Book Review: The Innovation Stack

Problems Are Everywhere—So Are Opportunities

Throughout McKelvey’s career, he has observed a series of problems that he was not willing to put up with. For example, when he was a computer-science student, he was disappointed with the textbook for a particular course. The course’s professor had written the textbook, which was somewhat awkward, but the book was riddled with outdated information and programming examples that simply didn’t work.

McKelvey saw this as a serious problem and had the audacity to write a better textbook. Ultimately, a publisher picked up the book, and it became a bestseller—which led to a second book. It takes awareness to see the problems in our world, and it takes courage to confront them and do something productive to solve them.

Although McKelvey is best known for his entrepreneurship in technology and venture capital, he was also a bona fide small-business owner, working as a glass artist. In great detail and with emotion, the book describes how he lost the sale of a piece of glass art that would have been particularly lucrative because he was unable to accept his customer’s American Express charge card. American Express is famous for having higher transaction fees than its competitors, so many small businesses do not accept it as a means of payment. Jim was frustrated and wondered whether he could change this.

In a flash of empathy, he considered his friend Bob, a fellow artist who—despite having great talent—had spent a lot of time living out of his car. As result of his itinerant lifestyle—not having a permanent residence, never mind his probably poor credit score—Bob’s application to process credit cards was denied. Therefore, he could do only cash sales. As you might guess—and similar to the scenarios in last month’s review of Weapons of Math Destruction—this created a negative feedback loop in which Bob couldn’t get access to credit-card processing because his sales were too low, and he couldn’t make bigger sales because he couldn’t get access to credit-card processing.

Squaring Innovation

One big lesson I took from my time in business school was that, whenever unfairness, inequality, or underserved parties exist in a marketplace, there is opportunity for new entrants. McKelvey realized this when he and Jim Dorsey examined the credit-card market.

They expected to encounter resistance as they attempted to enter the credit-card industry. After all, there were terms and conditions and financial regulations that had been written to protect banks and established players from new entrants. However, when they evaluated the market, what was very surprising to them was that the small-business owners who could least afford excessive costs were the very ones who actually drove the greatest revenues for credit-card companies.

While their analysis revealed a typical transaction fee of 1.8% per transaction for small businesses, high-volume customers—large companies such as Macy’s, Best Buy, and others—were able to use their size to negotiate a rate of only 0.04% per transaction. This might make sense in terms of negotiations with individual firms, but the result was that the 5.2 million small businesses that the credit-card companies were squeezing actually made the greatest contributions to the credit-card companies’ revenue and profit. At the time, 90% of American retailers processed less than $100K in sales per year, versus the largest 125 firms who processed more than $1 billion per year. However, the smaller retailers contributed 42% of credit-card revenue.

Square’s pyramids diagram, shown in Figure 1, illustrates how this distortion resulted in smaller retailers’ paying 45 times more than larger retailers. This is a perfect example of how regressive fees—and taxes—hurt people and businesses with smaller incomes and fortify existing wealth—at the expense of the smaller businesses.

Defining the Innovation Stack

Seeing this institutionalized unfairness led McKelvey and Dorsey to create their innovation stack, which comprises a series of value-based decisions that level the playing field and disrupt markets.

An innovation stack’s series of interconnected capabilities and solutions build on each other to create a sustainable, hard-to-copy market advantage.

Here are few examples from Square’s innovation stack:

• simplicity—Square eschewed the arcane structures of traditional credit-card agreements and simplified pricing.
• free sign-up—They expanded their customer base quickly.
• cheap hardware—Square’s original reader cost only 97 cents to build—at a time when the cheapest card reader on the market cost $950. This lowered the barrier to entry for small merchants.
• no contracts—They facilitated trust and loyalty through performance, not the threat of tort.
• no live support—They kept their costs down and forced the team to focus on a simplified, easy-to-use experience.

Of course, there are several other elements in their innovation stack, but this list illustrates a series of decisions that led to an integrated solution. A competitor could not copy just one part of the innovation stack and hope to win.

Innovation Under Attack

Of course, it is the nature of business to be attracted to a market that a new entrant is disrupting. This is what happened when Amazon decided to enter the payments market in 2014. McKelvey describes the entrance of Amazon into your market as about the scariest thing that can happen to a business.

From my own experience, the prospect that Amazon would make inroads into business-to-business (B2B) distribution channels for industrial equipment led several manufacturers to undertake digital-transformation initiatives to maintain their channels. McKelvey describes the destruction of diapers.com’s financial model when Amazon aimed its market power at the startup by reducing its own prices for diapers by 30%.

In competing with Square, Amazon attempted to launch Amazon Register. What’s funny is that I don’t recall ever hearing about Amazon Register. As McKelvey describes it, much of Amazon’s strategy focused on identifying the visible weaknesses of Square—a wobbly card reader and no live support—and launching something that was just a bit better. Surprisingly, Square did nothing to fight Amazon. The team wisely saw that this would lead to a war of attrition, so they focused on sticking to their own strategy—their own innovation stack. Key to that was their focus on customers.

Ultimately, Amazon was unable to acquire enough customers to make Amazon Register viable. When Amazon shut down Register in early 2016, they sent Square card readers to the customers they had gained as a gesture of good will.

Conclusion

The Innovation Stack is an inspiring recollection of McKelvey’s entrepreneurial journey—through which he disrupted one of the most entrenched and protected industries in Western capitalism. Through the use of examples, the book illustrates how market inefficiencies and institutional unfairness expose opportunities—if we tune our senses to see them. It also provides direction on—although not a map for—how entrepreneurs can create their own innovation stack, leading to a hard-to-copy sustainable advantage.

The journey that McKelvey and Dorsey took in creating Square—and the reasons they embarked upon it—resonated with me. I’ve already recommended this book to several of my entrepreneurial-minded colleagues, and I think you should read it, too.