Jim McKelvey: 'The Innovation Stack'

Jim McKelvey is an engineer, businessman, investor, philanthropist and professional glassblower who also founded Square with Jack Dorsey. Jack had been an intern at one of Jim’s earlier ventures and they decided to start a company together after Jack was removed as CEO of Twitter. They only later came up with an idea for a product when Jim realised how frustrating it was as a small merchant to sell glass art using a credit card. Turns out it was a pain point shared by hundreds of thousands of small American businesses which had been theretofore ignored and underserved. The solution: a cheap, elegant card reader which could work on any smartphone, coupled with easy onboarding, transparent pricing and fast settlement. The rest is history.

I recently read Jim’s book, “The Innovation Stack”, and highly recommend it. It’s an autobiography and recounting of Square’s early days, although only in as much as that relates to Jim’s exploration of a wider question: how did Square survive a direct assault from Amazon? This leads him to define what kind of business Square was - one which created a new market - and to distinguish between businessmen and entrepreneurs, with the former entering existing markets by copying already-proven business models and the latter creating new markets by doing something that has never been done before. In treading new ground, entrepreneurs are forced to solve novel problems with novel solutions, a never-ending, iterative process which accumulates into what Jim calls an Innovation Stack:

The problem with solving one problem is that it usually creates a new problem that requires a new solution with its own new problems. This problem-solution-problem chain continues until eventually one of two things happens: either you fail to solve a problem and die, or you succeed in solving all the problems with a collection of both interlocking and independent innovation.

Jim describes Square’s Innovation Stack in detail in Chapter 4 and it’s excellent reading if you are interested in the company. And while he lists fourteen separate elements, he advises thinking of them like “ingredients in a stew” because each complements and reinforces the others. And so while Amazon could produce a superficially similar plastic card reader to Square’s - and afford to sell it at a materially lower price - it could not replicate all the underlying innovations behind the card reader which made Square a success in the first place:

An Innovation Stack isn’t simply a list of independent changes to an existing business model. The innovation is integrated. Each block in the Stack only works in conjunction with all the others, and the entire Stack fails if one block is missing. For example, regarding Square’s Innovation Stack, online sign-up is great, but it only really works if you dispense with traditional FICO underwriting, and you can only do that if you’ve developed new ways to model risk, and you can only develop those models with high volume, which necessitates a number of the other blocks in the Stack. Copying just one—or even a few—of our elements wasn’t going to be enough for our competition to beat us. Amazon would have to copy them all successfully in order to win.

Jim tells how he spent his life looking for entrepreneurs to be his role models but found only businessmen. So he turned to history and found three entrepreneurs whose Innovation Stacks could illustrate his thesis: A.P. Giannini who founded the Bank of Italy and brought banking services to people who had never used a bank; Ingvar Kamprad who founded IKEA and brought the world great design at low prices; and Herb Kelleher who founded Southwest Airlines, America’s first low-cost carrier with flights as cheap as bus tickets. The common theme is that to build something new, these entrepreneurs had to become superheros for whom innovation was synonymous with survival. As Jim puts it, “Combine extremely harsh conditions with a sufficiently stubborn founding team, and the Innovation Stack evolves.”

What to make of this as an investor? Jim’s primary conclusion is that companies in new markets can be more resilient to competition than they appear thanks to their Innovation Stacks - the novel solutions they have devised to overcome novel problems.

I think the framework can be applied to more mature businesses too. If we try to understand all the problems a company has had to overcome to deliver its product or service the way it does, we can learn a lot more about how hard it would be to replicate. For example, how does Domino’s take an order and profitably deliver a delicious hot pizza in twenty minutes? How does Amazon profitably fulfil billions of orders of millions of SKUs, often in as fast as two days? Or how does Evolution profitably handle thousands of bets in-real time every second? The answers can all be found in a thick stew of innovation.

Business culture is an important element of an Innovation Stack too - ‘how we do things around here’ - which helps explain why change is so hard for most companies. Think how difficult it has been for so many incumbents to disrupt themselves in the face of obvious challengers. The example Jim points to is the failure of full-service airlines to compete with low-cost carriers:

The copycats also forget that corporate culture is itself part of an Innovation Stack. A corporate culture that evolves along with the Innovation Stack naturally harmonizes with and helps create the innovation. Southwest had developed its Innovation Stack by surviving in the marketplace. Everything about Southwest’s culture supported its Innovation Stack. [United Airlines’] Ted and the other doomed copycats tried to impose a culture and set of business practices as a management exercise with all the sincerity of a telemarketer telling you to “have a nice day.”

We should think too about what Jim calls ‘the Horizon of Possibility’: the new problems we can tackle once the old ones have been solved. Technology is additive in this sense and what we take as cutting edge today could only exist thanks to all the innovations which came before it. In turn, today’s cutting edge technology highlights new problems for entrepreneurs to solve, kaleidoscopically creating an endless array of new business opportunities. For example, Apple popularised smartphones. And because smartphones enabled us to stay constantly connected to the internet, Facebook could become part of the fabric of our lives. Facebook’s variable cost, targeted advertising in turn enabled new businesses too, like direct-to-consumer brands, free-to-play gaming and social influencers. Etc. etc.

My favourite chapter of the book is Chapter 15 in which Jim shares an entrepreneur’s best defence against competition: low prices. Note that this differs from ‘lowest price’:

Low price results from a company philosophy to constantly deliver maximum value to the customer. Entrepreneurs strive to keep price as low as possible, while still maintaining the quality of the overall experience. The lowest price, in contrast, requires a comparison with another company selling a similar product or service. A company that values having the lowest price must constantly look over its shoulder to see what the competition is doing.

This is not unlike Nick Sleep’s ‘scale economies shared’:

Imagine a company that has just invented a way to lower the cost of producing its product. It has two choices: keep the savings or share it with the customers. It may seem like the better choice from the company’s perspective is to keep the money. But keeping all the money sends two dangerous messages to the employees. The first is: watch out, you work for a place that will take everything it can get. The other message is: we value short-term gains over long-term goodwill. You might want to keep your résumé updated at that firm.

Consistently low prices build customers’ trust. And that trust can train habits - like purchasing from a website or travelling to a store - which can be very hard for competitors to break. Low prices are also a rallying cry around which to build a culture and motivate teams. And low prices starve would be copycats of oxygen, making it even more expensive for them to mount a challenge:

Low price protects the entrepreneurial company from competition. Keeping prices low even when there is no immediate competition leaves little room for new entrants. By dropping prices to a low point in all markets, the entrepreneur ensures that these copycats have no room for error.
Let’s say that your Innovation Stack allows you to sell your product for $5 when the nearest competition is selling something similar for $10. If your competition wants to match your price, that company will need to copy most if not all of the elements of your Innovation Stack or create a Stack of its own… Making a jump from $10 down to $5 is too big a chasm to cross in one jump. Most of your competitors will just quit.
But now consider the same situation where you are charging $9, still the lowest price, but not a low price. In this case, a competitor may be able to copy one or two elements of your Stack and sell for $8. Of course, you can now drop your price to $7, but your competitor still needs to implement only one or two more elements from your Stack to drop its price to $6. Of course, you can still go down to $5. But now you have competition only a dollar away and it may be able to catch you.
By “maximizing profit” at every step, you give your competitors breathing room as they slowly copy your Innovation Stack. As we saw in chapter 13, the math of copying a few elements is relatively easy. If you adjust your price in response to competitors who are slowly replicating your innovation, you create an easier environment for them. Conversely, if you reflect every efficiency of your Innovation Stack in your low price, your competitors will be forced to attempt everything at once and will likely quit or fail.

There are so many lessons from this book that I was tempted to copy and paste whole chapters for you here. But this is a fun, easy and wonderfully insightful book to read yourself. Once again, I highly recommend it.