Why E-commerce Firms Fail

A new study claims that many E-commerce firms fail because they don't understand the basis for competition in their industry. This examination of the Internet revolution, seeks to discover why some business models have failed and hopes to identify those models that have a better chance of succeeding.

Many E-commerce firms fail because they don''t understand the basis for competition in their industry, according to a new study by Harvard Business School professor and disruption theory guru Clayton Christensen and Innosight.

After the Gold Rush," a 54-page compilation of six papers examining various aspects of the Internet revolution, was released by Innosight last week. The study seeks to answer why some business models have failed to work on the Internet, and to identify those models that have a better chance of succeeding.

The progression of competition in an industry is down market, according to Christensen. Once companies overshoot what customers need in a particular competitive tier, competition moves further down market. In the first tier, companies compete on the basis of functionality; once functionality has exceeded what is necessary, the basis of competition become reliability. Once reliability no longer drives competition in a market, the basis becomes convenience, or speed, responsiveness and customization. The final basis for competition is price. Incumbents tend to thrive in the first two phases, but disruptive entrants gain an edge when convenience becomes the basis of competition. The classic case is Dell Computer in the personal computer field. Dell''s advantage, based on customization and convenience, has been further enhanced by the Internet.

"The factor that drives transition from one basis of competition to the next is oversupply," the paper said. "If the prior basis of competition is not yet oversatisfied, then a competitor who prematurely leaps to the next basis of competition will be unlikely to find success. Many Internet-based companies that are struggling to sustain viability suffer from this problem: they prematurely leapt to a convenience- or price-based competitive model in markets that are not yet overserved on the prior basis of competition." Such companies are forcing a behavioral change for which the market is not yet ready.

Pure-play online banking may be one area that is destined to fail, according to the paper. The primary basis of competition in the retail banking industry is reliability and convenience; trying to compete on functionality or price misses the current basis of competition in the industry. The Internet has actually enhanced the convenience advantage of conventional banks, and as such is a sustaining technology in that industry. E*Trade Bank, for one, has tried to surmount the inconvenience problem by purchasing a network of ATM machines. But the other problem faced by pure-play Internet banks is market size: the deep market penetration of traditional retail banks hasn''t left a large population of new, previously unserved customers to introduce to the market, unlike the brokerage business, which was a natural for the Internet.

Christensen doesn''t consider the Internet to be an inherently disruptive technology, but an infrastructural technology that can be used in either a disruptive or sustaining way. But it does enable disruptive enterprises, which historically have shared six qualities: they were enabled by infrastructural innovations; they reshaped the prevailing business model to earn money in a new way; they served customers as the portals of their day; they enabled customers to do for themselves what only specialists could do before; they migrated upmarket, as they gradually satisfied the needs once filled by the overserved high end of the market; and branding opportunities shifted from the product to the channel.

The paper examines many industries affected by the Internet, among them brokers, pharmaceutical retailing, catalog retailers, auto dealerships, publishing and book selling, real estate, travel, banking, voice recognition technology, search and portal sites, and insurance, but the two lengthiest studies are of retailing and portals.

In the paper on portals, titled "The Death of Differentiability," Christensen argued that "the suppliers of the scale-intensive back end subsystems will appropriate the greatest value from the Internet. Companies like Akamai, Inktomi, Veritas Software, Digex, Network Appliance, EMC and UPS are in a great position to squeeze the most profit out of the system."

The first three eras of disruption in retailing were driven by infrastructural advances: railroads enabled departments stores; Rural Free Delivery enabled mail-order catalogs; and the automobile enabled the rise of discount department stores. And now the Internet has enabled online retailing, the fourth wave of disruption in the industry. E-tailing hasn''t quite reached the level of disruption yet, the paper argues; it must first achieve some combination of margin-and-turn formula (margins earned times annual frequency of inventory turnover) approaching 120% (i.e., 15% margins times 8 turns per year), the margin-and-turn formula achieved by the first three waves of disruption. The paper also predicts that the "portal" strategy, as exemplified by Amazon.com, will likely be supplanted by focused, branded retailers, in much the same way that retailers like Home Depot and Staples are pre-empting Wal-Mart and K-Mart.

"It is impossible to know if this pattern will repeat itself in the Internet category," the paper said. "Nevertheless, it is likely that the managerial benefits inherent in focused retailing, along with the ease of travel across Web sites, will give a slight edge, eventually, to focused players."

The paper also spent a great deal of time on established companies'' efforts to move part of their business to the Web. Companies are encouraged to make their Web divisions separate entities and to avoid "cramming" their current business model onto the Internet.

New entrants into a specific tier of a market should look carefully for existing companies whose processes and values may be enhanced by the Internet; the report cites the success of pharmacy benefit managers like Merck-Medco against upstarts like Drugstore.com and PlanetRX. If there are no established players whose processes and values may be sustained by the Web, and if the Internet is disruptive to the values and processes of established companies, "then a new entrant with a disruptive approach stands an excellent chance of prevailing in that tier of the market."

"After the Gold Rush" is available from Innosight at http://www.innosight.com.

Reprinted from VC Watch.


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