Market evolution (or innovation) is often catalyzed from a multitude of mechanisms. Software digitizes and streamlines archaic business models, technological breakthroughs give birth to whole new markets, etc. In this post, and the main topic of discussion, I wanted to take the time to formalize an important driving force of market innovation, called functionalization (not to be confused with the similar term used in materials science, which means something very different). This will be the first post in (hopefully) a series of posts formalizing what I call “innovation theory”, or the formal framework which describes precisely what makes companies valuable.
Before I begin, I wanted to pre-emptively point out that – to the best of my knowledge – the ideas presented in this post have not been formalized in precisely the same way before. If they have, forgive my ignorance.
At a very high level, functionalization the process by which companies (and entrepreneurs) make the consumption of a set of products or services by the end user (which may be a consumer, business, etc) repeatable, scalable, and predictable, which in turn makes them cheaper and better. Even more than that, functionalization actually describes one of the two key driving forces of market evolution (innovation), the other being core technological, ideological, and societal breakthroughs (we will discuss this in a later post). Basically, market innovates by introducing breakthroughs, and then functionalizing them. This often occurs in cycles, where a new breakthrough introduces new solutions and ideas, the market adopts them in rudimentary ways, and brilliant entrepreneurs functionalize them into a streamlined and rapidly adoptable product/service.
Functionalization represents itself in various murky forms, and it is often hard to pinpoint, but once you understand the basic idea, you will notice that a huge number of startups and new ventures are effectively just functionalizing existing platforms.
Definition (Platform): A platform is a set of products and/or services that provides a particular utility to the end user. Everyday, both consumers and businesses dependent on a platform (and usually sets of platforms) to perform their day-to-day activities.
Home-Depot, for example, is a single platform that provides products and services for home/office improvement, but itself can be decomposed into sub-platforms. A real estate agency is a platform that offers services for finding of a residence/retail/office space. Regardless of what the platform is, it can be simply formalized as an entity that offers a products and services to achieve a particular goal.
Definition (Functionalization): The composition, transformation, and standardization of a set of platforms into a modular and callable function, rendering the platform scalable, repeatable, and predictable. Typically you can functionalize a platform and launch it scale if you highly standardize it. Standardization makes replication of the platform cheap and easy. In some cases, you can functionalize something so well that it can just be reused with minimal sunken costs.
In the rest of the article, I will illustrate functionalization through concrete examples. Finally, I will formalize functionalization and hopefully provide a useful theory. At the end, I hope you can use this new mental model to better frame new startups and understand investment opportunities.
Now, let’s suppose that I’m a talented chef, with some money in the bank, and have decided that I want to open up a new restaurant. If I’m smart about the technology and services at my disposal, I will require (at least) the following platforms to open up the restaurant:
- Intelligence platform: find a service that provides information on where to open up the restaurant. This could, for example, be a startup that provides intelligence on expected pedestrian traffic and other big-data insights.
- Location platform: basically, the real-estate agency to help you find the physical space.
- Design platform: an agency to help you design the restaurant itself, including potentially the branding.
- Sourcing platform: a service to source your ingredients and stock up your inventory.
- Furnishing platform: finding all the appliances and other furniture you may need.
- PR platform: a service to help your restaurant’s name get out there.
- Compliance platform: a service to help me figure out the legal requirements.
Even opening up a simple business such as a restaurant has incredible complexity. Most restaurants do not make it past the first year, and across the board the amount of sunken costs are tremendous. If lucky, you’ll end up breaking even. If extremely lucky, your restaurant will be a success.
Now, let’s take a look how functionalization comes into play. Functionalization is the process by which you can take any of the above platforms, and standardize them to become extremely low cost callable services. In fact, you can potentially take multiple of such platforms, combine and standardize those offerings, to make a new functionalized platform. A few examples:
- A startup can functionalize the design platform and the PR platform to provide a simple callable service that tailors specifically to people looking to open their own restaurants.
- A startup can functionalize the real-estate and furnishing platform, setting you all up with the physical space.
- A more ambitious startup can functionalize all those platforms, making “opening a restaurant” an end-to-end callable service.
Although all those are examples of functionalization, they are not all necessarily worthwhile. In order for a new venture to make a strong functionalization case, it has to prove that the functionalization of platform A and platform B is significantly better than platform A and B called independently. Basically, a new venture is worthwhile if:
benefits of functionalization(A, B) > (benefits of A + benefits of B)
Going back to the examples above:
- Such a startup wouldn’t likely benefit much, since there isn’t much to gain from standardizing the design and PR studio for restaurants. These platforms are already extremely efficient and cost effective independently, and it is unlikely that together they will provide much value (although, maybe I’m wrong).
- Such a startup would benefit greatly from functionalizing those two platforms. For example, this is similar to what Zeus (zeusliving.com) is doing with corporate housing, where the company functionalized the real estate platform and the furnishing platform to provide an end-to-end managed property service that tailors to corporate housing. A startup would provide with the physical space + the furniture. They would gain greatly over having a restaurant owner purchase the furniture and appliances and finding the lease independently of each other, through two different providers. The fictitious startup could offer short-term leases at competitive costs (locations are tailored towards restaurants) and could reuse kitchen appliances (making them much more cost effective for the restaurateur).
Another great example of functionalization done outstandingly well is Lambda school (lambdaschool.com). Lambda school is a trade school for programming with an income sharing agreement (ISA) model. Basically, Lambda school has functionalized (at least) three platforms: a money lending platform, a 9-month coding education (trade school) platform, and a recruitment platform. Before Lambda school, you had to get a loan and then use that loan to pay someone to train you to code. Finally, you had to do all the job applications yourself. Lambda school functionalized these platforms into one cohesive and callable service, making getting a job as a software engineer a scalable, repeatable, predictable, and cheaper service than what you could achieve before. What makes Lambda school an interesting functionalization example is that it entirely hides two of the platforms that it functionalizes. Using the ISA model, it effectively abstracts away loans in the form of shared income down the line, and using its extensive network and name, it gains greatly in the recruitment aspect.
An interesting question is how does functionalization relate to product market fit? Basically, you achieve product market fit when you have figured out the right things to functionalize. Although you may, in principle, have a great idea for a business, it is often the case that entrepreneurs do not standardize the right things.
Functionalization is everywhere, and effectively every new highly successful startup (modulo those that reinvent the wheel) have functionalized the right set of platforms. There are vastly more examples of functionalization, and I will keep expanding on this article over time to include them. Just a few include Netflix, Uber, WeWork, and basically everything else out there.