Recognizing the Opportunities for Network Effect Startups
When thinking about successful startups, chances are that companies like Airbnb, Facebook and LinkedIn are among the first ones that come to your mind. With billions of active users and quite consistent presence over the years, these companies are excellent examples of successful network effect startups.
In addition to these global names, there are many other companies that operate in niche or local markets and that achieved success proportional to the size of their target audience. All this thanks to a careful market segmentation and focus on creating a powerful network effect.
But, what is the network effect really?
For one, the network effect includes much more than creating a large user base and this is exactly what makes it different from virality. In fact, these two concepts are essentially different because the second one is a matter of creativity and, of course, the marketing budget. As opposed to this, a network effect startup can grow only with a comprehensive marketing plan in place from the start. This is primarily because the value of their product for an individual user is very low unless they have a large user base.
And we all know how difficult this may be. Although big budgets do help, startups that operate in two-sided markets may have a more difficult launch than those that rely on classic economies of scale. This is why they need to understand the basic principles behind creating value for their users and recognize their growth opportunities in them.
Understanding the network effect
The term network effect has been a buzz in the Silicon Valley for years now, but is still misinterpreted surprisingly often. Most frequently, people associate it with social networking, which is actually not far from true. Yet, the network effect is a bit more complex concept that matters to a great number of startups out there trying to build a large user base.
Originally calculated in 1980s by George Gilder in relation to telecommunications, the network effect (also known as Metcalfe’s law) suggests that “the power of a network is proportional to the square of the number of users connected to that network.” As Neal Cabage and Sonya Zhang point out in The Smarter Startup: A Better Approach to Online Business for Entrepreneurs, this later became a metaphor for the significance of community adoption for startups that depend on social interaction.
In simple terms, this means that every single user of a specific product contributes to increasing its value for all its other users. The product that is most often quoted as the classic example of network effect is the telephone. What would its value be if you couldn’t use it to talk to your family and friends?
That’s right – none. This is exactly the same logic that applies to today’s most popular social networks. People don’t use them simply because everybody else does, but because there they can talk to a friend, a colleague or engage with their favorite brands, bands or anything else they like. This is probably most evident in the case of LinkedIn, which is a form of social platform, but that actually can get you a job or professional advice.
Network effect vs. virality
Precisely because of the useful features mentioned above, LinkedIn counts dozens or even hundreds of users more than any small business. Yet, small businesses too can create a powerful network effect even without becoming viral. The difference between the two is nicely explained in this (lengthy) study by Eric Jorgenson.
Namely, since both increase business value as new users join, the network effect and virality are often equated. Yet, the network effect can be achieved through completely different strategies. One of the great examples for this is Belly Card (or simply Belly), a company that managed to grow their business from 17,000 users to more than a million in a single year!
The key to their success is a carefully thought-about network effect strategy that was focused on a local market in Chicago before it expanded beyond. Through strategic partnerships and marketing initiatives, Belly created localized network effects for their customer loyalty program.
After all, both Twitter and Facebook were first conceptualized as networks for specific communities. Facebook was launched as a social network for Harvard University students, while Twitter boomed after its SXSW 2007 appearance. These two clearly emphasize the importance of knowing who you’re catering to and doing everything to reach that specific audience.
10 Strategies for creating a successful network effect startup
Although there’s no single formula for creating a network effect, there are quite a few important things companies need to consider in order to be able to stay competitive in the network effect market. Besides the general strategies related to market research, choosing a great domain name and developing an online presence, the essential thing for network effect startups is creating a minimum viable critical mass, as suggested by Sean Ellis. Without this, your chances of becoming the next big name are equal to zero.
This means that you should take a leaf out of Belly’s book and try to decide on a specific strategy for creating either localized or niche network effects. Furthermore, probably the best advice for succeeding in the network effect market comes from John M. Gallaugher, who lists 10 critical strategies for competing in the market, along with examples.
1. Move early. Be there before everybody else and maintain the top position with constant innovation.
2. Offer incentives for early adopters. Consider the example of PayPal that subsidized the adoption of the service by offering a $15 rebate to users once they spend their first $30.
3. Leverage viral promotion. Use social networks to build brand awareness quickly and encourage early adopters to keep talking about your service to their friends and family.
4. Expand in one of the following ways: either redefine the market to bring in new categories for users or converge markets.
5. Choose alliances and partnerships strategically to accelerate growth across target markets.
6. Plan the use of distribution channels. This can be achieved through partnerships or other strategic initiatives.
7. Encourage the development of complimentary goods by offering resources in addition to your primary business.
8. Compatibility options: either maintain backward compatibility to encourage a wider use of your product or develop one that is compatible with leading standards.
9. Keep innovating to block rival efforts to take over your position in the market.
Now, all this may sound too theoretical for a startup that has a variety of other real-world problems to cope with. However, a strategy regarding the entire path from a starter to leader in the network effect market is one thing that separates big players from mediocre companies.
