Venture Capitalists: Here’s How To Identify Network Effects

It’s always surprising how little many Venture Capitalists know about network effects. They think they do. However, when I ask them to define network effects and explain how to spot whether a startup is taking advantage of them, they often miss significant aspects. Most Investors confuse network effects with virality, winner-take-all dynamics, and even product-market fit. It’s paramount for VCs to correctly identify network effects because they can be incredibly advantageous to the companies they invest in. Incorrectly calling network effects, on the other hand, may lead to a bad investment decision.

In this post, I explain the fundamentals of network effects and provide a framework for VCs to quickly assess whether or not a startup is taking advantage of them. I illustrate this analysis grid with case studies of startups capitalizing on network effects—and others that seem to do so but don’t.

What are network effects and where do they come from?

Participants of my VC Career Accelerator (active VCs and Angels, or Aspiring VCs) all go through an online module called What Do VCs Do?, where they learn about critical tasks of the VC Cycle, from generating deal flow to selling portfolio companies. One such step is the evaluation of startups considered for investment—and among them, how to identify network effects. They frequently struggle to give a simple definition to explain this central concept in Venture Capital investing.

A network effect occurs when the value of a product or service increases with each additional user.

Let’s use a simple example to illustrate this definition: the telephone.

Bell’s phone: the textbook case study

The invention of the phone by Alexander Graham Bell in 1876 revolutionized the way people communicated. Bell saw the potential for a device that could transmit sound through electric signals over long distances. After several years of hard work and experimentation, he was able to patent the telephone.

At first, people were skeptical about using telephones since there wasn’t any infrastructure for them. But Bell had a plan. In a move that could be considered the first tech growth hack in history, he let people use the phones for free if they agreed to have them installed in their homes and businesses. This was a stroke of genius as it incentivized more people to get on board with the new technology and start using it.

By 1900 there were nearly 600,000 phones in Bell’s telephone system; that number shot up to 2.2 million phones by 1905, and 5.8 million by 1910. It was clear that Bell’s invention would be incredibly successful and change how we communicate forever.

Characteristics of network effects

It is easy to get lost in the various types of network effects at play in tech today. The folks at VC firm NfX are probably the most sophisticated on the topic (hint: it’s in their name). They’ve listed no less than 16 different kinds of network effects, including social network, product, infrastructure, and data network effects.

However, since most VCs don’t have time to dig into the subtleties of network effects, here are some rules of thumb to identify them:

• Is one more user making the experience better for existing ones? Again, let’s go back to the telephone. If you have the only telephone ever built, it’s not a fun experience. Two connected users vastly improve it. Three even more. And so on.
• Is the value of the product or service increasing exponentially or proportionally? Social networks are a great example of an exponential increase in value. As users multiply, it becomes easier to find more people to connect with and discover more content. Even with a small number of users in its early days, Facebook was able to generate incredible growth.
• Is the impact direct or indirect? In some cases, it is harder to identify network effects because they are indirect: adding users strengthens the product for all. Think of operating systems such as Windows, which is successfully integrated into third-party applications and with hardware manufacturers.
• How fast will the network effects materialize? The velocity of network effects is a significant characteristic—the faster they do so, the stronger their impact on a company’s performance. Consider WhatsApp: its rise to becoming one of the most popular messaging platforms was incredibly rapid. It took Whatsapp four years to reach 100 million users; two more years to quadruple to 400 million; and that number grew again by 2.5x in the next two years.

One more concept central to network effects is the ability to generate increasing returns. Standford professor Brian Arthur describes them as the tendency of products and services to become more valuable as they gain in popularity. In a 1996 Harvard Business Review article that is often credited as one of the first mentions of network effects, he examines how increasing returns can create a cycle of advantage for certain firms and disadvantage for others.

That’s where we go to next: understanding why VCs are so crazy about network effects.

Why Do Network Effects Make Companies Valuable?

Network effects are incredibly advantageous for businesses capitalizing on them because they give them an edge over their competition that is difficult to replicate. In Venture Capital lingo, we call it a moat, a fancy word for a barrier to entry or to exit.

When it comes down to it, businesses want two things: repeat customers (people loyal enough to return) and new customers (people willing to try out something new). Network effects address both of these needs because they incentivize existing customers not only to stay but also to recommend the product/service by sharing with their friends who may be willing to try something new.

The snowballing nature of network effects creates exponential growth potential where even relatively small numbers can add up quickly.

OpenTable: Exploiting Network Effects To Increase Market Penetration

In a recent interview with Tim Ferris, Benchmark’s Bill Gurley illustrates how network effects made OpenTable, the restaurant reservation app, so successful. Like most platforms, adding more restaurants made the experience better for users; and adding more users made it more profitable for restaurants to use OpenTable’s service.

The startup was able to capitalize on the “chicken & egg” problem by providing a valuable service for both restaurants and customers. By connecting these two groups, OpenTable was able to establish an extremely valuable revenue stream for itself and become one of the most successful companies in its field. The key to its success was recognizing how powerful network effects can be in this type of business model and leveraging them accordingly.

We started looking for startups exploiting network effects because they tend to cause outlier outcomes.

Bill Gurley – Benchmark (Source: The Tim Ferriss Show)

Bill Gurley also tells a story involving OpenTable’s CFO, who warned him that he was going to quit after realizing that the service would never become profitable. It turned out that the veteran retail professional had greatly underestimated OpenTable’s potential market penetration, capping it at 17% in his model. However, as the company grew, it got close to 90% market penetration in the cities in which it was active.

Once a significant enough base of restaurants had joined the service, it was hard for others to ignore it. The momentum reached by OpenTable’s network effects allowed it to rapidly expand its user base and become one of the leading providers of reservation services in the world.

VCs Beware: Network Effects Are Not Just Virality

Venture Capitalists evaluating investment opportunities often confuse network effects with virality, and sometimes with adjacent concepts such as winner-takes-all markets. Although they are often necessary for network effects to develop, these characteristics are only peripheral. As a result, Investors may lend incorrect qualities to the startups they invest in, ending up surprised when the unassailable moat does not materialize.

How Virality differs from network effects

I believe that Investors confuse virality and network effects because both are related to the idea of rapid growth. However, there is an important distinction between the two concepts:

• Network effects occur when customers become more valuable as the user base grows
• Virality is a measure of how quickly a product or service spreads through word-of-mouth

Network effects are driven by customer satisfaction and loyalty, while viral strategies rely on incentives and referral programs to encourage people to share a product or service with their colleagues, friends, and family.

Let’s take an example.

I’ve been using the online appointment booking tool Calendly for a couple of years, and I’m highly satisfied with it. It’s helped me eliminate considerable time I used to spend (re)scheduling meetings. Before it was as popular as it is now, I systematically recommended Calendly to clients, friends, and everyone in my network. Word-of-mouth at its best.

When a new user joins Calendly, booking appointments becomes easier for that person. But does it add anything to existing users’ experience? Not really. Existing users act as ambassadors. The first adopters are so committed that they take time to explain to their friends why they should also use such a tool. It’s virality at its best and helps reach product-market fit faster.

But there are no network effects. Competing services have met some success, and although there is no reason to stop using Calendly, it’s not difficult to switch to another provider—compared, say, to moving out of Facebook or LinkedIn to join a competitor.

Case Study 1: Hotmail And Viral Marketing

Hotmail is a poster child of startup virality. At the time, it was the media company that had created the fastest user base ever: 25 million active accounts in less than three years. That’s faster than what two wunderkids of the media world, CNN and AOL, had done in their day.

How did Hotmail grow so fast? Did it benefit from network effects?

We need to provide some context to understand Hotmail’s extraordinary trajectory. Back in 1996, when Jack Smith and Sabeer Bhatia founded Hotmail, users had to pay for the email service they got from providers such as AOL (remember the “You got mail” computer voice?). Yes, you read it right. It’s hard to believe it now, which underlines how disruptive Hotmail’s idea of a free email service was. (Note: AOL charged for general access to the internet, which included email.)

Another advantage Hotmail offered was that it was web-based, allowing users to connect from anywhere. AOL subscribers, on the other hand, could only consult email from their own computers. But even with a superior product, how did Hotmail reach so many users so fast? After all, startup cemeteries are full of good products that nobody wanted.

I came up with Hotmail’s viral marketing idea.

Tim Draper (Source: Andrew Bellay)

Hotmail used a devilishly simple trick. Each Hotmail message sent bore a footer telling the recipient that Hotmail’s service was not only web-based but also free, with a link to open an account. The exact sentence was: “Get your free email at Hotmail.” No doubt competitor AOL was unhappy about such tactics, but it worked. Hotmail, which was spelled HoTMaiL to showcase its HTML roots, was the cool kid in town.

Having users advertise your product to their networks several times daily is a clever virality ploy. In fact, this tactic became the poster child of “viral marketing”, a terminology made famous by the VC Firm DFJ (Tim Draper widely credits himself with the Hotmail viral marketing idea.)

However, did Hotmail benefit from network effects? Not really: it was still possible to use different services, even other webmails, and interact with Hotmail users. RocketMail, which later became Yahoo! Mail, is a prime example. In other terms, there wasn’t any real upgrade in the user experience to have more Hotmail users, other than faster email delivery.

Case Study 2: Dropbox And Referral Marketing

Dropbox co-Founder Drew Houston is widely acclaimed as the marketing wiz behind Dropbox’s success. As was apparent in Dropbox’s S1 document when the company filed for its IPO, the growth in users was exponential between 2009 and 2016. In just 15 months, from September 2008 to January 2010, the number of registered users went from 100,000 to a staggering 4 million. 

Did Dropbox benefit from network effects?

A slide deck published in 2010 provides more data on Dropbox’s impressive growth and helps us answer the question. According to Drew Houston, most of it was due to “word-of-mouth and viral” (in his mind, these seem to be two different things). The referral program alone accounted for 35% of daily signups.

The referral program was quite simple and borrowed a page from PayPal’s playbook. Instead of earning money, as in the PayPal program, both Dropbox referrer and referee were awarded storage space. It allowed the first ones to upload even more documents on Dropbox, and was sufficient for newcomers to test the solution. 

So-called two-sided incentive programs are nothing new. American Express has been running one for years. The trick is to offer the same reward to both parties. However, Dropbox took it to a whole new level:

• Customers who performed specific tasks were rewarded with more space
• They could initially refer up to 32 friends
• Users could easily monitor how much free space they had been awarded 

The process was designed to be effortless so that users could quickly and easily send referrals without any hassle. It encouraged more people to take advantage of the system, thus increasing Dropbox’s user base.

However, are there network effects at play here? While more users may have helped reduce bandwidth costs for Dropbox, the customer experience did not necessarily improve with each new user. In fact, Dropbox had the potential to keep any cost savings that came from additional users rather than sharing them. Ultimately, these benefits were not tied to booming network effects in any tangible way.

Case study 3: Facebook, “the big kahuna” of Network Effects

Every social network relies on network effects: every time a new user joins, it makes the experience better for everyone else (unless newcomers behave poorly). MySpace, Twitter, Instagram, Quora, and Reddit all present the same dynamics. New members increase content, business opportunities for some, and networking ones for all.

To understand how Zuckerberg was able to exploit network effects so efficiently, it is worth going back to his previous entrepreneurial venture: Facemash.

Facemash: Zuck’s Foray into Network Effects

As portrayed in the 2010 movie, The Social Network, Mark Zuckerberg’s first endeavor at Harvard was to create a website where male students could rate female students. In the face of justified outrage, he ultimately took Facemash down.

By that time, Zuck’s website had become the most popular on campus. The Harvard Crimson published an article in 2003 describing Facemash’s rapid growth. According to the article, the link to Facemash was initially sent to only a few friends but within hours had become one of the most popular sites on Harvard’s network. 450 people used it on just the first day and voted an astonishing 22,000 times.

Facemash was Zuck’s first encounter with the power of virality.

Zuckerberg said that he was aware of the shortcomings of his site and that he had not intended it to be seen by such a large number of students.

The Harvard Crimson (2003)

Zuckerberg’s defense against the initial backlash of Facemash may have been a weak attempt to avoid being expelled. However, the huge popularity and engagement from Facemash showed early signs that Zuckerberg had tapped into something—namely, the power of network effects.

Not only did students want to tell their friends about this fun and cool new site, but they also wanted to compare how they rated each other. By having more of their friends join, users found that it made for a much better experience than if they were alone. This desire for connection is what drove Facemash’s impressive growth, and was a lesson well learned by its Founder.

Facebook: Lesson Learned

When thefacebook.com launched outside of Harvard, and then outside of campuses—a typical beachhead strategy—it employed two tactics to increase organic growth through virality.

The first was making it easy for existing users to invite friends by email. Facebook’s research showed that the average person would sign up after being sent an average of seven emails from friends. Zuck’s teams obsessively tracked and removed any friction in the user’s ability to invite friends.

Facebook also sought to convince users on campuses with their own facebook sites to move over to Facebook. To do this, they deployed on campuses close to the target campus (Yale, Princeton, Stanford) and had students from these surrounding areas invite their friends at the target campus.

Once the virality machine became efficient, Facebook turned on network effects. To understand how they operated, we need to distinguish the core motivations, even belief systems, underpinning virality and network effects.

Utility vs. Community

Virality relies on practicality, or utility as it is known in economics. If a platform provides a useful service that meets users’ needs, they are more likely to be active on it and share it with others. For instance, if a platform offers a service that makes life easier, such as finding nearby restaurants or ordering food from home, then people will be more inclined to use it and encourage their friends to join.

Utility helps create virality by giving users a reason to share the platform with others, which brings in new users and encourages existing users to stay active.

Network effects, on the other hand, rely on core human traits such as curiosity, sharing ideas, and the fear of missing out. They tie into our social fabric—we want our friends and family to use the same platform as us so that we can stay connected and be part of the same community. Understanding these motivations is critical when attempting to create effective network effects.

How did Facebook encourage this sense of community?

Firstly, it allowed users to tag other users in photos and events, driving increased sharing and organic growth on the platform.

Secondly, and perhaps more significantly, Facebook encouraged members to create community groups and pages, helping them find friends and like-minded individuals from all over the world and build relationships far beyond geographic boundaries.

In essence, by leveraging network effects across various aspects of its business model, Facebook has been able to become a global leader in social media with 2 billion monthly active users worldwide.

Conclusion: tl;dr

Recognizing network effects can help Venture Capitalists identify promising investment opportunities. By understanding how particular products or services are enhanced by increasing returns on user numbers, Investors can make informed decisions when selecting which startups to back.

Network effects occur when a product or service increases in value as more users join, and often rely on our sense of community—as the Facebook case study clearly shows. By contrast, virality, which is a necessary but insufficient condition of network effects, relies on utility and practicality, a principle I illustrated with the Hotmail and Dropbox case studies.

Network effects can provide a serious competitive advantage and should be considered when evaluating potential investments. Investors should look for startups that have an existing user base and are likely to benefit from strong network effects in the future. They also need to understand how virality and community contribute to an effective business model and how these dynamics are used by the startup.

However, VCs should be aware that strong network effects are rarely found in startups. Failing to do so may lead to subpar performance on the investment.