Deep Dive Into Network Effects

An artificial web

In our last post we started discussing what defensibility is, how it’s different from ‘competitive advantage’ and why you need it. We also discussed the different forms of defensibility as they were presented by the NFX Guild. If you missed this post or just interested in a reminder – you can find it all here.

Today we’re going to further drill down into defensibility by talking about network effects, which is considered by many to be the strongest form of defensibility.

Wait… can you please remind me what a ‘network effect’ is?

Sure. If your product is designed to have a built in network effects it means that the value of each user grows as more users are joining the platform/service.

The classic example that I provide all the time is the Whatsapp app. By yourself – there is not much value you can extract of it. It’s therefore in your best interest to bring your friends & family so the value you are extracting from this product will grow dramatically.

Thus, in essence – network effects encapsulate both accumulative value to each user and a built-in distribution mechanism. This is what makes it so strong.

So… what’s the difference between network effects to virality?

In short – virality is about embedding a mechanism in your product where your users are incentivized to distribute it for you, and thus helping you with the growth of your product. Hence, virality is about growth.

Network effects also assist with the growth of your product, but first and foremost it’s about defensibility. The fact that each user/customer who is added to the platform adds value for the existing users/customers makes it harder for the users or customers to leave, because the network is a big chunk of the value

With virality you may attract new users easily, but they can leave your platform in the same effortless manner once they believe they found a better product. 

What other types of products have a built-in network effect?

Well, by definition almost all social networks rely heavily on network effects. Also products which are built around marketplaces, such as AirBnb and Uber tend to have network effects if designed properly. 

But when thinking about network effects don’t limit yourself only to software products. Network effects can apply to physical networks as well. The Internet, as a concept, has one of the strongest network effects. The cellular network also relies on network effects and in fact, according to Wikipedia – one of the presidents of Bell, the telephone company, coined the term back in 1908.

Network effects are covered very thoroughly in another article by James Currier from NFX. I therefore suggest you pause for a second, bookmark this article for later reading, and then proceed.

Since the article is indeed thorough there is no point for me to repeat what’s written there.

Rather, I’d like to provide my added value on this topic by helping you examine how, and if, you can leverage network effects in your product..

Ok.. so how can I leverage network effects in my product?

Let me start with some sad truths:

  1. Not all products can be (re)designed to include network effects
  2. Not all network effects have the same ‘power’ or contribute to your defensibility in the same level

This means that if, after giving it a lot of thought and consulting with people you respect, you are still unsure how to embed network effects in your product, then it’s very probable that there is no natural way to do it. If that’s the case – it’s still not the end of the world – there are other forms of defensibility that were mentioned in my previous post that you can apply.

In fact – it happened to me recently with one of the products I was in charge of. The product was still in the design phase so it wasn’t too late to think how to bake network effects into it – but sadly – no matter how I approached this challenge – I couldn’t find a natural way to do it. So instead I decided to focus on the next two forms of defensibility – scale & embedding – and I manage to develop a strategy that will include both of them.

My second point above means that sometimes, even though you manage to come up with some form of network effects that can be developed into the product – the effort of building such a network and maintaining it might not provide any positive ROI at the end of the day (for example, it may involve constant biz-dev work which is costly). If the value that the network provides to each additional user or customer is quite small (and be honest about it) then it might not be worth the effort.

Thus, our goal is not to be able to state that ‘our product has built in network effects’, but rather to keep the business defensible. Don’t forget it.

 

We started with the bad scenarios so now let’s switch to how to identify good opportunities for network effects.

In order to identify if there is an opportunity for you to leverage network effects in your product you need to focus on the term ‘network’.

Is there some kind of natural network in your product? Here is a very short checklist:

  1. Does your product connect people in any way? (can they formally connect or communicate with each other through your product? Form a community maybe?)
  2. Does your product connect businesses in any way? (some glorious form of ‘directories’? Can help create virtual syndicates/guilds or something similar?)
  3. Does your product connect machines in any way? (some neural network? Combined resources? Something which makes the group bigger than the sum of the individual nodes?)
  4. Does your product have supply and demand sides? some sort of marketplace?

 

If the answer to any of the above is ‘yes’ then you certainly have the potential to design your product in a way which includes network effects.

 

Since there is no way for me to relate specifically without knowing the small details of the business – let me provide you with some hints as for where to look for the gold. (I’m happy to provide some free advice if my time allows – so feel free to reach out regarding this).

B2C Businesses

If your product is in the B2C space it means you are interacting directly with the end users. This is very exciting, but also very challenging. The advantage here is the mass of users. Since you have many individuals (I’m assuming your product has a decent product market fit) the network can grow quite fast if designed properly.

If, in your current product, each user lives in their ‘own world’ – check if you can change it in a natural way. Can you add some sort of ‘communities’ to the product? When going to this venue you need to think carefully how joining a community provides a meaningful additional value to each user and how it strengthens the whole community.

For example – let’s say you have an ecommerce site. By default it means that each user is isolated from the rest and it’s all about individual transactions. What if you could change this? What if you could find a mechanism that groups together users who are interested in the same products so that they can form an ad-hoc community and get some discounts on similar transactions?

I’m not saying it’s easy to pull off – but imagine what will happen to the dynamics of your business if you do?

B2B

When you are selling to businesses it may feel a bit unnatural to think about network effects. It could be indeed that due to the nature of your business – it doesn’t make sense. However, you owe it to your business and product to pause for a second and give it a real thought.

Is there any value for your customers to connect with each other? Can they share data in any way which doesn’t jeopardize their business? 

For instance – let’s say your business is selling accounting software to businesses. On the face of it – each business stands by itself.

However, at the end of the day – behind each business you sell to there are specific individuals who will be working with your software. Can you help them reach similar professionals in the other business you sell to? Does it make any sense to create a marketplace of financial spreadsheets templates? Business visualization templates? Share advice? 

Anything that will make these individuals say – ‘gosh, the product is good, but the network makes the real difference here’.

 

Again – it could be that such a move doesn’t have a real positive ROI, but before you reach such a conclusion – maybe try a small POC and see how it works?

B2B2C

This is quite similar to B2C. Your product will interact with the end user at the end of the day, but you first need to sell to a business and they need to get value from it by themselves.

Your best bet is still to design your network effect around the end users, but because you’re going through a business – there is the danger of silos. Meaning – you may be forced to form several smaller networks instead of a single big network (which is preferred).

A real life example – I once met a company which provides a smart commenting system to digital publishers. Their approach was to build a community of users for each of the publishers. I suggested that they aim to build a one big community combining all their end users (across all the publishers they were working with), but they claimed that the publishers are unwilling to authorize that.

I’m not convinced to this day that they put enough effort into properly designing it and/or selling it to their customers, but that’s not the point. The point is that you must get the buy-in of your customers if you want to unleash the full potential of your network in such types of businesses – and that may be the biggest challenge.

Marketplaces

Marketplaces usually belong to the B2C space, though it’s not mandatory. I once worked in a B2B company which designed a marketplace.

Anyway – if your product is around a marketplace – then you are already well positioned to leverage network effects. By definition a marketplace means that you have a demand side and a supply side – and they both need each other.

Marketplaces deserve a post of their own, and I promise to do one in the future.

However, for now I will just say that the fact that your product is a marketplace doesn’t mean the network effects exist or are strong enough.

Examine your marketplace closely and ask yourself what’s the value that each additional player on the supply side or the demand side provides the rest of the group.

You may find out that any additional player/user that is added to the demand/supply side is only beneficial to one side of the marketplace and the value, by itself, is not great. What if you could change it?

What if you could change the dynamics so that each new addition to your marketplace (and it doesn’t matter from each side) – adds value to both sides of the marketplace?

 

For example – AirBnB.

It’s very clear that each new end user who is looking for an apartment to short-term lease is adding value to the suppliers (the people who offer apartments). However, each new supplier is actually taking away value from the other suppliers because they create a competition for them, and hence lowering prices.

What if AirBnB could create some kind of internal network for the suppliers, so suppliers can connect to offer a full vacation to renters, spread across different geographical regions (and hence planning a vacation becomes much easier and economical)?

Yes, suppliers around you will still be a competition, but suppliers located 40 mile away would become partners.

Again, just a thought – it may be very likely that this idea was already explored and disqualified, but I’m just trying to train you on the way you need to think about this.

 

With all the examples above I hope I was able to spark in you the initial desire to explore network effects in your product. Yeah, it may not fit yours, but if you do find a creative and beneficial way to embed network effects in your product then the upside is gonna be really big!

 

That wraps up the post for today.

If you found this post/series useful – feel free to let me know in the comments. If you think others can benefit from it – feel free to share it with them.

 

Thank you, and until next time 🙂

Related posts

A man is buttoning his suit

The CEOs You’ll be Working With

The previous posts were somewhat ‘heavy’ so today I’d like to have a shorter and lighter post. Hence, today we’ll be discussing the various types

Two robots sitting back to back

Asta La Vista Baby!

Maybe I’m late to the party, I don’t know, but it took me some time to process it. I gave it a lot of thought

An advanced robot leaning forward

Never Say Always

Ideals, principles and values People just love to hold on to them. I get it.  It gives us a sense of control over the chaotic