The digital transformation is changing the added value of companies
Companies have been dealing with digital transformation since at least the 1980s by coordinating, automating and outsourcing productive activities. Client-server architectures replaced mainframes, renewed supply chains and promoted decentralization. Enterprise Resource Planning (ERP) and Customer Relationship Management (CRM) systems automate back office and front office processes. The move to the cloud and SaaS has changed software development and the economics of renting versus owning. Machine learning and artificial intelligence uncover patterns that drive new products and services. During the Covid-19 pandemic, virtual interactions replaced physical interactions out of necessity.
Some of these changes were as simple as moving processes from analog to digital. In other cases, companies changed the way they work or act.
But in the midst of all this transformation, something new – and perhaps fundamental – has changed: Where and how companies create value has changed. The added value is increasingly coming from outside, not inside, and from external partners instead of internal employees. We call this new production model an “inverted company”, a change in the organizational structure that affects not only the technology but also the management leadership associated with it.
The most obvious examples of this trend are the platform companies Google, Apple, Facebook, Amazon and Microsoft. They managed to achieve economies of scale in sales per employee that would put the hyperscalers of the 19th and early 20th centuries to shame. Facebook and Google do not create the posts or websites they provide. Apple, Microsoft, and Google don’t write the vast majority of the apps in their ecosystems. Alibaba and Amazon never buy or produce an even larger number of the items they sell. Smaller companies modeled on platforms show the same pattern. In Forbes Global 2000 samples, platform companies had much higher market values compared to industry controls ($ 21,726 million versus $ 8,243 million), much higher margins (21% versus 12%), but only half of the employees (9,872 versus 19,000).
In the past, high sales per employee were evidence of highly automated or capital-intensive processes such as refining, oil exploration and chip manufacture. In fact, the automation enabled Vodafone to reduce the workforce managing 3 million invoices per year from over 1,000 full-time employees to just 400. This time, however, the transformation is different. Inverted companies achieve a far higher market capitalization per employee not by automating or shifting labor into capital, but by coordinating external value creation.
The digital transformation with the highest value results from company inversion, ie the transition from value that the company alone creates to one that it helps to orchestrate. Cultivating a successful platform means providing the tools and market to help partners grow. In contrast, incumbents typically use digital transformation to improve the efficiency of their current operations. New sales projections usually focus on capturing value. Of course, digital transformation can and should support operational efficiency, and this often comes first, but it cannot stop there. Digital investments must enable the business to work with users, developers, and vendors on a large scale, with an emphasis on creating value that is the foundation for business inversion. Unconstrained by the resources that the company alone controls, inverted companies use and orchestrate resources that others control.
How inverted companies create value
The most compelling evidence of digital transformation as corporate inversion comes from a recent study of 179 companies that have implemented application programming interfaces (APIs). As an interface technology, APIs enable companies to modularize their systems to facilitate exchanges and upgrades. APIs also serve as “permissioning” technology, which grants outsiders carefully controlled access to internal resources. These features not only allow a company to quickly reconfigure systems in response to problems and opportunities, but also enable outsiders to build on the company’s digital real estate. Researchers (including one of the authors) classified companies based on whether API users have used them for internal capital adjustments, the upgrades and opportunities the company was pursuing, or APIs for outward-looking platform business models that developers and other partners have used to make their own develop your own upgrades and options.
The difference in results between these two approaches is striking. As measured by increased market capitalization, profits were inconclusive for companies embarking on the internal efficiency path. In contrast, companies that took the external platform path and became inverted companies grew an average of 38% over 16 years. The digital transformation of the latter kind led to enormous increases in value.
Inverted companies rely heavily on the commitment of their external contributors. This strategy is based on partners that the company does not know, who contribute voluntary ideas that the company does not have – a completely different process than with outsourcing, in which the company knows what it wants and concludes contracts with the best-known supplier. For a fixed inversion to work, others need to join the ecosystem, otherwise it’s about as useful as throwing a potluck where no one comes. Good management is what makes you give answers and guests who create good things to share. How new guests are rewarded, what resources are made available to them and the willingness of the company to help shape this value can determine whether previously unknown partners decide on added value. This requires a different mindset of management, from control to activation and from capture to reward. The more a company can motivate its partners to invest, ideas, and make voluntary efforts, the more this external ecosystem thrives.
To attract partners, these inverted firms follow a simple rule: “Create more value than you take.” A little thought shows the power of the rule. People like to voluntarily invest in time, ideas, resources and market expansion when they receive added value in return. Partners flock to a company that makes them more valuable, which in turn helps the company’s ecosystem to thrive. In contrast, a company that takes more value than it creates sells people. Why should they cook in a kitchen where the chef keeps all sales or rely on digital real estate where the landlord pays all of the rent? Such ecosystems wither.
Good platform management means taking no more than 30% of the value, and it can be a lot less. Too many product companies start with the bad habit of asking “How do we make money” when they should instead start with “How do we create value?” and “How do we help?” Other Create value? “Only those who create value are entitled to earn money.
The new rules of value creation
The fixed value used to be tied to property, plant and equipment, but that is no longer the case. The IP valuation company Oceantomo has documented a 30 year trend of shifting corporate values from tangible to intangible assets. As of the 2020 year-end, intangible assets made up 90% of the valuation of S&P 500 companies. Of course, intangible assets cover a wide range of things, including brand value, intellectual property, and goodwill. However, these assets were known well before the 1980s.
In inverted companies, the network effects that arise when partners create value for one another are a major source of intangible asset growth. The ability to coordinate value creation and exchange – user to user, partner to partner, and partner to user – is one way traditional businesses are transforming. It also offers opportunities for scaling. Converting atoms to bits improves margins and range. The transformation from the inside out increases ideas and resources.
Certainly, a fixed inversion carries the risk of outside interference and negligence on the part of the partner. When partners are part of the value proposition, a brand can suffer when that promise fails. A co-author’s family member rented a host’s home on Airbnb only to find it had no shower or bathroom, a fact carefully omitted from the service description. Airbnb stepped in quickly to discipline the host and provide nicer, free accommodation for the tenant. The dependency on third-party manufacturers also includes a strong quality curation of partner offers and a quick possibility to exchange your own offer or that of another partner. In addition, those who make their data and systems accessible to outsiders can be at increased risk of cyber attacks. This means taking responsibility and being a good steward of other people’s data. Preserving data means giving back value and protecting those who share it. All in all, those companies that understand and mitigate these risks will significantly outperform those that stay closed and avoid the upside while avoiding the downside.
The formation of the inverted company has a number of important implications. Most importantly, an organization’s ability to orchestrate third-party assets is likely to have several gaps. The introduction of digital technologies alone will not transform an internal organizational structure into one that functions externally. Executives need to understand and operate partner relationship management, partner data management, partner product management, platform governance and platform strategy. You need to learn to motivate people they don’t know to share ideas they don’t have. Firms as diverse as Barclays Bank, Nike, John Deere, Ambev, Siemens and Albertsons have listed 200,000 vacancies for these platform functions and for running their increasingly inverted firms. In fact, companies that only look inward will be the ones that aren’t moving up.