What exactly are Network Effects?

What exactly are Network Effects? We all think we understand the basic concept of Network Effects and how they build startup businesses into competitive successes. Matt Ward does a great job at explaining that what we think we know about them, is not exactly right as learned from recent examples like Blue Apron.

What exactly are Network Effects?

Remember the beach? It was always a battle to build the best sandcastle. But inevitably, the tides turned and waves washed away your creation… you were devastated.

I hope you learned your lesson.

Moats are the most important aspect of any business. A defensible moat is the difference between lasting value and profitability and being ripped apart by the waves (i.e. competitors).

And while every entrepreneur “knows” they are building an unbreakable moat, is that really the case?

Moats

Rats run towards food, founders flock to money. Large opportunities lead to fierce competition — and nothing ruins venture returns quite like competition.

There is a saying among investors:

“Being ‘right’ doesn’t lead to superior performance if the consensus forecast is also right.” — Bill Gurley

Consensus never pays.

Competition catches on to obvious ideas (hence the issues with Uber’s business model).

Uber built a business around the “idea” of a moat. Because of local network effects between riders and drivers, Uber was able to build incredibly strong local networks — and to raise over $22B to fund their expansion.

I won’t dig into the issues with Uber’s model/assumptions again, but instead, I want to use their “moat” as an entry into the various moats most businesses employ.

So, how do you keep competitors at bay?

Many, Many Moats

In business, there are many ways to stand out. And what is defensibility if not a reason to choose one brand over another, or to remain a customer?

A moat either traps customers on your island or makes your castle an attractive destination… both acquisition and retention drive revenue.

It boils down to: What is your unique competitive advantage?

Without that, you don’t have a business. With that, you may have an empire…

Broadly speaking, there are seven customer acquisition and three customer retention moats that power the vast majority of businesses.

The best businesses build barriers for both.

Acquisition moats:

  1. Brand
  2. Network effects
  3. Product
  4. Patents and/or proprietary products
  5. Licenses
  6. Distribution
  7. Pricing power

Retention moats:

  1. Brand
  2. Network effects
  3. Switching costs

Understanding Moats

Acquiring customers is sexy. People prefer increasing revenue to cutting costs — it is our shortsighted, ego-driven nature. In venture especially, revenue is king. If we can acquire customers and make money, we will figure out the economics eventually. Raise round after round until you figure out profitability, right?

Of our acquisition advantages, I’d argue all but network effects are pretty well understood.

You know why you buy Apple (brand), use Comcast (no choice), prefer Netflix (great product) or get the best deals on Amazon (price + selection)… acquisition is relatively easy to understand.

The biggest misconception is with network effects, specifically with anticipating them.

The same is true for retention. It is a nightmare to change your bank and you’ve always voted Democrat (brand) so why switch things up? If it ain’t broke, don’t fix it.


The Nuances of Network Effects

Nothing trumps network effects. Businesses without strong network effects (NFx) always struggle, both in terms of growth and profitability.

Thanks to business basics and GAFA’s chokehold on the economy (and on our attention), we all have at least a basic understanding of network effects.

The problem is, by assuming we understand and can anticipate network effects, many entrepreneurs set themselves up for failure.


6 Misconceptions About Network Efforts

1. Word of mouth ≠ network effects

Telling friends about Facebook improves your experience; the same isn’t true for Starbucks. At best, Starbucks gets more business. At worst, I’m stuck behind more coffee crazed addicts waiting for a fix.

Word of mouth is a powerful tool, but by itself does not constitute a network effect.

2. Incentivized referrals ≠ network effects

The same holds here. Incentivization is a great acquisition strategy but not a defensible, product enhancing network effect in the majority of instances (cryptocurrencies excluded).

3. Data ≠ network effects

Data alone doesn’t define a network effect. While data is incredibly valuable to understanding and influencing customer behavior, it only becomes a product improving network effect once you learn to effectively utilize it. Plenty of companies capture mountains of data — they just don’t know what to do with it. Insights are valuable, noise isn’t.

4. Law of diminishing returns still applies

Network effects never die, but the resulting impact on overall defensibly and product has diminishing returns. The two-billionth person on Facebook did little to improve either social graph connectivity or user behavior patterning.

Network effects, like everything else, operate in an S curve — the question is, how high is the ceiling?

5. Not all network effects are international

Case in point, Uber. Uber’s product improves as local usage increases, but NYC having more drivers and riders does approximately nothing for my experience in Zurich. That means local networks are secure, but also frail. Competitors can enter any individual market, outspend incumbents and claw their way to the top.

In the situation of Uber, because any city or country can create competitors and any fool (or fund) can fund those upstarts, the competition tends towards infinity. What happens when supply exceeds demand?

6. Scale decreases CAC, i.e. improves economics


Blue Apron’s Big Problem

We mentioned Uber, but Blue Apron is a more interesting example.

Founded in 2012, Blue Apron pioneered the subscription meal kit. Get all the ingredients for an at-home, five-star meal — no worry, no hassle.

The value prop was obvious: easy, convenient, healthy, home-cooked, tasty meals. What family wouldn’t want that? And even though the price was a bit high, Blue Apron targeted the upper-middle-class anyway — it is a health food thing.

Growth was spectacular, it just took off.

And investors ate it up, literally. To date, the company has raised just south of $200M (excluding IPO).

On June 1st, 2017 Blue Apron filed for IPO. They were looking to raise $500M from public investors to further growth of the company and hit scale. Interestingly, their unit economics were still a bit shaky. But that was okay; plenty of companies had gone public prior to hitting profitability. As long as you were moving towards profitable, everything was on track.

Unfortunately, Blue Apron’s acquisition costs and business model were built around a relatively long payback period and anticipated a decreased CAC (cost of customer acquisition) because of course network effects would spread the service (via word of mouth, etc.).

It didn’t quite turn out how they planned. Instead, customers canceled at higher rates and it became clear that between market saturation (of high-end healthy foodies) and increased competition from other startups, Amazon, and even supermarkets made acquiring and retaining customers much harder and more expensive.

Keep Reading

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.