OnStartups

Understanding Real Network Effects

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I hear the term “network effects” a fair number of times when I talk to software company founders.  The thinking goes something like this:  “We’re going to give away our AJAX-driven, patent-pending, orphan sock matching software away for free so we can build a large base of customers and take advantage of network effects."

 

In my experience, In about 1 out of 4 times the term “network effect” is used, it is used incorrectly.  People often mistake having a large customer-base with an automatic network effect.

 

I’m by no means an expert on network effects and couldn’t give you a rock-solid, academically oriented definition, but I can provide a simple explanation:  A network effect exists when each user/customer/member that is added to the network increases the “value” of the network to other users.  So, if you have 10,000 customers, you don’t necessarily have a business model with a “network effect” unless customer X benefits from the fact that customer Y is also on the network.  Though a (weak) argument can be made that customer X indirectly benefits customer Y, because they’re paying money, thereby increasing your revenues, thereby giving you more resources to improve the product – this is really not what network effects are about.

 

Social sites like Linked In, delicious, and others have a network effect.  The more users there are, the more everybody benefits.  If I’m a user, there is some benefit (sometimes miniscule) to me if you also join the network.  The power of this model is that when users understand this, they are more likely to refer other users (because they would benefit from the growth in the network).  Other examples are the phone system (the more people that have phones, the more people that you can potentially talk to), instant messaging, Skype and others.

 

A good example of the absence of network effects is the Google search engine.  I’m going to argue that just because I’m using the Google search engine does not directly increase the value of the engine to you.  I could stop using Google tomorrow, and it would still work for you just as well.  In fact, in a theoretical sense, you could be the only user to use the Google search engine, and as long as the algorithm still worked and the index was still there, you’d get about the same value.  It helps you find stuff.  In fact, you have little incentive to convince me to use Google as well (other than good will) because it does not increase your Google experience at all.

 

So, next time someone tells you their business takes advantage of “network effects”, ask them how you would benefit from the system by getting other people to join.  If there’s not a good answer, or the benefit is indirect, chances are, there’s no network effect.