The Network Effect Isn’t Good Enough

Note: I’m pleased to have co-authored this post with Sangeet Paul Choudary, who analyzes business models for network businesses at Platformed.info. Follow Sangeet on Twitter at @sanguit.

If there is one altar at which Silicon Valley worships, it is the shrine of the holy network effect. Its mystical powers pluck lone startups from obscurity and elevate them to fame and fortune. The list of anointed ones includes nearly every technology success story of the past 15 years. Apple, Facebook, Microsoft, eBay, and PayPal, have each soared to multi-billion-dollar valuations on the supreme power of the network effect.

But today, the power of the network effect is fading, at least in its current incarnation. Traditionally defined as a system where each new user on the network increases the value of the service for all others, a network effect often creates a winner-takes-all dynamic, ordaining one dominant company above the rest. Moreover, these companies often wield monopoly-like powers over their industries.

In the Beginning

Once, all a company needed to do to leverage the network effect was facilitate communication between a critical number of customers. If enough people used a particular system to exchange information, a leader would emerge and become the de facto platform. Companies who could either form a marketplace or facilitate the flow of information between parties became tremendously powerful as central hubs of data transfer.

In fact, the first network effect platform was Bell Telephone, which established a government-sanctioned monopoly nearly 100 years ago. Since then, successful network effects businesses have sung from essentially the same hymnal.

First, establish a medium of communication by building the required infrastructure or inventing a new technology. For example, lay down telephone wires from coast to coast. Then, provide access to the network to improve the ease of information transfer — say, by selling fax machines. Finally, race to grow the user base before competing services do. If you get bigger faster than your competitors, voilà! You’re inside the pearly gates.

Rapture

That’s the plan at least. But today, things are not quite so simple. For one, in the old days, consumers paid to access the network through their upfront investment in hardware. These upfront costs locked users into the network and once they were in, they were in for good, thus erecting barriers to entry for would-be competitors.

However, the cost of providing access to the network has fallen precipitously. The days of customers buying expensive hardware to use a network are gone as is the correlating lock-in effect.

Converts

In addition to access costs falling to zero, another key component of what once kept users locked into a network has vanished. Once, porting contacts onto a new network, like switching instant messaging services from Yahoo! to AIM, was a non-trivial task.

Today however, customers use their Facebook, Twitter or Google profiles to join a new service in seconds. A burgeoning network, take Instagram or Pinterest, can leverage the single sign-on enabled by the social graph to reach critical mass faster than ever before. Users not only port their personal information but bring their connections as well. In the age of the social web, the convenience of the social graph has largely toppled the lock-in that once kept users bound to one network over another.

Tending the Flock

Without the upfront investment in physical hardware and users’ newfound ability to port personal information and contacts, how is a company to retain its users? Is the network effect’s ability to lock-in users dead? Hardly.

The power to leverage the network effect now resides in “stored value.” Unlike network access costs, stored value is investment that comes in small increments with repeated use, increasing the importance of the service the more a user engages with it.

Stored Value

Stored value comes in four forms, and companies leverage these tiny investments to build lock-in to their service and retain users.

Creative content (e.g. Pinterest, Facebook, Instagram): Users invest in creating a portfolio of creative content, which forms the basis of their interactions on the platform. The quality and quantity of the content results in more interactions with other users, which, in turn, provides greater value to the content creator.

Reputation (e.g. TaskRabbit, AirBnB, StackOverflow): Although marketplaces for physical goods, such as eBay, have been around for some time, services marketplaces have grown in popularity lately. Trust is an important component of this new breed of network effects business. As a result, reputation built on the platform directly contributes to greater value for all users. Building reputation on a platform requires consistent delivery of highly rated services and may also involve qualifying for some minimum criteria set forth by the platform. Hence, once a service provider builds reputation on a platform, it prevents her from migrating to a competing platform.

Usage Data: Users store value in the form of data, either by actively collecting information, such as in the case of Dropbox or Reddit, or passively as their usage improves the service by offering more relevant information, such as is the case with Quora, which delivers a personalized news feed based on usage. The more a user consumes information through the platform, the more intelligent the algorithm becomes in recommending pertinent content to the user. In both cases, the data set built by or for the user delivers greater value with increased usage, something that won’t directly be available on a competing platform.

Influence (e.g. Twitter, YouTube channel subscriptions): Networks that utilize a one-sided follow model create an influence dynamic. Unlike importing contacts or “friending” people, collecting followers is largely outside the direct control of the user. With the exception of sketchy tactics banned by the Twitter terms of service, accruing more Twitter followers can only be done by tweeting content others find interesting enough to share. As the user’s follower count grows, so does the stored value in the network and the incentive to stay actively engaged.

Keys to the Kingdom

Creating a network effect is not what it used to be. Today, stored value created by the users reinforces the power of the network effect to retain users and grow market share. This dynamic makes creating user habits all the more important as investments of stored value only occur through successive passes through the user experience (see Nir’s previous article and video).

With the portability of the social graph and the fall of upfront costs to join a network, companies must leverage new ways of acquiring and retaining users, rather than just the network effect. Business models that leverage a network effect plus stored value, hold the keys to the kingdom.

Photo credit: opensourceway