Slide 1 © Carliss Y. Baldwin and Kim B. Clark, 2004 Designed to Evolve: Winning Strategies for Option-Rich, Modular Design Architectures Carliss Y. Baldwin Harvard Business School Real Options Conference Montreal, Canada June 17, 2004

Slide 2 © Carliss Y. Baldwin and Kim B. Clark, 2004 Three parts to this presentation  Option-Rich, Modular Design Architecture (ORMDA)  You live in an ORMDA if …  Winning Strategies for ORMDAs

Slide 3 © Carliss Y. Baldwin and Kim B. Clark, 2004 Part 1—Option-Rich Modular Design Architectures

Slide 4 © Carliss Y. Baldwin and Kim B. Clark, 2004 First, some definitions—

Slide 5 © Carliss Y. Baldwin and Kim B. Clark, 2004 D = Designs  Instructions that turn knowledge into things  Span all artifacts and human activities –Tangible, intangible –Transacting, contracting, dispute resolution –Government  The wealth of an economy inheres in its designs

Slide 6 © Carliss Y. Baldwin and Kim B. Clark, 2004 The Great Chain of Design and Production Finance lives here! Must value everything that is made, including designs Designs are the start of everything that is made

Slide 7 © Carliss Y. Baldwin and Kim B. Clark, 2004 Designs are Options  Design process = search under uncertainty  New designs may be better or worse than preceding solutions –Take the ones that are better –Reject the others –That’s a classic option  “Technical potential” of a design =   Option value goes up with  (naturally)

Slide 8 © Carliss Y. Baldwin and Kim B. Clark, 2004 A = Architecture of Designs  Small designs “just get done” by one person or a small team  Large designs require architecture –“The design of the design process” –Forward-looking, future oriented –Analogous to physical architectures »Create and constrain” movement and search  Major social technology, but not much studied

Slide 9 © Carliss Y. Baldwin and Kim B. Clark, 2004 M = Modular  Division of knowledge and effort  Module = a set of tasks separable from others –Unit of design architecture

Slide 10 © Carliss Y. Baldwin and Kim B. Clark, 2004 Virtues of Modularity  1st Virtue: decentralizes knowledge and distributes action –Makes more complexity manageable –Enables parallel work  2nd Virtue: tolerates uncertainty –“Welcomes experimentation” –—> Creates Portfolio of Options

Slide 11 © Carliss Y. Baldwin and Kim B. Clark, 2004 Modularity Creates a Portfolio of Design Options Split options, decentralize decisions, fragment control Evolution

Slide 12 © Carliss Y. Baldwin and Kim B. Clark, 2004 OR = Option-Rich   s vary by module and across design architectures  Versions are evidence of option values being realized over time  Low Medium Zero High

Slide 13 © Carliss Y. Baldwin and Kim B. Clark, 2004 Option-rich designs  Have lots of technical potential (High  )  Lots of things left to do  Modular architectures are VERY valuable and VERY disruptive in these cases  Mature design architectures => –Everything conceivable has already been done –Modularity not valuable More  makes more modules more valuable!

Slide 14 © Carliss Y. Baldwin and Kim B. Clark, 2004 Life Cycle of a Design Architecture

Slide 15 © Carliss Y. Baldwin and Kim B. Clark, 2004  Stage 1—clear thresholds  Stage 2—build first minimal system (probably integral)  Stage 3 —discover users’ functional needs/desires  Stage 4 —build first modular system –Modular operators: »Substitution »Augmentation »Exclusion  Stage 5 — maturity and stability Life Cycle of a Design Architecture

Slide 16 © Carliss Y. Baldwin and Kim B. Clark, 2004 Value of a Modular Design Process V(System) = [ Thresholds(All = 1) ] * [ V(Stable portion of system) – Cost + {  max V j (Substitutions) – Costs } m k m + {  max V j (Augmentations) – Costs }] n k n V(System) = [ 1*1*1…*1 ] * Stable portion + {  …   } + { …. } Substitutable modules Augmentable modules Options

Slide 17 © Carliss Y. Baldwin and Kim B. Clark, 2004 Example: Birdseye in the UK  Stage 1 — Clearing the last threshold — discover flash- freezing process for fish  Stage — construct minimal system –Docks, trucks, cold storage warehouses, refrigerators at the groceries –Naturally modular => Watch out!  Stage 3—grocers discover that customers like frozen beef, vegetables, ice cream and pizza! –Stored in the refrigerators the grocers already own because of Birdseye –Modular augmentation creates value –Much experimentation, competition with new frozen foods  Stage 5 —many frozen foods NOT offered by Birdeye

Slide 18 © Carliss Y. Baldwin and Kim B. Clark, 2004 Loss of control, loss of advantage NOT a winning strategy!

Slide 19 © Carliss Y. Baldwin and Kim B. Clark, 2004 Example: IBM System/360  Stage — Clearing thresholds & finding out what customers want –Binary compatibility and seamless upgrades of equipment  Stage 3 — construct first modular design architecture –HUGE set of substitutable modules  Stage 4—IBM’s product line expands, BUT many engineers leave IBM to join startup firms making plug-compatible peripherals (PCPs) –Hooked up to IBM installations at the modular interfaces –Modular substitution –Suit and countersuit: Intellectual property vs. antitrust  Stage 5 —a new computer industry: most firms make modules not whole computer systems!

Slide 20 © Carliss Y. Baldwin and Kim B. Clark, 2004 Unconscious strategy… IBM meant to retain control; Spent a lot of $$ trying to get it back, With no success!

Slide 21 © Carliss Y. Baldwin and Kim B. Clark, 2004 Option-Rich Modular Architectures IBM System/360 DEC PDP 11; VAX Apple 2 IBM PC Sun 2; 3; Java VM RISC Internet Protocols (end- to-end) Unix and C; Linux HTML; XML The Computer Industry

Slide 22 © Carliss Y. Baldwin and Kim B. Clark, 2004 Value Created

Slide 23 © Carliss Y. Baldwin and Kim B. Clark, 2004 ORMDAs are— “Compelling, surprising, and dangerous…” End of Part 1

Slide 24 © Carliss Y. Baldwin and Kim B. Clark, 2004 How do you know if you “live” in an ORMDA?

Slide 25 © Carliss Y. Baldwin and Kim B. Clark, 2004 You know you are “in” an ORMDA if  Engineers and strategists are always talking about –“the stack”, –“components of the stack”, or –“moving up the stack”  A stack is often a set of nested ORMDAs –New layers become the focus of competition when the prior/lower layer develops stable standards for interoperability –“Information hiding” in the components

Slide 26 © Carliss Y. Baldwin and Kim B. Clark, 2004 The Computer Stack, 2004 You live in a BIG ORMDA if: Your Stack List seems incomplete; The Stack keeps growing

Slide 27 © Carliss Y. Baldwin and Kim B. Clark, 2004 Other signs of an ORMDA:  Industry strategists are talking about: –The “vertical-to-horizontal” transition –Industry fragmentation –Complexity theory –The “ecosystem”  The industry is “turbulent” –Market shares and leadership changing; –Relative values bouncing around

Slide 28 © Carliss Y. Baldwin and Kim B. Clark, 2004 NOT an ORMDA, if  The same 2-3 companies always show up to bid any project  Gaining 1-2 share points in a quarter is cause for celebration (not just noise)

Slide 29 © Carliss Y. Baldwin and Kim B. Clark, 2004 Vertical-to-Horizontal Transitions  In 1995, Andy Grove described a vertical-to- horizontal transition in the computer industry: “Modular Cluster” “Vertical Silos”

Slide 30 © Carliss Y. Baldwin and Kim B. Clark, 2004 Andy’s Movie The Computer Industry in 1980 Top 10 Public Companies in US Computer Industry Area reflects Market Value in Constant US $

Slide 31 © Carliss Y. Baldwin and Kim B. Clark, 2004 Andy’s Movie The Computer Industry in 1995 Top 10 Public Companies in US Computer Industry Area reflects Market Value in Constant US $

Slide 32 © Carliss Y. Baldwin and Kim B. Clark, 2004 Andy’s Movie—the Sequel The Computer Industry in 2002 Top 10 Public Companies in US Computer Industry Area reflects Market Value in Constant US $

Slide 33 © Carliss Y. Baldwin and Kim B. Clark, 2004 Turbulence in the ORMDA Departures from Top 10:  Xerox (~ bankrupt)  DEC (bought)  Sperry (bought)  Unisys (marginal)  AMP (bought)  Computervision (LBO) Arrivals to Top 10:  Microsoft  Cisco  Oracle  Dell  ADP  First Data Sic Transit Gloria Mundi… Sic Transit

Slide 34 © Carliss Y. Baldwin and Kim B. Clark, 2004 ORMDAs are — “Compelling, surprising, and dangerous…” End of Part 2

Slide 35 © Carliss Y. Baldwin and Kim B. Clark, 2004 Winning Strategies for ORMDAs

Slide 36 © Carliss Y. Baldwin and Kim B. Clark, 2004 Real Options Thinkers have an advantage in ORMDAs  Because real options theory takes “  ” ” seriously  But… real options theory needs to be modified to suit the new context –Few exogenous high-frequency time series –Option is to take max of k experiments where k is endogenous and unknown –Strategies for value capture are not well understood

Slide 37 © Carliss Y. Baldwin and Kim B. Clark, 2004 Real Options Theory vs. Five Forces  Porter’s Five Forces had –NO modules; NO complementors; NO “  ”s  ORMDAs have modules, complementors and a “  ” on every module –… and the “  ”s change through time! –as Augmentable Modules are added and the Module Designs mature

Slide 38 © Carliss Y. Baldwin and Kim B. Clark, 2004 Real Options Theory vs. Five Forces  Porter’s Five Forces had –NO modules; NO complementors; NO “  ”s  ORMDAs have modules, complementors and a “  ” on every module –… and the “  ”s change through time! –as Augmentable Modules are added and the Module Designs mature + {  …   } + { …. }

Slide 39 © Carliss Y. Baldwin and Kim B. Clark, 2004 Strategic Games in ORMDAs  Architectural ControlMicrosoft, Intel  High  / High cost modulesSun vs. Apollo –ROIC War Dell vs. Compaq  High  / Medium cost modulesCisco, AMZN –Buy those who are … –Born to be Bought  High  / Low cost modulesNo profit –Kids rule  Varying  Lots of modulesLinux, Apache –Voluntary, collective development –The enemy of my enemy is my friend IBM  Low  / Lots of modulesToyota –Learning organization

Slide 40 © Carliss Y. Baldwin and Kim B. Clark, 2004 It’s all about ROIC (Return on Invested Capital) Game 1: High , High Cost Modules

Slide 41 © Carliss Y. Baldwin and Kim B. Clark, — IBM provided all of System/360’s Modules

Slide 42 © Carliss Y. Baldwin and Kim B. Clark, — Apollo made less, outsourced more Smaller footprint was a feature, not a bug!

Slide 43 © Carliss Y. Baldwin and Kim B. Clark, 2004 Then Sun came along… And did even less! How?

Slide 44 © Carliss Y. Baldwin and Kim B. Clark, 2004 Then Sun came along… And did even less! Design Architecture for performance Public Standards for outsourcing

Slide 45 © Carliss Y. Baldwin and Kim B. Clark, 2004 Result: Sun gets More Upside-  for Less $  Sun workstations interoperate with Unix/Ethernet networks (Standards)  Sun’s boxes are as fast and functional as Apollo’s (Product Architecture)  Sun’s boxes cost the same and use less capital (Process Architecture) Sun’s downside-  -twin never went public— many were started, but only a few survived

Slide 46 © Carliss Y. Baldwin and Kim B. Clark, 2004 Result: ROIC advantage to Sun Sun used its ROIC advantage to drive Apollo out of the market … Consciously and legally

Slide 47 © Carliss Y. Baldwin and Kim B. Clark, 2004 Dell vs. Compaq 1997 Dell started cutting prices; Compaq struggled, but in the end had to exit. Like Apollo, they were acquired by HP!

Slide 48 © Carliss Y. Baldwin and Kim B. Clark, 2004 Summary of Game 1:  Works for High , High Cost Modules  Small footprint in the system –Design Architecture for performance –Public Standards to outsource  Competitive product, less Invested Capital per unit  Higher ROIC for any price  Wage price war until competition exits  Then figure out what to do when maturity sets in …

Slide 49 © Carliss Y. Baldwin and Kim B. Clark, 2004 Strategic Games in ORMDAs  Architectural ControlMicrosoft, Intel High  / High cost modulesSun vs. Apollo –ROIC War Dell vs. Compaq  High  / Medium cost modulesCisco, AMZN –Buy those who are … –Born to be Bought  High  / Low cost modulesNo profit –Kids rule  Varying  Lots of modulesLinux, Apache –Voluntary, collective development –The enemy of my enemy is my friend IBM  Low  / Lots of modulesToyota –Learning organization

Slide 50 © Carliss Y. Baldwin and Kim B. Clark, 2004 It’s all about M&A (Mergers & Acquisitions) Game 2: High , Medium Cost Modules

Slide 51 © Carliss Y. Baldwin and Kim B. Clark, 2004 Joy’s Law “Most of the bright people don’t work for you—no matter who you are. You need a strategy that allows for innovation occurring elsewhere.” Quoted by George Gilder circa 1995

Slide 52 © Carliss Y. Baldwin and Kim B. Clark, 2004 The Real Options Approach  Launch inhouse design efforts  But don’t exhaust NPV  Let VCs fund medium-size experiments in new designs/technologies  Acquire “the winners”  Let VCs unwind the rest…

Slide 53 © Carliss Y. Baldwin and Kim B. Clark, 2004 Strategy is almost a Bayesian- Nash subgame perfect equilibrium IBM’s former “we own it all” strategy is not!

Slide 54 © Carliss Y. Baldwin and Kim B. Clark, 2004 Cisco invented this strategy  History of Cisco acquisitions: An equal number of minority equity investments—optional paths to control (So far)

Slide 55 © Carliss Y. Baldwin and Kim B. Clark, 2004 A new battle is shaping up  Cisco vs. Juniper  The market loves Juniper  Substantial ROIC advantage to Cisco Anyone want to bet?

Slide 56 © Carliss Y. Baldwin and Kim B. Clark, 2004 Strategic Games in ORMDAs  Architectural ControlMicrosoft, Intel High  / High cost modulesSun vs. Apollo –ROIC War Dell vs. Compaq High  / Medium cost modulesCisco, AMZN –Buy those who are … –Born to be Bought  High  / Low cost modulesNo profit –Kids rule  Varying  Lots of modulesLinux, Apache –Voluntary, collective development –The enemy of my enemy is my friend IBM  Low  / Lots of modulesToyota –Learning organization

Slide 57 © Carliss Y. Baldwin and Kim B. Clark, 2004 ORMDAs are — “Compelling, surprising, and dangerous…” and a lot of fun if you know what’s going on! End of Part 3

Slide 58 © Carliss Y. Baldwin and Kim B. Clark, 2004 Questions? Comments?

Slide 59 © Carliss Y. Baldwin and Kim B. Clark, 2004 Thank you!