Build Better Business Models with Network Effects
Updated: Oct 4, 2022
Network effects are fundamental to many business models and virality can be crucial for certain aspects of growth for some businesses, but the two are not to be confused.
So what are network effects?
At its most basic, network effects happen when the product or service that a company offers increases in value as more people use it.
Why are they beneficial?
Network effects—and there are many different types of them—are a primary way to create a competitive advantage. They’re also the best option when it comes to seeing long-term exponential growth. If you want to become the GOAT, you’ve gotta create the moat!
What about virality?
Virality, on the other hand, occurs when your existing users get you new users for free. This usually happens when information about a company’s service or product spreads rapidly via word of mouth.
Why isn’t virality as conducive to growth as network effects?
Virality is exciting for obvious reasons. It feels good to see more people using - and talking about - your product/service. And it can be very effective and cost-efficient for generating rapid awareness and adoption - important aspects of growth.
The downsides, however, are that for many business models it’s generally not great for increasing the value of the core customer proposition, it isn’t effective when it comes to overall defensibility, and the numbers typically aren’t great in terms of customer retention.
Types of network effects:
Broadly, there are four different types of network effects: marketplaces, interaction networks, data networks, and platforms. However, these can be broken down even further into 16 different types of network effects-driven business models:
● Physical (direct)
● Protocol (direct)
● Personal utility (direct)
● Personal (direct)
● Market network (direct)
● Marketplace (2-sided)
● Platform (2-sided)
● Asymptotic marketplaces (2-sided)
● Tech performance
● Bandwagon (social)
● Belief (social)
● Tribal (social)
Success with network effects and the cold start problem
Many of the most famous tech companies and startups owe some of their success to network effects, including Twitter, Apple, Uber, Lyft, and Waze. Imagine if there were lots of riders, but not enough drivers or vice versa when using ride-sharing apps. I remember when Uber entered the Detroit market where I was building my startup that I ultimately sold to Ford. There was only one driver who would pick up late at night in Detroit. It was comical. It took time and concentrated effort by Uber to get both drivers and riders to change their behavior from auto-owning, obsessed Detroiters in addition to the effort of many of us trying to change the perception of the city. In the case of ride-sharing, the value of the marketplace itself improves and is interdependent as both sides of the market grow, whereas with Waze - the more quality real-time data points you get from a larger user base, the quicker and better the reliability of the user experience becomes, which builds trust in the brand. It’s easy to see now how scaling with network effects has improved the value of the user experience for these kinds of companies over time, but early-stage startups who want to leverage network effects can find it challenging. We call this the “cold start” problem.
The cold start problem is an issue that nearly every founder runs into. At the very beginning, how can you have network effects when you don’t yet have customers? Different companies have tackled it in different ways, but with the right plan, it is possible to start with zero customers and scale to billions using network effects. Andrew Chen of a16z talks about how different companies have done this successfully (and analyzes why others have failed) in his book The Cold Start Problem: How to start and scale network effects.
Virality and network effects at Gameplay:
In 1999, I was on the founding team of Gameplay, Europe's biggest online ecommerce store for games, gamers, and online multiplayer gaming. I was working for the founding CEO developing new online multiplayer gaming experiences and partnerships to accelerate growth. In order to gain attention and grow brand awareness amongst casual gamers, we created a “celebrity death match” between Robbie Williams and Liam Gallagher, who were publicly feuding at the time. It garnered so much press and web traffic that all of our servers immediately crashed.