Network Effects

A N U H A R I H A R A N , C H R I S D I X O N , J E F F J O R D A N , S O N A L C H O K S H I , A N D K A T H Y WA N G
What are network
effects?

Properties, terms, and Case studies of Strategies for What aren’t network
laws of networks companies with network building effects?
effects network effects
Simply put, a network effect* occurs when a product
or a service becomes more valuable to
its users as more people use it

*also known as:

demand-side economies of scale
 Why does this matter?

Because understanding network effects helps build better

products and businesses

Especially since network effects are the key dynamic

behind many successful
software-based companies
 Network effects

Create barriers to exit for existing users and

barriers to entry for new companies
(help build moats)

Protect software companies from competitors’ eating

away at their margins

Can help create or tip winner-take-all markets

 Properties, terms,
and laws of
networks

What are Case studies of Strategies for What aren’t network

network effects? companies with network building network effects?
effects effects
Putting the ‘network’ in network effects

Networks, which are basically just a set of nodes connected by

links, have various properties

Some of those relevant properties include:

1. Whether the nodes are homogeneous or heterogeneous

2. Their type of clustering and degree of connections
3. Directionality of those connections
4. Whether they have (or are) complements
1. Homogeneous or heterogeneous?

Homogeneous Heterogeneous

Composed of similar types of nodes Composed of different types of nodes

Skype is an example of a homogeneous OpenTable is an example of a heterogeneous

network where most of the value is derived network with two distinct categories of
from a single class of users, all interested in participants: one side is restaurants, the other
placing a phone call side is diners

Image source (Skype): http://letsbytecode.com/security/skype-the-phantom-menace/

2. Degree of connections and type of clustering

Degree: Measures number of

connections to a single node

Clustering coefficient: Measures

degree to which nodes in a graph
(e.g., social graph, interest graph,
intent graph, etc.) cluster together

Type of cluster: Can range from

hub-and-spoke (star) to connected Example of Facebook friends connections clustering (high
(clique) school, college, significant other’s, etc. clusters)

Source: Albert-László Barabási, Linked: The New Science of Networks

Source (original chart): https://griffsgraphs.wordpress.com/tag/clustering/
Zooming in a bit further on those terms
Degree Clustering Coefficient (CC) Type of Cluster
Homogeneous
Number of connections How likely are two nodes that are The resulting CC(A) represents the
to a single node connected part of a highly connected fraction of possible interconnections
group of nodes? between the neighbors of A
0 ≤ CC(A) ≤ 1

hub-and-spoke clique

In hub-and-spoke or star networks, the fittest node

(central hub) grabs all connections, leaving very
little for the rest of the nodes
Node A has 4 connections, If A is the node,
therefore its degree is 4 and d is the degree A = 4, In clique networks, node A is connected to its
then n is the # of links between neighbors and all those neighbors are
neighbors (blue dots) of A = 1 connected to each other

For example: [For operating systems, Microsoft

CC(A) = 2*N/D(D-1) = 1/6 Windows is regarded as a central hub,
with 85% share of the network!]

Source: https://youtu.be/K2WF4pT5pFY
See also: Albert-László Barabási, Linked: The New Science of Networks
3. Connections: Unidirectional or Bidirectional?
Friends
Facebook, for example, is one place where
connections tend to be bidirectional
With bidirectional or two-way friending, you are
more likely to have balanced connections:
• You are friends
• You are not friends
Follower
Twitter, for example, is one place where connections
can more easily be unidirectional
Unidirectional or one-way following leads to
asymmetrical connections (e.g., the asymmetric
follow)
• People follow you, but you
don’t follow them back
• People don’t follow you, but
you do follow them
Note: You could still have balanced connections here where you
both or neither of you follow each other
4. Complementary Networks
T W O P R O D U C T S A R E C O M P L E M E N TA R Y W H E N T H E Y A R E S E PA R AT E B U T A R E M O R E U S E F U L T O U S E R S
TOGETHER

Increase in usage of one product by a

set of users reinforces and increases
the value of a complementary (but
separate!) product, which in turn,
increases the value of the original
More usage of the More usage of the
MS Windows MS Office suite of
operating system applications

operating systems have strong network

effects of their own (via developers) as
do productivity apps (via file formats),
but in this case they also reinforce each
other
Source: http://cdixon.org/2009/08/25/six-strategies-for-overcoming-chicken-and-egg-problems/
 Besides those properties, networks
(more specifically, communication networks)
can also exhibit the following laws:
3 common laws for assessing the
value of communication networks

1 2 3
Sarnoff’s law Metcalfe’s law Reed’s law

Value of a network is Value of a network is Value of a group-forming network

proportional to the number of proportional to square of is proportional to number and ease
viewers number of connected with which groups form within it
users (subgroups grow faster than sheer
number of P2P participants)

Broadcast Peer to Peer Group Forming

Yahoo Facebook Slack or WhatsApp groups

Sources: Andrew Odlyzko et al http://www.dtc.umn.edu/~odlyzko/doc/metcalfe.pdf

Facebook is a classic example of Metcalfe’s law

Every new user connecting to other

peers in the network (peer-to-peer)
non-linearly increases the number of
connections

Source: Bob Metcalfe/ IEEE Computer 2013, via Bill Krause

And finally, let’s define some commonly used
terms in the context of network effects
Terms and definitions for our purposes

Network is a group of interconnected people (social network) or system of things

(telephones, printers to computers)
Marketplace is a network where money/transactions flow between two or more sides with
distinct (i.e., heterogeneous) groups of users on each side; a successful marketplace is where
supply and demand are attracted to the same place
Platform is a network of users and developers; the multi-sided feedback loop between those
users, developers, and the platform itself creates a flywheel effect increasing value for each
of those groups. It can also be thought of as a network that can be programmed, customized,
and extended by outside users—often meets needs and creates niches not defined by its
original developers at the outset
Examples

Network Marketplace Platform

Social network Online auction Operating systems

marketplace Messaging app like
Telephone network WeChat
Dating sites (can be
Office printer & heterogeneous or
computer network homogeneous!)
So why do any of these details—topologies, other properties,
precision of terms—matter to startup founders?
 Because these details suggest what questions to ask
(e.g., is this network defensible?) and what the corresponding
entrepreneurial strategy should be
For example, if it’s X, then ask Y:

Network Marketplace Platform

What should the entry point be (to build a How do we build liquidity in the Will the market we’re eyeing
network effect)? marketplace/solve the eventually be served by a single
chicken-and-egg (which side comes platform and will it be shared
What are the growth levers/tactics/hacks first) problem? (Ethernet) or will it be a fight for
to get to critical mass? proprietary control (MS vs
Which is the money side vs Apple)?
What’s the critical mass inflection point subsidy side of the marketplace?
(at which a network
effect occurs)?

How do you drive engagement?

How do we take advantage of irregular

topologies to find clusters and sub
clusters?
Most of these questions really boil down to
What’s the initial growth lever or tactic
to help us get to scale?

Another way of thinking about this is:

What’s the deterministic (not-so-random) solution
to the bootstrapping problem?

These questions help counter the wishful thinking

and sometimes faulty assumption behind the belief that
if we build it, they will come
We’ll share specific strategies for
attacking all these questions

First, let’s look at some examples

But there’s one more question/definition
to know before doing so…
Is the product single or multiplayer mode?
Single Player Mode Multiplayer Mode

The product has immediate The product has no utility

utility for a single user for a single player
(especially true for communication
Examples products—a phone is useless without
someone at other end)

Examples

(early days): (early days):

tool to store bookmark restaurants
private photos you’ve been to need connections messaging for teams
to other users to
make calls

Source: http://cdixon.org/2010/06/12/designing-products-for-single-and-multiplayer-modes/
 Note: You can sometimes have both
single and multiplayer mode for a single product
Single player mode is more powerful when accompanied by an initial ‘hack’
or other bootstrapping of early network growth.
(e.g., Instagram’s cool photo filters was a way to post photos
on Twitter before there was enough critical mass)

Single player mode can also help with adoption in the early stages
of a product, when network effects aren’t strong enough yet
come for the tool, stay for the network.
(e.g., Medium offering a beautiful publishing tool before
it built its network of people and ideas)
 Case studies of
companies with
network effects

What are Properties, terms and Strategies for What aren’t network
network effects? laws of networks building network effects?
effects
Facebook
T H E U LT I M A T E C A S E S T U D Y I N N E T W O R K E F F E C T S

Started off as a social Became a platform Has elements of a

network (peer to peer (with developers) marketplace
connections) (users/advertisers,
Instant Articles)
So what led to network effects for Facebook?
C O R R E S P O N D I N G Q U E S T I O N S : W H AT ’ S T H E E N T R Y P O I N T ? W H AT A R E T H E G R O W T H L E V E R S ?
W H AT ’ S T H E C R I T I C A L M A S S I N F L E C T I O N P O I N T ? H O W D O W E D R I V E E N G A G E M E N T ?

Mode/product value Growth tactic Engagement trigger Network effects

Began as online student
directory with information that
was immediately useful even to
a single player (user)
Became a way for college
students in courses and clubs to
connect with other
(multiplayer mode)
Accessed the entire Harvard
directory early
on; critical in driving
early adoption
And because the product had
inherent virality, it spread
from one user to another as an
organic consequence of use
Identified early on that
connecting a new user to 10
friends within 14 days of
sign up was critical to
improving retention
So they used email contact
imports, suggested friends
and embedded widgets to
drive that engagement
Continued tweaking product
(relationship status,
timelines, etc.) to get
everybody to join and stay
on board
So made sure there was an
increase in usage even as
the number of their users
grew

Sources: Mark Zuckerberg interview with James Breyer, https://youtu.be/WA_ma359Meg

Chamath Palihapitiya interview https://youtu.be/raIUQP71SBU
By the numbers: Early growth as key (but not sole) indicator

900 845
MAUs
800

700 608
(millions, year-end)

600

500
360
400

300

200 145
58
100 12
1 6
0
2004 2005 2006 2007 2008 2009 2010 2011

Founded at 800+ college FB mobile Launched Introduced Introduced Introduced Introduced

Harvard networks and share on platform chat Like button Graph API Timeline
partner sites with and for easy
developers payments integration
and apps

Source: Facebook S-1

By the numbers: Focus on daily usage to help grow network
C O N S T A N T LY R O L L E D O U T N E W F E A T U R E S A N D O P T I M I Z E D T H E S I T E T O I N C R E A S E E N G A G E M E N T , D A I LY

Hyper growth in DAUs and MAUs pre-IPO

1000
MAUs
800
In millions

600
DAUs

400

200

0
Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11

Source: Facebook S-1

By the numbers: A sign of network effects
INCREASE IN USAGE EVEN AS NUMBER OF USERS GREW

100%

80%
DAUS/MAUs (%)

54% 55% 56% 57% 57%

60% 51% 53% 53% 54%
45% 47%

40%

20%

0%
Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11

Source: public company data

 Some takeaways

While many social networks today start off launching to everyone, Facebook’s entry
strategy was taking a clustered approach (get Harvard) before rolling it out to other
clusters (Stanford, etc.)

More importantly, they were focused on engagement, not just growth

Contrary to popular belief, Facebook kicked off offering immediate utility in single
player mode (the online school directory), but people started connecting with each
other (multiplayer mode) right away too
Airbnb
TWO SIDED MARKETPLACE WITH OVERLAP IN BOTH SIDES

Network effect from both sides

of the network

More hosts attract more

More More guests and vice versa
guests hosts
More hosts = more
availability for guests

More guests = more

business/$ for hosts
A unique aspect of some peer-to-peer marketplaces
like Airbnb is overlap between supply (hosts) and
demand (guests)

In other words, guests also become hosts and

hosts also become guests!
How did Airbnb achieve its network effects?
C O R R E S P O N D I N G Q U E S T I O N S : H O W T O B U I L D L I Q U I D I T Y / S O LV E T H E C H I C K E N - E G G P R O B L E M ?

Critical mass on
Mode/product value Growth tactics Critical mass
both sides Network effects
Network effects

Airbnb capitalized on an
existing problem/need— very
limited or expensive hotel
space
Turning homes to lodging
provided immediate value to
users: 30%-80% cheaper than
hotels and highly differentiated
type of inventory (less sterile
and more personal/social than
hotel rooms)
Airbnb targeted cities with sold-
out events and constrained hotel
supply (such as during the
Democratic Party national
campaign or World’s Cup) with
traditional marketing and other
methods to advertise its
alternative
Launched photography services to
make offerings more appealing
to guests
Also added ability for mutual
social connections to see who else
had stayed to help build trust in
the marketplace
As more guests stayed in more
places (demand), more hosts got
more business and more hosts
offered their places which in turn
created more supply for guests
As measured by number
of room nights
By the numbers: There was no viral growth in the early days.

# of new listings (early days of Airbnb: March 2008 to May 2011)

traditional marketing around launched photography launched social

targeted events program connections

# of transacting users (early days of Airbnb)

Note: Y-axes masked for confidentiality

But then there was a sign of network effects
I N C R E A S E I N N U M B E R O F G U E S T S T H A T S T AY E D E A C H Y E A R , C R E A T I N G M O R E S U P P LY A N D M O R E D E M A N D

18

16

14

12
Millions

10

6
took nearly 36 months to
4 build sufficient liquidity and
to start seeing signs of
2 network effects

-
2008 2009 2010 2011 2012 2013 2014

Source: Company data

 Some takeaways
Airbnb focused early features on building the demand side and in a
marketplace, supply will always go to where the demand is
(and will stay if you help grow their business)

Note: a product or service does not necessarily have to have viral growth
to lead to network effects

Traditional marketing methods—branding, design,

targeting, direct advertising—can help

Trust and safety is paramount in all marketplaces

Source: Jeff Jordan in http://a16z.com/2015/02/24/managing-tensions-in-online-marketplaces/

See also http://www.forbes.com/sites/valleyvoices/2015/10/21/how-to-guard-your-marketplace-against-fraudsters/
Medium
TWO-SIDED NETWORK WITH CROSS AND SAME-SIDE NETWORK EFFECTS

Network effect from But can be on the

both sides of same side of the
the network network, too!

More writers = more time When readers invite other

More More readers readers spend on Medium readers (via highlights,
writers
mentions, replies, and
More readers = More annotations), the overall
writers begin to write value of the entire network
increases as more ideas are
shared in that network itself
What is leading to network effects for Medium?
CORRESPONDING QUESTIONS: HOW TO BUILD LIQUIDITY? HOW TO DRIVE ENGAGEMENT?
Mode/product value
Provided immediate,
single-player utility—in the
form of an elegant and
easy-to-use publishing tool
Often described as the “best
web editor I’ve ever used” for
both experienced and
inexperienced writers
Growth tactic
Curated special content
collections/star contributors to
create perceived exclusivity and
as a beachhead to attract other
influencers
Used the 1-9-90 internet
rule—where 1% users actively
write, 9% participants edit,
90% read—to invite those
who engaged to also
become writers
Source: Ev Williams https://medium.com/the-story/medium-is-not-a-publishing-tool-4c3c63fa41d2
Critical mass on
Engagement
bothtrigger
sides Network effects
Network effects
As they built critical mass, More writers writing directly on
Medium designed the platform Medium and more readers
itself to optimize for spending more time reading
engagement—through directly on Medium
“in-content interactor”
features such as highlights, Becoming a network of
recommends, responds, people and ideas
and mentions
Used taxonomy of collections and
publications to cluster highly
engaged community around
topics of interest
By the numbers: Early signs of network effects
NON-VIRAL STORIES GET A MAJORITY OF TRAFFIC FROM WITHIN MEDIUM

TTR (total time reading) by referrer Medium Social Other

increasingly coming from Medium
for long tail and middle—represents Tail 48% 23% 29%
the audience that writers can’t easily
reach on their own without Medium

Middle 30% 35% 35%

Top 12% 54% 34%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Source: https://medium.com/data-lab/quantifying-network-effects-7e6bc167aea5 , company data

 Some takeaways

Reminder that single player mode can help get to multiplayer mode. The appeal of the
tool attracts users initially to help build enough critical mass, and then getting those
users to participate over time creates the network
come for the tool, stay for the network

They didn’t just built the tool and wait for users to come; a lot of up-front work went
into curating and editing early content and community

See also: http://cdixon.org/2015/01/31/come-for-the-tool-stay-for-the-network/

WhatsApp
A N E V E N M O R E H I G H LY C L U S T E R E D N E T W O R K T H A N F A C E B O O K

1 WhatsApp user While this is fewer

had ≈20 connections connections, they were
compared to ≈980 friends highly clustered among
on Facebook close family and
friends or WhatsApp
Groups and therefore
led to more
engagement
What led to WhatsApp’s network effects?
C O R R E S P O N D I N G Q U E S T I O N S : W H A T S H O U L D T H E E N T R Y P O I N T / S T R A T E G Y B E ? H O W D O W E T A K E A D VA N T A G E
OF IRREGULAR TOPOLOGIES TO FIND CLUSTERS AND SUB CLUSTERS?

Critical mass on
Mode/product value Growth tactic Engagement
bothtriggers
sides Network effects
Network effects

Single-player utility:
Initial product enabled
“what’s up” status updates
of phone contacts that were
useful even without
interaction
Multi-player utility:
Provided instant
messaging—essentially
better, simpler, sand free
SMS in international
markets (now 50% bigger
than global SMS)
Was one of the early apps to
leverage the phone book as
social graph: Each user
invited users from their phone
contacts (“closest family and
friends”)
Started small with close-knit
Russian community in West
San Jose to build initial
critical mass before spreading
to
other subclusters
Group Chat feature helped it
go beyond pairwise
connections
Multimedia (MMS) helped it
be used like Facebook
(family photo sharing, etc.) in
India and other places where
people didn’t use web-based
apps as much
WhatsApp didn’t just have
growth, it had more engagement
(as indicated by % DAU x %
MAU growth)—in other words,
more users added more value for
other users (that engagement is
high at over 70%)

Sources: http://www.forbes.com/sites/parmyolson/2014/02/19/exclusive-inside-story-how-jan-koum-built-whatsapp-into-facebooks-new-19-billion-baby/
http://www.businessinsider.com/whatsapp-engagement-chart-2014-2 https://growthhackers.com/growth-studies/whatsapp
 WhatsApp Growth vs Other Popular Platforms
FA S T G R O W T H : H I T 6 7 M M A U S I N 2 Y E A R S ( 5 . 5 X B I G G E R T H A N FA C E B O O K A N D 1 7 X B I G G E R T H A N T W I T T E R Y E A R
TWO)

WhatsApp: 419m
450
MAUs (800m+ today)
400

350

300
(millions)

250

200 Facebook: 145m

150 Gmail: 123m(1)

100 Twitter: 54m(2)

50
Skype: 52m(3)
0
Year 0 Year 1 Year 2 Year 3 Year 4

Source (WhatsApp): http://www.forbes.com/sites/parmyolson/2014/02/19/exclusive-inside-story-how-jan-koum-built-whatsapp-into-facebooks-new-19-billion-baby/

By the numbers: Sign of network effects
PEOPLE AREN’T JUST READING/RECEIVING MESSAGES BUT WRITING/SENDING MESSAGES

35
WhatsApp outgoing messages/day (bn)
30

25

20

15

10

0
Sep-11 Mar-12 Sep-12 Mar-13 13-Sep Mar-14 Sep-14 Mar-15 Mar-15

Sources: WhatsApp, a16z

See also: http://ben-evans.com/benedictevans/2015/1/11/whatsapp-sails-past-sms-but-where-does-messaging-go-next
 Some takeaways
Remember, usage—not just growth—is what helps indicate
network effects

Unlike Facebook, WhatsApp launched globally at outset but still pursued a

clustered approach by making sure product was working in one subcluster
first...Product continued to grow in clusters, not just peer to peer

“No ads, no gimmicks, no games”—focused on simplicity first which tends to

viral before adding extra features

Also, phone as login provided a very low barrier to entry for users (especially
internationally, where more people
have phone numbers than email addresses)
 Strategies for building
network effects

What are Properties, terms and Case studies of What aren’t network
network effects? laws of networks companies with effects?
network effects
How do you build—and maintain—network effects?

note that viral growth, while very helpful, is not

Viral growth
necessary for critical mass

Product should provide

inherent value, Growth tactics to Engagement Sustain network
whether in single or drive adoption trigger effects
multiplayer mode
Some strategies for building network effects

1 2 3
What is your entry strategy? What are the growth levers What is your critical mass
to drive adoption? inflection point?
Bowling pin strategy
Growth strategy Critical mass goals

4 5
What are the engagement How can you leverage an
triggers? irregular network?

Engagement strategy Irregular networks

1. Bowling pin strategy to overcome chicken-egg problem
Facebook did this well by starting with Harvard before moving to other schools and then opening
up to everyone

Segment Segment Segment Should I build supply first One way to overcome that
or demand first tension is to use Geoffrey
Moore’s (Crossing the
And how much of each do I Chasm) Bowling Pin
need? strategy:

Segment Segment Where do I start? Start with a niche segment

where the chicken and egg
can both be easily
overcome, then eventually
move to other niches and
the broader market
Segment
2. Bootstrapping growth to drive adoption early on

Accessed the entire Created several accounts Canvassed friends and

Harvard directory early on their own and submitted
on to provide immediate a lot of interesting content
utility for early adoption link to make the site feel
alive for new users and thus
quickly helped create
a community
family for early feedback
and reviews; also found and
nurtured the
top 100 super users
as tastemakers
Made it “the” place to find
and discuss all things hip
and cool related to a
particular city

Source: https://www.quora.com/What-are-some-growth-strategies-used-by-Reddit
See also: https://medium.com/@nishrocks/why-we-created-the-yelp-elite-squad-b8fa7dd2bead
3. Setting goals to help attain ‘critical mass’ more quickly

Connect a new user to 10 friends Tag at least 3 friends to

within 14 days of sign up each campaign

Facebook realized early This focus from Similarly, Tilt

on that it was important Facebook on repeat observed in the early
to connect each new user engagement is what days that campaigns
to at least 10 friends for drove network effects were 75% more likely
them to stay engaged on to tilt if at least 3
the platform friends were tagged
(repeat usage)
4. Having specific triggers to sustain engagement in network

Constantly rolled out new First of its kind to leverage

features (Like button, news “phone book contacts”; the
feed, chat) to keep stickiest cluster coupled
engagement on with the high utility of the
the platform product (free SMS in
international markets)
helped keep engagement
high
5. Leverage irregular network topologies
B Y F I N D I N G C L U S T E R S , C O M PA N I E S C A N R E A C H C R I T I C A L M A S S W I T H I N T H O S E S U B C L U S T E R S A N D E X PA N D
BEYOND

Real life networks are WhatsApp took They also targeted the
often very different from advantage of the fact international
the uniform distributed that social connections communities (e.g.,
networks pictured in are highly clustered in Russian community
textbooks your phonebook and in bay area) that
used that as a found WhatsApp a
“beachhead” to launch cheaper alternative to
groups expensive SMS
Strategies for creating network effects
MARKETPLACES

6
How do you attract the
harder side of the
marketplace?

Subsidizing strategy

Via cdixon.org
6. Attracting the harder side of the marketplace

In almost every Common way to attract the

two-sided market, one harder side is to subsidize
side is harder to acquire that
More More women than the other harder side
men Bars
For example, single bars
often have special
ladies’ nights promotions
on slower nights offering
women discounts
on drinks
Reducing prices for the hard side of the market (e.g., Adobe Flash and PDF for
end users) can help build critical mass

But solving the chicken-egg problem only by subsidizing has to be considered

carefully in the context of the overall business model—i.e., there’s a difference
between building initial critical mass and building a sustainable business (can’t
ignore overall unit economics)

This is why understanding which is the money side of the marketplace and the
side of the marketplace where the most value is coming from matters so much
because then you know
which side to carefully subsidize

See also: Thomas Eisenmann https://hbr.org/2006/10/strategies-for-two-sided-markets

 However, this dynamic may play out a little differently in
so-called “sharing economy marketplaces

Because such marketplaces can be supply-constrained due to

unfamiliarity with the sharing economy model

So those marketplaces have to work harder to get more supply as well,

and hence may also subsidize that side or build other features to
address these issues in other ways
Strategies for creating network effects
P L AT F O R M S

7 8 9
Show long-term Provide stand alone Vertically integrate when
commitment to platform value of the base supply uncertain

Via cdixon.org
7. Showing a long-term commitment to the platform
W H E N FA C E B O O K A C Q U I R E D O C U L U S , T H E Y S I G N A L E D T H E I R L O N G - T E R M C O M M I T M E N T T O H E L P D R I V E
P L AT F O R M S U C C E S S ; O C U L U S A L S O A N N O U N C E D I T W I L L P U M P $ 1 0 M I N T O I N D E P E N D E N T G A M E - D E V E L O P M E N T
EFFORTS

Getting to critical mass in Because you are a

indirect networks platform you are
can be challenging dependent on 3rd party
developers to remain
engaged and grow your
platform

WHEN THEY LAUNCHED THE XBOX, MICROSOFT

DID SOMETHING SIMILAR IN PROMOTING THEIR
P L AT F O R M A N D S I G N A L I N G T H E I R C O M M I T M E N T

See also: http://cdixon.org/2009/08/25/six-strategies-for-overcoming-chicken-and-egg-problems/

8. Providing standalone value of the base
T H I S C O M P L E M E N T A R Y N E T W O R K E F F E C T I M P R O V E D T H E VA L U E A N D I N C R E A S E D S A L E S V E L O C I T Y
OF BOTH THE BASE PRODUCT (VCR) AND COMPLEMENT (VIDEO CASSETTES) AND REMAINED THE
S TA N D A R D F O R Q U I T E A L O N G T I M E !

The standalone value of the This installed base enticed

VCR—“time shifting” of
TV programming”—was
strong enough to get >1M
people to purchase one
early on
entrepreneurs to develop a
market for pre-recorded
videocassettes, creating an
indirect network effect
improving the value of the
VCR and protecting it from
incremental alternatives

Source: http://cdixon.org/2009/08/25/six-strategies-for-overcoming-chicken-and-egg-problems/
9. Integrate vertically into critical complements

By vertically integrating For example, Nintendo In platforms, one

the complement product is the leading doesn’t necessarily
(game) as well as the developer of games for have to be dependent
base product console), a its own consoles and only on outside
company can attempt to Microsoft and Sony developers—
ensure adequate supply also fund many of the companies can ensure
of both goods most popular games critical complements
on their platforms as are built by themselves
well as well

Source: http://cdixon.org/2009/08/25/six-strategies-for-overcoming-chicken-and-egg-problems/
 What aren’t
network effects?

What are Properties, terms and Case studies of Strategies for

network effects? laws of networks companies with building network
network effects effects
Debunking some common misconceptions

1 2 3
Network effects and Viral growth is NOT Just because a platform has
virality are NOT the necessary for network scale does NOT mean you
same thing effects have
network effects
1. Network effects and virality are not the same thing!

Network effects increases value as more users join a network,

whereas viral growth increases just the speed of adoption
(of a particular network’s product/service)

These two concepts are often co-occurring so are sometimes

conflated, but they’re not the same thing
What’s the difference?
DEFINITIONS

Speed Value

Virality Network effects

Product that spreads from one user to
another through direct customer to
customer contact
Network effects help build a moat for
Viral growth implies low CAC
(customer acquisition cost)
Often measured by viral coefficient
(K factor): [average number of
invitations sent by each existing user]
* [conversion rate of invitation to new
user]
Product becomes more valuable as
more users use it
the business, leading to high
engagement/ repeat rates and
higher margins
Represented by Metcalfe’s Law:
value of telecom network is
proportional to square of number of
connected users of system (n2)

See also: Sangeet Chaudhary http://platformed.info/virality-viral-growth-network-effects/

Distinguishing between various flavors of viral growth
‘PRODUCT VIRALITY’ TRADITIONAL VIRALITY

Network effects Word-of-mouth Referrals with no incentives Casual contact

A product that has This is where customers This is something that This is where a product
inherent virality—i.e., recommend the product spreads without financial spreads virally via customer
spreads from one user to to other customers or or other sharing to customer contact (not via
another as an organic distribute it via other incentive due to being users intentionally inviting
consequence of use— platforms (like Facebook exclusive, invite-only, or other users)
will have a network and Twitter) due to a other
effect (referred to as a positive experience with Example: Hotmail acquired
‘direct network effect’ in it Example: Gmail created users by including footers
academic literature) buzz (the hot thing with for free accounts at bottom
Example: games like 1GB storage that was of every email; DocSend
Example: Facebook Angry Birds; BuzzFeed available only to a few) acquires customers when
without friend ‘The Dress’ and encouraged existing users email links to
connections is customers to send invites view/download files
not useful slowly

See also: Thomas Eisenmann http://platformsandnetworks.blogspot.com/2011/07/business-model-analysis-part-5-virality.html

So why do those distinctions matter?

Because product virality (a product that is inherently

viral) leads to network effects

But traditional virality does not always

lead to network effects
By the numbers: Product virality leads to network effects
FA C E B O O K I S T H E C L A S S I C E X A M P L E O F T H I S

Product virality = Connections with friends Network effects

The platform became more valuable as more users joined
Product spread from one user to another as an organic
consequence of its use, allowing Facebook to acquire The signpost of network effect in this case is high engagement
users at $0 CAC even as number of users increased

MAUs CAGR ‘04-’11: 162% Engagement (DAUs/MAUs)

900 845 100%

800
MAUs
80%
(millions, year-end)

700 608

DAUS/MAUs (%)
55% 56% 57% 57%
600
60% 51% 54% 53% 53% 54%
500 45% 47%
360
400 40%
300
145 20%
200
58
100 1 6 12
0%
0
2004 2005 2006 2007 2008 2009 2010 2011

Source: public company data

 This distinction also explains cases where things that
(seemed to) have viral growth did not lead to network effects

In most cases, that viral growth was really word-of-mouth

By the numbers: Word of mouth ≠ Network effects
ANGRY BIRDS IS AN EXAMPLE OF THIS

The key difference: Organic consequence of use

Angry Birds (est. downloads in millions) Product spread from one user to another via word of
mouth referrals/ brand popularity as people started
600 playing on their own—did not spread as an organic
500 500 consequence of its use
400 400
350
300
200 225
Key question: Does value increase for users?
100 30 100
0 Users do not get incremental value when other users
download and play the game

So Angry Birds does NOT have network effects (and

has a weak competitive moat as a result)

Chart source: https://www.macstories.net/news/angry-birds-reaches-half-a-billion-downloads/

And remember, you can have network effects without
(product or traditional) virality
By the numbers: Network effects without virality
AIRBNB IS AN EXAMPLE OF THIS

No virality…. …yet strong network effects over time

Early days required traditional marketing and # of guests that stayed at Airbnb saw hyper growth 3
numerous growth hacks to build liquidity on both years after launch
sides of the marketplace Leads to more money for hosts and
more availability for guests

20
# of new listings between 2008 and 2011

Millions
15

10

# of transacting users between 2008 and 2011 5

-
2008 2009 2010 2011 2012 2013 2014

Source: Company data

 To clarify one final term/misconception:

Just because a platform has scale does NOT mean it

has network effects
What’s the difference?
DEFINITIONS

Cost Value

Economies of scale Network effects

Product becomes cheaper to produce Product becomes more valuable as
as business increases in size and more users use it
output

Increasing scale leads to lower cost Network effects help build a moat—
per unit of output (cost per unit leading to high/repeat rates of
decreases as fixed costs are spread out engagement, higher margins
over more units)

See also: Sangeet Chaudhary http://platformed.info/virality-viral-growth-network-effects/

To sum up: Network effects vs Virality vs Economies of scale

Network effects

Economies of scale

Virality 1P
 Zooming in on economies of scale
SUPPLY SIDE
Economies of scale (also referred to as just ‘economies of scale’) is a
function of production size; so scale leads to lower cost per unit of output
(unit economic efficiency)

DEMAND SIDE
Economies of scale (also referred to as network effects) is a function of
users, so with scale leads to more utility for users

They’re both competitive moats, but network effects tend to be stronger—

users have higher barriers to exit
 Example: amazon.com

Amazon’s ecommerce site (1P) has supply-side economies of scale—shared

warehouse facilities, cheaper shipping options, etc.—that benefit Amazon
in the form of purchasing power and buyers in the form of lower costs

Amazon’s peer-to-peer marketplace (3P) has demand-side economies of

scale—aka network effects—which help make it the winner-take-all… is
growing much faster than the ecommerce
aspect of the site
Strategies: Don’t forget these less obvious, but no less important,
sources of network effects

1 2 3

Hardware Infrastructure Data

 Simply put, a data network effect is
a network effect that results from data

“
MAX LEVCHIN:
The defensibility of these businesses lies in their ability to build…a network effect of data.

MATT TURCK:
Data network effects occur when your product, generally powered by machine learning,
becomes smarter as it gets more data from your users. In other words: the more users use
your product, the more data they contribute; the more data they contribute, the smarter your
product becomes (which can mean anything from core performance improvements to
predictions, recommendations, personalization, etc.); the smarter your product is, the better it
serves your users and the more likely they are to come back often and contribute more data—
and so on and so forth.

Sources: http://max.levch.in/post/41116802381/dld13-keynote
http://mattturck.com/2016/01/04/the-power-of-data-network-effects/
But simply having a lot of data does not a data network effect
make!

The data needs to not only benefit from/extract that data,

but also add value back to the network of users
A missing graph we’d love to see in pitches that posit data network
effects is something that answers this:

How much does the

value of the product or
service increase as a
result of the data?

How much data do

you have over time?
ACKNOWLEDGEMENTS

Chris Dixon, general partner

Jeff Jordan, general partner
Sonal Chokshi, editorial partner
Kathy Wang, MBA intern summer 2015
…and a few other a16zers!

NOT including experts, articles, and sources cited throughout

©Andreessen Horowitz, 2017

see also https://a16z.com/advice-and-how-to/network-effects/