of competitive advantage to sources of competitive disadvantage.
Technology and platforms have neutralized scale advantagesIn their recent book, Unscaled, Hemant Taneja and Kevin Maney talk about how the technologies of cloud and AI have turned scale economies on their head.
In the world of cloud computing, IT resources are available cheaply to everyone meaning that — other than for the platform providers like Microsoft— scale doesn’t matter. A business can rent as little or as much IT as it needs, conferring little scale advantage in running massive operations.
But it’s not just IT resources, the same model is being applied everywhere. Take human resources, it is becoming increasingly easy to contract the people a company needs at the time they need them through platforms such as Malt and through a new breed of companies like Pangea, Digital Knights and WeDigitalGarden.

In economic terms, technology has lowered the minimum efficient scale of production to a point that is within the reach of most SMEs. And with a monolithic business structure, diseconomies of scale kick in sooner and are more material.
Artificial Intelligence is also having a profound impact on scale. If new technologies and platforms make it possible to manufacture profitably without scale, AI is making it possible to know what each and every customer wants — so that product and service can be tailored to everyone.
While the slight flaw in the unscaled argument is that more scale leads to more data and more data leads to better AI, it is nonetheless the case that any company offering undifferentiated products at scale will soon lose market share and scale. And so we see white space for new kinds of business models, where firms — or platforms — are able to take advantage of these new technologies to offer mass customization at scale.
The incumbents’ challengeThe incumbents challenge is, therefore, how to move away from this heritage of scale. This is likely a bigger challenge than it seems. Many companies in the industrial age missed shifts in consumer trends, but because of scale they could in many cases afford to catch up — copying rivals, buying rivals, etc.
In this digital age, the scaled business model is likely to lead to the double whammy of failing to spot new trends and the impossibility of catching up. Moreover, scale is so deeply embedded — across company structures, performance metrics, remuneration, processes, employee skillsets, cultures — that it will be so difficult for incumbents to make the transition.

And it’s not just an issue facing companies. Take Germany, for instance. For so long, its industrial sector has been admired all over the world for consistently high quality engineering. But, the German economy is struggling to make the transition to the unscaled, digital world. It doesn’t (yet) have a vibrant entrepreneurial ecosystem from which the new unscaled models are emerging and the corporate structures and practices are very deeply ingrained.

But there is hope. We do see many incumbent companies, including in the banking industry, adopting new, unscaled business models for the digital age.

New banking business models for the digital age
In many ways, the following section is an update to a piece I wrote two years ago looking at how technology and new regulations, particularly PSD 2, were likely to lead to new business models. Where back then we identified 4 business models, now we identify 5 (but now fully discount the universal banking model as a relic of the industrial age). And where back then we framed the choices around asset intensity and profitability, we now frame the choices around the size of the demographic a firm wishes to serve and the number of products it offers to this demographic (although profitability is likely to improve in correlation with these factors).
Let us consider each in turn.
The unbundled start-upThis is the model that most B2C fintech companies have pursued until now. They spot a niche, which could one of: a product that wasn’t previously offered (e.g Coinbase), a demographic that is un- or underserved (e.g Lending Club), a much better experience (with likely cheaper pricing), combining tech and design thinking (e.g Transferwise) or all of the above(e.g. WealthFront).
It is very much the embodiment of an unscaled model: using cloud infrastructure to operate at low volumes and using AI to serve small segments of the market. However, given it is both targeting a niche and targeting the consumer directly, it is often difficult to make this model profitable. The low infrastructure costs are more than offset by high customer acquisition costs which, because these tend to be single product companies, cannot be spread over many revenue lines. There are exceptions, of course, where the regulatory costs are low and the market is large (e.g WorldRemit), where there is a virality in the product design that lowers acquisition costs (e.g Revolut) or where the product solves a big issue in a big market such that it becomes a very large company (PayPal, M-Pesa, Stripe).

But the much more likely outcome is that successful unbundled start-ups start to bundle multiple products under the same brand.

The rebundled start-up

Once a start-up has found a strong product/market fit, it is logical for it to offer multiple products in order to boost its return on capital by cross-selling and upselling to its existing clients. It effectively moves from a single, unbundled product offering to rebundling a full banking service over time. However, it is different from a traditional universal banking model in a number of ways, such as the fact that it is digitally native but more importantly because it remains focused on serving the same demographic. In that sense, it doesn’t engage in mass marketing and production, but sticks to a narrow target market. Were it to begin to offer all products to all customers, it then risks becoming the victim of unbundling itself.

Examples of successful unblundled to rebundled start-ups include Zopa, Transferwise and Revolut.
The platform modelThe platform model is somewhat of an anomaly in this list since it is essentially a scale play. However, it is likely to be an enduring model since:
1/ it is underpinned by strong network effects in a way that the universal banking model isn’t;
2/ it is often executed as part of an unscaled holding company strategy (see later); and,
3/ it is offered in the service of (and helps to make sustainable) the model of unbundled start-ups.
The platform model is simple. Banks rent out their back office as a service to others. For the unbundled start-ups who would be clients, it offers the advantage of not having to undertake a bunch of low value-added regulation and IT activities and it helps them to go beyond just renting IT infrastructure to renting IT applications and compliance. For the banks, it helps them to spread the largely fixed costs of IT and compliance over much larger volumes, improving economics.

The challenge, as pointed out in the last blog, is that this is a difficult model to scale across borders, limiting its profitability potential and meaning that there will be likely only one or two platform players per country/geo.

Examples of this model we have seen so far include Wirecard, Railsbank, Solaris and Bancorp. And it is no surprise that they are cropping up in the largest banking markets first where potential for scale economies is greatest.

The aggregator model

The aggregator model is where a firm uses its grip over distribution to introduce the consumer to the right unbundled services. Effectively it uses AI and machine learning to understand the customer’s financial affairs and preferences and to anticipate their needs so that it can make the right service recommendations at the right time. With the introduction of PSD 2 — and similar regulation across the world — this model becomes easier to operate since it forces banks to share customer data. And, theoretically, it becomes possible to operate this model without engaging in any product manufacturing or without having a banking licence or any compliance team — as firms like Centralway Numbrs are trying to implement.

Nonetheless, our view — consistent with the blog from two years ago — is that this model will be thin, open but vertically integrated. By this we mean that aggregators will work with many different unbundled start-ups, but because of the nature of banking, they will likely manufacture some products — like current accounts that require a banking licence. And because of the need to deliver exceptional customer experience, they will end up having to become more vertically integrated. We observed the same thing happening in other industries, such as with Amazon and Netflix, and now we observe the same thing happening in banking. When unbundled fintech start-ups rebundle, they tend to become more vertically integrated — witness Transferwise’s move off the Currency Cloud platform or N26’s move off Wirecard.

And so it is not a surprise that the aggregator models we are starting to observe in banking are thin and vertically integrated, such as M-Shwari and Starling Bank.

However, there are a couple of potential issues with the aggregator model. The first might arise from regulation. Will regulators allow banks that offer own-labelled services to aggregate services from third-parties and trust them to do so completely impartially? Especially given the marked tendency for aggregators to move from collaboration to competition over time. Moreover, there may be a business model challenge in that, as Ben Thompson observes so clearly in his recent post, models like Starling’s rely on third-parties while seeking to internalize the network effects, especially around data.

So, while we continue to believe that this is a sound model, aggregators of this type will need to look to empower the ecosystem by externalizing network effects and may seek to use arms-length intermediaries, like Bud, to avoid potential pitfalls around regulation.

And, where these potential issues are not addressed, aggregators leave themselves open to the threat from rebundled start-ups and from holding company models.

The Holding Company Model

The holding company model attempts to replicate the universal banking model — or conglomerate model in other industries — for the unscaled world and in a way that confers competitive advantage on the subsidiaries, especially by dint of network effects.

There is probably no “standard” for the holding company model. Berkshire Hathway is a great example of how a holding company structure can create competitive advantage across the group companies, in its case by using the cashflows and very low cost of capital of its insurance business to provide the cheap cash for investing.

Amazon is another great model to study and probably more relevant for banking. Jeff Bezos made a decision in 2002 to standardize the way information is shared across Amazon using APIs. It was a brilliant move in how to achieve control at scale. Essentially, the inputs and the outputs of every team were measurable in real time, such that their performance was instantly calculable and all other teams would get the information needed to conduct their work without bottlenecks, but it still allowed the teams autonomy in how to execute. The upside of this API model, so well documented in this post from Steve Yegge, was manifold:

it allowed the different teams to operate autonomously so that that those business could be opened up to work with third-parties (as happened with AWS)
It allowed each unit to be kept focused on its own KPIs, which essentially means that they are forced to remain close to customer trends. As Ben Thompson writes in another recent post, the genius of Amazon’s customer obsession is that it forces every part of the business to innovate at the same time as making it practically impossible to overshoot consumer demands.
It critically allows every business unit to stay focused on its niche (essentially an unscaled model) but allowing for scale at a group level (e.g IT resources, distribution and brand), positive working capital flows, and the exploitation (internalization) of network effects across group companies.

This is what makes Amazon such a formidable company. It has figured out how to make the conglomerate model work in the digital age — through a holding company structure. And, furthemore, in its digital form, it overcomes one of the key shortcomings of its industrial age predecessor — it can achieve increasing returns to scale thanks network effects.

In the financial services space, the best example of this holding company structure is Ant Financial. Where Amazon has figured out how to adapt the conglomerate model for the digital age, Ant Financial has figured out how to recreate the universal banking model for an unscaled world. Its hub and spoke model sees the group leverage data, brand and distribution while the subsidiaries remain narrowly enough focused — on unsecured lending, investing, money market funds — to remain nimble and adaptive in the face of changing technologies and customer trends.

The Holding Company as a model for reinvention

We see a strong trend in banking for incumbents to launch new digital banks. The examples abound, such as BNP Paribas’ Hello Bank. While this model to reinvention is in many ways sound — it allows these banks to transplant customers and trust into a new digitally native version of themselves — it risks creating another universal banking model, albeit one built on digital foundations. A better way of going about reinvention would seem to be a holding company model. This might be built on a Berkshire Hathaway model, as seems to be the case with Equitable Bank’s creation of its EQ Bank subsidiary, to create a sticky, low cost source of funds for its lending business. Or, probably more likely, it would be an Ant Financial model of having individual subsidiaries target different business lines, which is the approach that Bank Leumi seems to be taking with Pepper Bank.

Conclusion

There is a clear danger that with the constant hype around technology, banks miss the need to redefine their business models before embarking on major technology renovation. In fact, technology renovation in the absence of business model renovation may well make things worse because it would entrench existing business models based on selling undifferentiated products at the greatest possible level of scale. The digital age calls for something else — products, many of which will be new, targeted on specific demographics, made possible now thanks to technology change. In this blog, we have presented 5 models which would work in this new paradigm, of which the holding company offers perhaps the best route to success — especially for incumbent organizations looking to reinvent themselves.

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