Newsletter #19: network effects 1
Newsletter #19: network effects 1
9 minutes reading time. Thoughts on startups, growth, and technology 🚀
Hey there,
In my previous two newsletters, I focused on defining marketplaces and assessing what's next for such models. Consequently, I touched on the concept of network effects as that's one of the most essential concepts in business and, in particular, when it comes to tech businesses and marketplaces.
Today, I would like to discuss further network effects, how to recognize them, and why such dynamics can give businesses moats i.e. competitive advantage.
In a nutshell, a network effect occurs when a product or service becomes more valuable to its users as more people are using it.
Let's take a familiar case and look at Airbnb being the most common example in my previous few posts.
What gives Airbnb a unique network effect is an interplay between supply and demand. Guests become hosts, and hosts also become guests; thus, the flywheel spins on and on.
Yet, network effects are not always present from the beginning in tech businesses.
The chart below illustrates how the network effect did not get triggered until the company received a critical mass of transactions.
In the early days, Airbnb focused on building features for the demand side because supply will always go where the demand is. While traditional forms of marketing e.g. branding, SEM, paid social, are important and can help, trust and safety are paramount in a marketplace.
Here I would like to mention that network effects are not available in marketplace models only. A study by NFX discovered that network effects drive roughly 70% of value in tech.
To name a few examples, the Big 5 - Apple, Google, Microsoft, Facebook, and Amazon are in the top 10 of the world's most valuable businesses. Airbnb is now worth more than Hilton. Uber is worth more than GM. All of them are network effect businesses.
The study assessed 336 companies between 1994 (approximately the time when the internet was already widely available) and 2017, and the main criteria were that each tech company should have reached a valuation of more than $1 billion.
It turns out that having a network effect is the single most predictable attribute of the highest value technology companies — other than perhaps “having a great CEO.”
To drive the point home, I looked at Facebook because while it resembles a marketplace model (users and advertisers), it's actually quite different, yet it demonstrates a strong network effect.
It's important to point out how the Facebook product had inherent virality, it grew from one user to another as an organic consequence of use.
DAU - daily active users | MAU - monthly active users
Early on, Facebook identified that connecting a new user to 10 friends within 14 days of sign up was critical to improving retention. As a result, they used email contact imports, suggested friends’ features, and embedded widgets to drive engagement.
With time they optimized timelines, introduced the like button, relationship statuses, which increased the number of usage and triggered a network effect, where the more people use Facebook the more valuable network it becomes. After all, would you use the product daily if you could not connect with so many important people in your life?
Here it makes sense to emphasize what is not a network effect. It is commonly believed that if your product has some sort of virality that automatically illustrates a network effect, but scale and growth are not necessary network effects. The main difference being that viral growth increases just the speed of adoption, but it does not make a product/service more valuable. Another way to look at the concepts is to consider how virality is all about speed and growth, while network effects represent value, engagement, and retention.
As explained in Metcalfe's Law:
the value of a telecommunications network is proportional to the square of the number of connected users of the system (n2)
Next week, I will focus on strategies for triggering network effects; if you like what you are reading, click the button below 👇 to share.
Articles/podcasts worth checking out:
📝70 Percent of Value in Tech is Driven by Network Effects | NFX Blog - companies that leverage network effects have an asymmetric upside. They punch above their weight. They are the Davids that beat the Goliaths and then become the Goliaths.
📝Two Powerful Mental Models: Network Effects and Critical Mass | Tren Griffin | Mar 2017 - One of the most important mental models in business is the concept of network effects. This is especially true today when other factors that can create a moat against competitors — brand, regulation, supply-side economies of scale, and intellectual property (like patents) — are under threat. As software continues to “eat the world,” network effects become even more important as a factor in creating a moat since that’s the primary way software companies build a barrier to entry against competitors.
🎙️Getting Network Effects | Anu Hariharan and Jeff Jordan | Jan 2019 - One of the biggest misconceptions around network effects (which are one of the key dynamics behind many successful and highly defensible software companies) is confusing growth with engagement. So how does one tell the difference between viral growth and network effects?
A quote worth remembering:
💬Author Michael Lewis on the stories we tell ourselves:
"As I’ve gotten older—I would say starting in my mid-to-late 20s—I could not help but notice the effect on people of the stories they told about themselves. If you listen to people, if you just sit and listen, you’ll find that there are patterns in the way they talk about themselves.
There’s the kind of person who is always the victim in any story that they tell. Always on the receiving end of some injustice. There's the person who’s always kind of the hero of every story they tell. There's the smart person; they delivered the clever put down there.
There are lots of versions of this, and you’ve got to be very careful about how you tell these stories because it starts to become you. You are—in the way you craft your narrative—kind of crafting your character. And so I did at some point decide, “I am going to adopt self-consciously as my narrative, that I’m the happiest person anybody knows.” And it is amazing how happy-inducing it is."
A book recommendation:
📖21 Lessons for the 21st Century by Yuval Noah Harari - As Harari explains:
“We are now living in an age of information explosion … the last thing people need is more information. What they really need is somebody to arrange all of the bits of information into a meaningful picture – and this is what I try to do.”
Positive news worth sharing:
The race to produce a vaccine is underway. The genetic sequence of SARS-CoV-2 was published on 11th January. Every week sees progress, preliminary trials, and further collaboration.
Vaccine development has a high failure rate, so the more approaches there are, the greater the chance of success. Some human trials have already begun. This is the fastest vaccine development in history.
Check out the source here.
Onward and upward 🚀