What are network effects?

My preferred definition of network effects is: 

A network effect occurs when a product or service becomes more valuable to its users when more people use it

\It’s important to distinguish this from viral effects, which is where a product or service encourages users to recruit other users in order to grow the product. Take Wordle, the game that took the world by storm in early 2022. Many of us, myself included, started playing as a result of friends’ recommendations. This is somewhat of an in-built growth hack, deployed by many startups as a way of acquiring customers (often incentivized by referral benefits—e.g. HelloFresh or other DTC brands). 

Crucially, the experience of the product doesn’t improve with the more people that join it (aside from some bragging rights). The result? There’s little defensibility to the product, evident in the inevitable slump in Wordle’s daily users.

Products with network effects have both this in-built growth hack and a core defensibility, from the fact that the experience improves with each new addition to the network. Those who used Skype back in the day will understand that, with each new user, the experience improves as there are more people you can speak to on Skype.

Challenges associated with creating network effects

Building a business around a potential network effect isn’t a guaranteed formula for success. There are a number of challenges that founders need to be conscious of overcoming:

This is the first, and arguably biggest, challenge you’ll face—a classic chicken-egg conundrum. If the value of the business is in its network, then how do you get those first initial customers on board before the network exists? 

There are a couple of ways to address this. First of all, you should try to enable a ‘single player mode’—some utility to those users who are coming in before there are any network connections. Adobe, as a way of trying to entice users to their full Adobe suite, has Adobe Acrobat as a free single player mode, allowing users to read Adobe (PDF) documents before paying for their software to collaboratively create and edit them. At Clear Score, we needed to onboard vast swathes of customers before some large credit card providers would partner with us: so we offered free credit reports in a very consumable and interesting way, along with tips on how to improve your credit score. 

Hyper-local launches are another way of addressing this. Rather than exploding into a large market at once, it can be more effective to address a much smaller market. Uber doesn’t launch into France all at the same time: they launch into central Paris or Lyon, and get a density going in that space. 

You may also have to be prepared to subsidise one side of the market. How many people will use Uber when there are no drivers; and similarly, how many drivers will register if there are no fares? Therefore in each market, Uber recruits a bunch of drivers and pays them a minimum fee for idling: that way, they have a bank of drivers ready to cater to the first customers. 

Finally, you should think about services you can offer on top of the network. Before launching their marketplace, OpenTable went into every restaurant with an iPad booking system to replace the primitive pen and paper method: once a number of restaurants were using this, they added them to the marketplace to entice customers. 

There are also a number of challenges associated with scaling your network. To build true defensibility you should consider how your business can overcome the following:

Network congestion

Multi-tenanting

What stops an Uber driver from registering for Lyft, Bolt, etc? What stops an eBay vendor from using Facebook Marketplace, Depop, and so on? There are no downsides to using both, and therefore I’ll likely use whichever pops up first. To avoid this, platforms have to really offer something unique or impactful to their network as a way of keeping them engaged, or make it impractical to run two systems.  

Disintermediation

Asymptotic effects

At Clear Score, we’ve faced this challenge: once you’ve onboarded most high street banks, any addition has minimal added value. So we’ve deployed two strategies:

• Actively sought out underserved markets— with regards to our market, this means working with providers who are reaching those with poor credit scores, or those who wouldn’t consider applying for a credit card

• Increasing our data leverage— this is behind our latest product, Drive Score, where we’re using black box data created from the DriveScore app to convince insurers you are a good driver (and get better rates) without an actual blackbox

Network effects come in many flavours, and when properly established, they can add huge utility to your customers and defensibility to your business. It is worth consciously exploring how you can maximise their impact and it will likely pay back many times over in terms of the value you create.

If you’re interested in reading more about network effects in startups, then check out the NFX ‘Network Effects Bible’