As an entrepreneur running a startup, you must have heard the phrase, “Network Effects”, however, like many entrepreneurs, you might not understand what it means or the effect it has on your business. Network effects are a powerful engine of growth that can affect your business in a profound way. Why should you learn about it? Let’s explore as we go.
In simple terms, a network effect is a situation in which a product gets more valuable as more users make use of it. Metcalfe’s law, propounded by 3Com founder and tech luminary, Bob Metcalfe, which states that the power of a network is proportional to the square of the number of users connected to that network, is the governing principle to gauge Network effects in its truest sense.
A good example is the telephone. The telephone would be useless if you were the only one using it, but because your friends, business partners, and other people use it, it is extremely valuable.
Unfortunately, most entrepreneurs confuse viral effect for network effect. For a viral product, the rate of adoption increases as more people use it.
The confusion arises because most companies with network effect also have a viral effect like Facebook. However, this is not always the case. A product can also have only network effects like Alibaba or only viral effects like Survey Monkey.
Facebook Growth Compared to Metcalfe’s Law
There are different types of network. Below, we discuss some of them.
An increase in usage causes a direct increase in value. A perfect example is Facebook; the more friends you have on Facebook, the more valuable it is to you.
An increase in usage fosters an increase in the production of a complementary product that in turn increases the value of the original product. For example, as more uses adopted Windows, more applications were built that in turn made Windows more valuable.
Increase in the usage by one category of users increases the value of a complementary product to a different category of users. For example, more riders do not increase the value I get from Uber but it draws more drivers that make Uber better.
To start with, for the past 23 years, about 70% of the total value created in the tech industry came from Network effects. This is not difficult to imagine when you consider multi-billion companies like Facebook, Twitter, Google, and Amazon.
In the highly competitive world of today’s market, it is only logical that a proper strategy is put in place to ensure success. One key success strategy is to harness network effects when starting your business. In fact, if you do not have network effects in your current business, you need to find a way to incorporate one.
By using network effects, you are able to create value as more users subscribe. It is a seemingly endless cycle, you create more value, more users get on board, and the cycle continues. However, you need to attain the critical mass before the network effect takes the wheel.
Think about this, when you have no customer, the value created by your service is zero. You have to look for ways to get early adopters on board. Do this for a while and when you get to the critical mass, BOOM! Network effect kicks in.
As customers or subscribers increase, the cost of maintaining these customers increases linearly, however, the rate of value creation increases exponentially till they intersect.
The intersection point is the critical mass and it defines the point where value created by the network is more than the cost of sustaining the network. This makes the growth sustainable if the right measures are put in place.
As you attain critical mass, your rate of value increases exponentially. What this means is that users will find it difficult to leave your platform for a similar platform because of the immense value derived from your product. Imagine a competitor with similar features with Facebook coming on board, good luck to them trying to convert Facebook users to theirs.
Also, incorporating a network effect gives you room to operate with a wider margin of error. This is because the value created depends on the network more than it does on your actions. Even when you release a debacle, the high cost of leaving your platform will dissuade your customers from leaving and this will give you enough time to correct your actions before things truly get out of hands.
Incorporating network effects in your business increases your chance of raising funds. With the knowledge of network becoming more widespread, many investors consider it before making an investment decision. In fact, 75% of investments in VC firms are in businesses that strategically harness the power of network effects.
It is almost certain that competition in the marketplace will only continue to rise as new startups continue to fall by the wayside. By understanding and taking advantage of network effects, you drastically improve the chances of your startup becoming the next big thing!
So startups, are you ready to take the big jump? Feel free to drop a note or reach out to us if you’d like to harness the power of network effects and amplify your valuation.
So till then, may your network be your driving force!
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