Network Effects: What VCs Really Look For (With Case Studies)

I'm often surprised by how little many Venture Capitalists know about network effects. When I ask them to define network effects and explain how to spot whether a startup is taking advantage of them, they often miss significant aspects. Most Investors confuse network effects with virality, winner-take-all dynamics, and even product-market fit. It's paramount for VCs to correctly identify network effects, as they are highly advantageous to the companies they invest in. Incorrectly calling network effects, on the other hand, may lead to a bad investment decision. In this post, I explain the fundamentals of network effects and provide a framework for VCs to quickly assess whether or not a startup is taking advantage of them. I illustrate this analysis grid with case studies of startups exploiting network effects—and others that seem to do so, but don't.

In This Article

What are network effects and where do they come from?

Venture Capitalists frequently struggle to give a simple definition to explain this central concept in Venture Capital investing. Here's the one I use to train VCs in my program:

A network effect occurs when the value of a product or service increases with each additional user.

Let's use a simple example to illustrate this definition.

Bell's phone: the textbook case study

Alexander Graham Bell's invention of the phone in 1876 revolutionized the way people communicated. Bell saw the potential for a device that could transmit sound through electric signals over long distances. After several years of hard work and experimentation, he was able to patent the telephone.

At first, people were skeptical about using telephones since there wasn’t any infrastructure for them. But Bell had a plan. In a move that could be considered the first tech growth hack in history, he let people use the phones for free if they agreed to have them installed in their homes and businesses. This was a stroke of genius as it incentivized more people to get on board with the new technology and start using it.

As more people began using phones, they started to realize how useful they were and how convenient it was to be able to communicate with someone far away simply by picking up a receiver and speaking into it. This created a network effect whereby each additional user increased the value of phone service for everyone else who was already subscribed.

By 1900, there were nearly 600,000 phones in Bell’s telephone system; that number shot up to 2.2 million phones by 1905 and 5.8 million by 1910. It was clear that Bell’s invention would be incredibly successful and forever change how we communicate.

Characteristics of network effects

It is easy to get lost in the various types of network effects at play in tech today. The folks at VC firm NfX are probably the most sophisticated on the topic (hint: it's in their name). They've listed no less than 16 different kinds of network effects, including social network, product, infrastructure, and data network effects.

However, since most VCs don't have time to dig into the subtleties of network effects, here are some rules of thumb to identify them:

• Is one more user making the experience better for existing ones? Again, let's go back to the telephone. If you have the only telephone ever built, it's not a fun experience. Two connected users vastly improve it. Three even more. And so on.
• Is the value of the product or service increasing exponentially or proportionally? Social networks are a great example of an exponential increase in value. As users multiply, it becomes easier to find more people to connect with and discover more content. Even with a small number of users in its early days, Facebook was able to generate incredible growth.
• Is the impact direct or indirect? In some cases, it is harder to identify network effects because they are indirect: adding users strengthens the product for all. Think of operating systems such as Windows, which is successfully integrated into third-party applications and with hardware manufacturers.
• How fast will the network effects materialize? The velocity of network effects is a significant characteristic—the faster they do so, the stronger their impact on a company’s performance. Consider WhatsApp: its rise to becoming one of the most popular messaging platforms was incredibly rapid. It took WhatsApp four years to reach 100 million users and two more years to quadruple to 400 million. That number grew again by 2.5x in the next two years.

One more concept central to network effects is the ability to generate increasing returns. Standford professor Brian Arthur described them as the tendency of products and services to become more valuable as they gain in popularity. In a 1996 Harvard Business Review article containing one of the first mentions of network effects, he examined how increasing returns can create a cycle of advantage for certain firms and disadvantage for others.

That's where we go next: understanding why VCs are so crazy about network effects.

Why Do Network Effects Make Companies Valuable?

Network effects are incredibly advantageous for businesses capitalizing on them because they provide an edge over competitors. In Venture Capital lingo, we call it a moat, a fancy word for a barrier to entry or to exit.

Businesses want two things: repeat customers (people loyal enough to return) and new customers (people willing to try out something new). Network effects address both of these needs. They incentivize existing customers not only to stay but also to recommend the product/service by sharing with their friends who may be willing to try something new.

The snowballing nature of network effects creates exponential growth potential. Small numbers can add up quickly.

OpenTable: Exploiting Network Effects To Increase Market Penetration

In a recent interview with Tim Ferris, Benchmark's Bill Gurley illustrated how network effects made OpenTable, the restaurant reservation app, so successful. Like most platforms, adding more restaurants made the experience better for users; and adding more users made it more profitable for restaurants to use OpenTable's service.

The startup solved the “chicken & egg” problem inherent to platform business models by providing a valuable service for both restaurants and customers. By connecting these two groups, OpenTable was able to establish an extremely valuable revenue stream for itself and become one of the most successful companies in its field. The key to its success was recognizing how powerful network effects can be in this type of business model and leveraging them accordingly.

We started looking for startups exploiting network effects because they tend to cause outlier outcomes.

Bill Gurley - Benchmark (Source: The Tim Ferriss Show)

Bill Gurley also tells a story involving OpenTable's CFO, who warned him that he was going to quit after realizing that the service would never become profitable. It turned out that the veteran retail professional had greatly underestimated OpenTable's potential market penetration, capping it at 17% in his model. However, as the company grew, it got close to 90% market penetration in the cities in which it was active.

Once a significant enough base of restaurants had joined the service, it was hard for others to ignore it. The momentum reached by OpenTable's network effects allowed it to rapidly expand its user base and become one of the leading providers of reservation services in the world.

VCs Beware: Network Effects Are Not Just Virality

Venture Capitalists evaluating investment opportunities often confuse network effects with virality, and sometimes with adjacent concepts such as winner-takes-all markets. Although they are often necessary for network effects to develop, these characteristics are only peripheral. As a result, Investors may lend incorrect qualities to the startups they invest in, ending up surprised when the unassailable moat does not materialize.

I believe that Investors confuse virality and network effects because both are related to the idea of rapid growth. However, there is an important distinction between the two concepts:

• Network effects occur when customers become more valuable as the user base grows
• Virality is a measure of how quickly a product or service spreads through word-of-mouth

Network effects are driven by customer satisfaction and loyalty, while viral strategies rely on incentives and referral programs to encourage people to share a product or service with their colleagues, friends, and family.

Let’s take an example.

I've been using the online appointment booking tool Calendly for a couple of years, and I'm highly satisfied with it. It's helped me eliminate considerable time I used to spend (re)scheduling meetings. Before it was as popular as it is now, I systematically recommended Calendly to clients, friends, and everyone in my network. Word-of-mouth at its best.

When a new user joins Calendly, booking appointments becomes easier for that person. But does it add anything to existing users’ experience? Not really. Existing users act as ambassadors. The first adopters are so committed that they take time to explain to their friends why they should also use such a tool. It’s virality at its best and helps reach product-market fit faster.

But there are no network effects. Competing services have met some success, and although there is no reason to stop using Calendly, it's not difficult to switch to another provider—compared, say, to moving out of Facebook or LinkedIn to join a competitor.