Network Effects

If there’s one thing that venture capitalists love more than anything else, it is the idea of network effects. The idea that the value of a product or service to a user increases as the number of users also increases. This was first seen in the coming of the telephone network, where Robert Metcalfe explained that the effect of this network was actually proportional to the square of the number of users that are connected to the system. It’s this fundamental idea that drives platforms like social media and buy/sell marketplaces and is the reason why companies such as Airbnb have become as enormous as they are now (among other reasons).

Not all network effects are created the same however. There is a positive effect and a negative effect. When the value of the product or service increases as the number of users does, we have a positive network effect and everything looks great. If, on the other hand, increasing the number of users actually decreases the value of the product or service, we have a negative network effect start to appear, also better known as congestion. When too many users are on a site and the server starts to slow down or even crash, the users experience congestion. This includes symptoms like frustration, slow connectivity, and a drop in usage.

In order to culminate a positive network effect, there is a point in a company’s lifetime where the value obtained from a product or service equals or exceeds the price that is paid for that product or service; this is known as critical mass. Startups that implement this model need to find a way to reach this point, otherwise they will not survive. This explains why startups that do work around network effects don’t always see the same success that others do who implement the strategy. A great example of this is the “freemium” model that apps commonly use to attract users in the beginning. (Note: the app store itself is considered to have a strong network effect as well).

The most likely reason venture capitalists become interested in startups that use network effects (Union Square Ventures even has it instilled in their investment thesis) is because, if implemented correctly, it becomes a massive magnet for users, which in turn can generate massive numbers in revenue depending on the model. The more users a product has, the more difficult it becomes for those users to stop using that product. This is mostly either because a lot of their peers are also using the product (think Facebook) or that the product is tied to something else and cutting off this product makes it difficult to access other parts of their lives (think cancelling an Amazon Prime membership). This is indeed what makes network effects so powerful and also attractive to venture capitalists.