🏰 Network effects: the ultimate startup defence strategy
Founders Factory Startup Bulletin #14
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The Big Five in Tech—Google, Meta, Alphabet, Amazon, and Microsoft—are in constant competition, vying for the crown of the world’s most valuable company. Across them sits trillions of dollars in value.
And yet, all five share the same core ingredient. All of these tech giants owe, in large part, their success to network effects.
Network effects—the phenomenon which sees a product or service grow in value to its users as more and more people use it. For investors, they’re an immense driver of value; for founders, they’re the ultimate defence strategy and a great way to build a moat around your business.
So what do you need to know about network effects, and more importantly, how can you begin to build them into the core of your business?
In this month’s newsletter:
Building network effects: a guide by ClearScore & Salary Finance co-founder Dan Cobley
Our Summer Reading List
Latest news from the Founders Factory portfolio
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Excerpted from a talk by Dan Cobley, co-founder of ClearScore and Salary Finance, and Managing Partner for Fintech at Blenheim Chalcot
Network effects are found in 20% of startups, but are credited with creating 70% of the value in tech since 1994. They’re a sure fire way not just of acquiring customers, but ensuring that users get value from the more people that use a product. In this sense, they stand to benefit from a company’s growth: as such, they’re more likely to remain loyal.
Most founders will now be thinking—how can I build that into my business? Network effects come in many shapes and forms, and carry with them a number of challenges you need to overcome. Here’s a step-by-step guide to building network effects:
1. Know the difference between viral effects and network effects
“Refer a friend and get £10 off your next order.” We’ve all used products that incentivise us to recruit new users by offering us perks or discounted products. But, crucially, these are not network effects: these are viral effects.
Viral effects are a growth hack, tapping into users to help acquire new customers. Network effects have this growth hack, too: I’m much more likely to recommend a product to a friend if I know my overall experience on it will improve (this is much how social media operates).
The key difference? Viral effects don’t incentivise users to stay on: once I’ve referred all my friends for a discount code, the product doesn’t offer me additional value the more people that use it. Network effects do, however.
It’s important to understand this difference: it will help you understand as a business whether the methods you’re deploying will contribute to growing your network, or if they’re likely to hit a wall soon.
2. Identify what type of network effects you’re building
There are many types of network effects, each for different products and with different network dynamics. Founders should understand what type of network they are building, and what levers you can pull in order to grow this specific network.
Marketplaces, for instance, where network effects correlate to your breadth of choice. OpenTable is a two-sided marketplace for consumers (literally) and restaurants: the growth of one feeds the growth of the other.
Data networks grow in value with the more data that they can harvest: Waze, for instance, provides increasingly accurate traffic data as more drivers use their app, meaning the experience grows in quality.
3. Understand what you need to acquire your first customers
If the value of your product is in its network, then what do you have to offer your first customers? Why would a driver join Uber if there are no riders, and vice versa? This is known as the cold start problem.
One way to combat this is to offer a ‘single player mode’: essentially, some sort of value that is available to users separate to the network. OpenTable managed to get restaurants on board by providing iPads and giving them access to their online booking system. You also may need to subsidise one side of the market. Uber often has to pay inactive drivers in certain localities in order to augment the supply side of the market.
4. Find ways to keep growing the network (without hitting a ceiling)...
Scaling networks aren’t without their challenges. One of the key challenges with network effects is known as asymptotic effects (referring to a line which levels out without ever quite reaching a limit).
Let me illustrate this. If I live in a village with one Uber driver, then adding another Uber driver doubles the value and halves my waiting time. But once there are 1000 Uber drivers, and you add one more driver, there is no discernible difference for me as a passenger, and no real incentive for the driver as it doesn’t increase demand.
Founders have to be creative with adding new value: thinking of new offerings that might enhance your experience or add value. Uber is experimenting with a Favourite Driver feature, which addresses that problem in part.
5. ….while also figuring out how to hold onto your network
The other key challenge with scaling is understanding how to keep your network engaged and on your platform. A number of scale side effects might start to put users off, such as network congestion. This is where the network reaches saturation point, and it no longer feels useful or exciting to be a part of (many social networks experience this).
On the supply side, scaling has its challenges too. You may see disintermediation, where there’s no value in operating through the platform to perform the function (a problem often found with food delivery, babysitting, or services like plumbing).
You might also experience multi-tenanting. The success of a business model will no doubt spawn copycats (the Uber effect with Bolt, Lyft, FreeNow, etc). This gives both demand and supply side more choice between platforms.
For both of these problems, founders must come up with creative solutions to stand out. Perhaps this is a unique feature, or an embedded value, that means that your network will not only opt for you over the others, but stay with you for the long haul.
You can read Dan Cobley’s full unedited article on Network Effects here
📚Our Summer Reading List
Parked up on a beach or beside a pool for the next few weeks? We’ve compiled a list of recommended reads for you as you soak up the golden hours of summer:
Billion Dollar Brand Club by Lawrence Ingrassia (recommended by Michelle Wilk, Investor at Founders Factory)
Michelle says: “Brilliant read for all consumer founders out there! Billion Dollar Brand Club contains tales from D2C brands, their genesis and the playbooks that helped them rise to success, written by an ex-Wall Street Journal and New York Times business editor. While this book is rooted in the heyday for digitally-native brands, we hope it still provides inspiration on how the next generation of D2C brands might thrive too.”
The Cult of We by Eliot Brown and Maureen Farrell (recommended by Simon Lovick, Content Manager at Founders Factory)
Simon says: “Before Jared Leto donned the sunglasses to play him in the recent WeCrashed series, this meticulous account by two Wall Street Journal writers exposes the truth behind WeWork founder Adam Neumann’s fantasy journey to the peak of startupland and back. It’s a cautionary tale for any founder, detailing some of the biggest misdemeanours you can make as a leader of a startup—from prioritising your own finances over that of your company, to misleading investors, to manipulating your staff.” ]
Anthro-Vision by Gillian Tett (recommended by Liam Lewis, Product Designer at Founders Factory)
Liam says: “Anthro Vision is a book that will unlock a super power helping you see things differently. The books puts froward an argument that everything we do in business and in life boils down to a study of humans & human behaviour – users, users, users – I kind of agree.”
The Startup Wife by Tahmima Anam
From the blurb: “When Asha starts work on a revolutionary app together with her new husband Cyrus, she's thrilled. But while she creates an ingenious algorithm, Cyrus' charismatic appeal throws him into the spotlight. What happens when the app explodes into the next big thing?”
INSPIRED: How To Create Tech Products Customers Love by Marty Cagan (recommended by George Brooks, Product Engineer at Founders Factory)
George says: “This book provides insight into how the biggest tech companies have created products that are incredibly valuable to users. It provides accounts of how some of the best product managers in the world have crafted their position in a company and made indispensable products. If you’re building a product, read this book to help guide your journey to success
💸 News from the Founders Factory portfolio
We announced the winners of our Gut Health Competition in partnership with Johnson & Johnson—Sanno, a patient care platform for digestive health; and Apriwell, who combine health products with virtual care and digital therapeutics to provide integrated care for chronic diseases. The two winners received up to $250k investment
WiseWorks have raised $1.2m to help them develop their AI solution for virtual communications. Their platform, built in our studio in 2020, analyses communications in the finance profession through Natural Language Processing (NLP) for compliance and automating tasks
🗓 Opportunities for founders
TechChill Milano Pitch Battle (September 27th-29th, deadline for applications August 12th)—pitch competition for early stage startups across Italy, Southern and Western Europe, to win €10k. Find out more here
Keen to attend? Get 20% off passes with our code FFxTechChill
See you next month 👋
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