I recently had a great conversation with the founder and managing partner of a very active venture capital firm in blockchain technology. In explaining how he assesses the types of startups his firm invests in, I noticed he repeatedly used the word "network effects". When I shyly asked him what that meant, he explained that it's probably the single most important 'metric' on which his startups depend. After the call, he recommended that I read about it because it is a hugely significant economic phenomenon for many digital tech businesses today, and it is influencing the way we interact.
What is the network effects?
Simply put, the network effect is the phenomenon that the value or utility of a product or service increases as more users join the network. The network effects lies at the core of the digital age, influencing everything from social media platforms and online marketplaces like Etsy and eBay to a wide range of new technology.
Metcalfe's Law vs network effects
Metcalfe's Law, named after the visionary engineer and entrepreneur, Robert Metcalfe, encapsulates the underlying principle governing the network effect. It states that the value of a network is proportional to the square of the number of its users. Metcalfe's Law is often used to explain and quantify the network effects that arise in certain contexts, particularly in technology and telecommunications industries. While the cost of new members to a network increases linearly as more people join, the value of being part of that network increases exponentially for everyone in the network.
Illustration of the network effects and Metcalfe's Law
To illustrate the power of network effects and Metcalfe's Law, picture a telephone network with a single user—a rather lonely scenario. However, as each added user joins the network, the potential for communication and interaction increases exponentially. With two users, only a single interaction is possible, but with three users, the number of potential interactions jumps to six. As the user base continues to grow, the possibilities become virtually limitless. Ray Stern's graphical illustration below gives an excellent summary.
Examples of the network effects in real life
Internet Adoption:
The internet stands as a testament to the undeniable proof of network effects and Metcalfe's Law.
In the early days of the internet, its value was relatively limited. However, as more users joined and connected with friends, family, and colleagues across the globe, the network effects intensified, propelling the internet into an unparalleled era of innovation and productivity.
The number of global internet users increased from about 400 million in 2000 to 4.7 billion in 2020. This led to the growth of online services, e-commerce, and the sharing of information—further enhancing the value and utility of the internet, which in turn has continued to attract more people.
Social Media Platforms:
Social media platforms like Facebook and Twitter have become quintessential examples of the network effect. Similarly, communication tools such as WhatsApp, Zoom, and Slack also rely on network effects. The more users join the platforms (or adopt the tools), the wider communication potential there is and the greater the engagement and content creation. This creates a virtuous cycle that attracts even more users.
"Facebook is quite entrenched and has a network effect. It's hard to break into a network once it's formed."
Elon Musk
Cryptocurrency and Blockchain:
Cryptocurrency and blockchain are now synonymous with the network effects and Metcalfe's Law. The larger the network of users, the more [exponentially] valuable and secure the cryptocurrency gets. For example, Bitcoin, the most popular cryptocurrency, has experienced exponential growth over the past few years as more people adopt it. It now has over 190 million users worldwide, with a market capitalisation exceeding $501 billion (having reached over $1 trillion once). This widespread adoption has attracted even more users, investors, businesses, and developers to the crypto ecosystem, which in turn has increased liquidity, market acceptance and blockchain infrastructure development. The network effects of cryptocurrencies are a crucial factor in their success and influence crypto's governance and market dynamics.
Transportation Networks:
Public transportation systems exemplify the network effect. A larger network of routes, stations, and vehicles leads to improved connectivity, shorter wait times, and increased convenience for passengers. For instance, the New York City subway system, one of the busiest in the world, carried over 1.7 billion passengers pre-Covid in 2019. A similar pattern is seen in other busy cities, whether with buses, trains, or flights. The network effects of public transportation also contribute to reduced traffic congestion, expansion of routes, better infrastructure development, lower carbon emissions, and enhanced accessibility, making it an essential component of urban mobility development.
Network effects are powerful moat for defensibility
Network-driven and patent-based businesses are probably the most defensive businesses, although you would wonder to what extent the later still is.
This is because the strength of network effects is reinforced over time, which makes it harder for competitors to break in. As more users join the network, the value of the network increases, leading to a higher barrier for new entrants to match the existing user experience and volume. This creates a self-perpetuating cycle where existing users have fewer incentives to leave and new users are drawn to the platforms with the largest user bases.
Users increasingly become reluctant to switch to a new platform that lacks a critical mass of connections, content, and interactions. Many tech companies, such as Google, PayPal, Facebook, and LinkedIn, have created a strong competitive advantage using network effects. Even a non-typical platform company like Apple has leveraged the power of the network effect so well by building an ecosystem that gets better and more difficult to escape with each added Apple product, software, and service. With over 2 billion active devices globally, Apple seamlessly integrates different features across its gadgets that foster customer loyalty and help drive recurring revenue.
Note: If interested in the different types of network effects or a deeper understanding, NFX, a pre-seed and seed stage VC, are experts on the topic and have free great content on the website.
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