What Are Network Effects and Why Should I Care?
Disclaimer - the content of this entire article is derived (in many cases verbatim) from an excellent, much longer, much better written blog post on the subject of network effects written by James Currier, Partner at NFX Capital. My intent here is to summarise and explain. It's a shortcut and a reference guide.
You hear a lot of investors and technology companies talk about network effects. This is because they are very valuable. They're a driving force behind most of the dominant technology firms in the world today. It's the reason they can grow so fast and gobble up market share from previously well-defended incumbents.
In simple language, network effects occur when a company’s product or service becomes more valuable as usage increases.
This is a mathematical phenomenon - the network’s usefulness is proportional to the number of nodes (people or devices) in the network. Usefulness grows exponentially.
Look at the below example:
This happens a lot in technology, and always has. AT&T achieved dominance in the American telecoms market in the early 19th century by acquiring the underlying physical telephone infrastructure from the Bell company. With control over the physical network, as the number of phone users grew, their power grew rapidly. They operated as a regulated monopoly for most of the 20th century, until they were eventually broken up in 1984.[1]
There are 14 (and counting) types of network effects
The internet is allowing the same thing AT&T did to happen again, in a myriad of ways. This summary will help you understand them, and think about which ones might be applicable to your business. If you use them right, they will make your company more defensible.
The 14 types of network effect fall into 5 overarching categories. Those at the centre of the infographic are the strongest. Source: NFX Capital
Generally, businesses exhibiting network effects closer to the centre of the above infographic will be more defensible
You will notice the network effects nearer the centre tend to be more concrete and easier to grasp. This is important - can you try to build the architecture of your company around stronger network effects? If you can, you should.
Also of note, many businesses will exhibit more than one type of network effect (eg. Amazon has 2-sided marketplace, data and tech performance network effects). Can you think about how to drive multiple types?
Network Effects are one of the last real ways to make your startup defensible.
The others - scale, brand and embedding (i.e. being stuck with a company and not changing because it's a pain) - take a lot of time and money to come into play. So if you are a startup, network effects are worth thinking about very seriously.
Below is a summary of the fourteen types of network effects, and examples of them in play. Hopefully it helps you!
[1] AT&T – Wikipedia. Sourced 18th February 2020 - https://en.wikipedia.org/wiki/AT%26T_Corporation