Society is built upon a story. The glue that holds humanity together is fiction, a creatively invented story for “the greater good.”
Look at money. Why trade our lives for paper? Wars are waged over this meaningless money. And money my friends is the one bubble that’s never popped.
Money’s also the source of power for government. Before that it was royalty, and force. Before rulers were gods, or ordained by the gods… and on and on. The power of stories defines humanity.
The story of the Ponzi scheme
For anyone who does not know, a Ponzi scheme is an elaborate scam where you pay to participate and just need to convince 3 friends to convince 3 friends to convince 3 friends… and so the money flows. Notice the pyramid-esque nature.
This is a Ponzi scheme, aka a scam. And it is illegal.
(BTW we aren’t talking about ICOs and cryptocurrencies, which are definitely a ponzi scheme (plus much more). For more on ICOs boom, bust and rebirth, and see this post)
You have probably heard of Bernie Madoff. He ran the most infamous Ponzi scheme ever, stealing a supposed $65B for “innocent” investors/fellow Ponzi participants.
Source: ScamAvenger
But that begs the questions: where are Bezos and Zuckerberg on this list?
Let’s talk network effects (NFx)
You could argue today’s social networks look eerily similar to a Ponzi scheme (still a far cry from ICO scammyness). The dynamics of a connected world create tangible value for network members and enormous financial rewards for the creator(s) of the network.
As an investor, I am constantly looking for startups with true network effects. Companies able to leverage the flywheel of continuously increasing value warrant ridiculous valuations.
From social platforms like: Facebook, Instagram and Whatsapp to B2C marketplaces like Amazon, Airbnb and Uber, successful network effects result in nearly untouchable monopolies (f_or more_ on today’s monopolies stifling innovation, see this post).
And network effects aren’t only applicable to consumer companies. Look at Slack and Box.
What do all these companies have in common? Great products with killer network effects.
Acquiring customers
One of the most important responsibilities of any startup founder is acquiring customers. Without users and cash, the business dies. Network effects and “virality” are two of the most crucial strategies for organic growth.
And organic growth built the unicorns and tech behemoths of today. Few giants grow from paid acquisition — the costs are just too high. And as markets saturate, CAC rises.
This is not true with true network effects. Instead as networks grow, all participants benefit and CAC remains constant, if not decreasing.
Look at Amazon. Onboarding initial buyers and sellers was hard. It was just a bookstore. Fast forward to today to the Everything Store. Suddenly Amazon’s doing $136B/yr and sellers everywhere are scrambling to get onboard. Amazon doesn’t need to pay a dime.
And customers come too. When Amazon has more options and better prices than Walmart, and delivers to your door, it isn’t even fair. Amazon’s flywheel fixes their initial capital challenges, increases margins, decreases CAC and drives LTV through the roof.
Source: PointofSale.com
The 5 types of network effects
Not all businesses can leverage NFx. And even many that do have limits (which is why Airbnb’s a 100x better business than Uber).
There are five type of network effects, each with strengths and weaknesses. They are:
- Marketplaces — aka Two Sided Networks
- Channel partners — aka Three Sided Networks
- Communications networks
- Content networks
- Local networks
1. Marketplaces — Two sided networks
The first and most obvious type of network the market. Markets have existed since the dawn of time and grown exponentially in the internet era.
Markets just make sense. People have needs and wants — from your stomach to sex to survival, markets pop up around every conceivable human want and desire. These traditionally consist of buyers and sellers.
Historically, prior to the rise of cities, nomadic traders travelled between small settlements, continuously peddling their wares and pulling in profit. Farmers bought tools, craftsmen bought meats and traders traded in everything.
Notice the movement. Traders came to the people. This has not changed. As buyers aggregate, sellers somehow find their way.
Implication:
Because acquiring customers is so much harder than acquiring sellers, businesses need to spend the bulk of their resources focused on buyers. As the number and quality of buyers in a market increase, companies can start to focus more on sellers — specifically quality control.
Look at Amazon and Ebay. What is the primary difference, besides success?
Ebay’s auction platform that encourages negotiation and lowball offers, hurting sellers and slowing the speed of transactions. This attracts low price, unattractive buyers.
Amazon does the exact opposite. They focus on seller quality, ensuring good customer experiences which leads to more word of mouth.
Buyers don’t brag about Ebay, sellers either. But everyone and their mother talks about Amazon. That is because Amazon is fast, cheap and easy to use — everything Ebay is not.
Source: The Motley Fool
Application:
Building a two-sided market? NPS is incredibly important (first for buyers, then for sellers). Onboard customers, make the process fast and seamless and suddenly you have a sharable marketplace.
Two-Sided Marketplace Examples
Low Tech: shopping centers, farmer’s markets and brothels.
Tech: Airbnb, Uber, Amazon
Strengths of marketplaces
- Nearly untouchable after critical mass
- Monopolistic pricing power to increase commissions
- Low maintenance and operating costs once established (unless like Amazon you own distribution)
- Huge valuation multiples due to strength of network
Weaknesses of marketplaces
- Very challenging to acquire customers/users
- Need to balance supply and demand
- Cash intensive to get started
- Revenue lags growth
(NOTE: For more on tokens/ICOs ability to disrupt established markets, see this post.)
Channel partners — Three sided networks
Not all commerce is conducted via a platform. The reason? Acquiring customers in a nascent market is hard.
Because the business models and structures of marketplaces and channel partnerships are so different, most companies cannot do both well.
A real world example. As an ecommerce/Amazon strategist, I’ve consulted for numerous public companies on their future and the world of Amazon. These corporates knew they needed to increase sales online but they had a problem.
To sell on a marketplace meant alienating existing distributors (channel partners). If XYZ competes with their distributors, distributors suffer and thus XYZ suffers. Can you kill the aging golden goose?
Perhaps the best example of the monopolistic power for this type of network is Microsoft. Microsoft owned the desktop and personal computing space. They built a vast network of suppliers and channel partners and then squeezed them. Companies could not afford to exclude Windows and Microsoft Office, users HAD to have it.
And because legacy systems and software were all built and reliant upon Windows, switching costs were prohibitively high. So Gates got to charge mafia money — pay the ransom or watch your business burn…
Source: JumpCloud.com
Most channel partnerships do no go like this. That said, it is usually the responsibility of the brand to boost awareness — unless you pick your partners well. Take for instance bookkeeping. Few entrepreneurs know, like or care about bookkeeping. They just need to get it done. So they find a bookkeeper who uses and recommends Xero.
Now the owner has two choices: find a new bookkeeper or use Xero. Inevitably most buy in. That is how Xero became a ~$4.5B business, off the back of recommendations (aka channel partnerships or affiliate marketing).
Implications/Application:
Channel partnerships do not work for every type of business. It really depends on the product and end customer. They can be massively lucrative and scalable when done right.
Channel partnerships require trust and demand generation — both of which can come from you or your partner. Here the medium and product play a large role.
For instance grocery stores get millions of pitches, they aren’t going to push your product. It is up to the brand to create demand and move inventory. If they can’t, shelf space goes to someone who can.
A great counter example would be podcast marketing. Joe Rogan (the UFC guy with a massive podcast audience) singlehandedly turned the Fleshlight into a huge hit. The adult product was Joe’s first advertising partnership and the product hit it off, quickly connecting with Joe’s audience and outside the box approach — the company didn’t need to do a thing…
What type of channel partnership can your company leverage?
Channel partnership examples:
Low Tech: bigbox retail, QVC, catalogs
Tech: Microsoft, Xero, affiliate marketing
Strengths of channel partnerships
- Outsourced acquisition means lower capital expenditure
- Ability to scale sales quickly with established networks
- Low maintenance and operating costs once established
- Ability to focus more on core product
Weaknesses of channel partnerships
- Long sales cycle for onboarding channel partners
- Demand/trust component
- Lower margins
- Less direct contact with end customer
- More dependent on partners, thus riskier
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Communication networks
Successful social media companies warrant crazy valuations. Instagram sold for $1B before making a buck. Snap has yet to prove they can make money and are valued at ~$17B. And don’t forget the 500k pound gorilla in the room, Facebook’s evil empire.
Communication is one of the truest forms of network effects. For every new user, my value goes up. If ½ my friends are on and ½ are off, there are ONLY two options: onboard everyone or switch to something better.
Imagine if your cell phone could only make calls within your carrier’s network. Joe’s on Tmobile, mom and dad have AT&T, grandma’s got Verizon… you would need 3 different phones and 3 different plans.
The same is true for social. Everyone or no one. If you have to switch between apps and services, you are not going to stick around.
But with communication the viral component is key. Add all your friends. Invite everyone on LinkedIn. Want to join Whatsapp?
The pressure to grow the network for my own personal reasons does the dirty work for them. Facebook isn’t spamming my friends, I am. And I and billions like me built a 2B+ person network worth $531B+.
The key to communications networks is onboarding — as quickly as possible. Networks that leverage users’ social proof scale. Networks that pay to acquire customers fail. It is that simple.
Implications/Application:
Given these dynamics, it is no surprise that social networks are winner take all. And that justifies massive valuations and upfront investments.
In winner take all markets, monetizing too soon can be catastrophic. In social, the outdated VC mantra of “growth at all costs” actually makes sense. Any advertising, any monetization and you risk reduced NPS scores and lower virality (the two MOST important aspects of any communication network).
Communication Network Examples:
Low Tech: fax, mail, phone
Tech: Facebook, Whatsapp, Slack
Strengths of communication networks
- Viral growth as users onboard their networks
- Increasing value as # of users increases
- Low maintenance and operating costs once established
- Massive switching costs to leave network
Weaknesses of communication networks
- Require lots of capital and runway to get started
- Need very strong NPS score to encourage sharing
- No direct monetization model
- Some networks get too big to control the noise
Content networks
Whereas communication networks involve two-sided, near real-time communication, content networks are much more one-sided. And as they say, content is king — and it lasts.
Content does for eyeballs and attention what markets do for commerce, it aggregates it. And content has long been a profitable business. Look at magazines and newspapers (pre-internet). These publications put out content, users subscribe (pay) and advertisers add tons of ads. The editors can sell ad space because readers are hooked and keep coming back for more.
And unlike communication networks, the one-sided nature of content allows it to scale easier. An article or video can have 100 or 100M views without much increase in base costs.
There are two keys to creating a killer content network: 1) the content and 2) the hook.
It is one thing to wow readers or viewers, it is another to get them coming back. But because advertising is such a weak monetization model, it means you need big volume and better have users coming back for more.
This is where the hook comes in. In television it is the cliffhanger ending that makes you come back next week (or next episode with Netflix). But blogs do this too. It is all about subscribing and remarketing again and again and again to drive the network.
Source: TVRopes.org
Implications/Application:
Content networks function inversely to marketplaces. Whereas marketplaces make money by initially aggregating buyers, content companies need creators. Without the first few landmark pieces, people get bored.
This is why organizations like Youtube or Netflix spend so heavily on content (empowering creators and creating content respectively). Evergreen content keeps producing, even after production ends.
And with all great content, people love sharing. How many of your friends recommended Game of Thrones or House of Cards or that horrible Gangnam Style video? People want to feel cool and know about things before their friends — look at any social feed.
Any content network that optimizes for quality and creativity can create a massive loyal following — as long as it effective remarkets and suggests additional content.
Content Network Examples:
Low Tech: newspaper, TV, radio
Tech: Youtube, Instagram, Medium
Strengths of content networks
- Evergreen content continually delivers
- Value (and potential customer base) increases as amount of content grows
- Creators do much of early marketing for you
- Large switching costs for creators leave network
- Low to no cost of content creation
Weaknesses of communication networks
- Onboarding creators or creating content is expensive/hard
- Need very strong NPS score to encourage sharing
- No direct monetization model
- Some networks get too big to control the noise
Local Networks
Last but not least, we have local networks. As technology and the internet have connected the world, these networks have struggled. That said they are still very relevant, especially the dynamics behind them.
Local networks will never die, unless VR ends reality. Look at humanity’s basic needs: food, clothing, shelter, sex/relationships. All of these are physical, tangible and heavily influence our daily lives.
And evolution bred society into humanity. We are social creatures. We are built to connect. Whether that is meeting for dinner, going to the game, poker night or a casual hookup, we tend to aggregate ourselves.
Think about sports? Almost every American has a TV. You could watch any game at home, whenever you wanted. So why do fans buy tickets? Why are sports pubs so popular?
No one likes drinking alone.
These dynamics are what make local networks so strong? Church groups, sports teams, the neighborhood pool… there are local networks all around us.
The problem with local networks is that they are small. For the most part they are not VC fundable. But businesses based locally with nationwide scale can succeed.
Look at Meetup— local networks of everything under the sun, organized by location and interest — like the Reddit or real life.
Implications/Application:
You build massive companies like this one piece at a time. Facebook was a local network before it was a communication network. The keys to growth: focus on one target customer in one location at one time.
A leaking ship eventually sinks. Networks that try to scale before perfecting the model need significantly more capital and still usually fail.
Franchisees are perfect example of this model. McDonalds started small, perfected the experience and slowly started to scale. Ray Kroc (not actually the founder), focused on each locale, perfecting the process and exciting the public. From their the franchise spread as nationwide and then international demand exploded.
Local Network Examples:
Low Tech: restaurant, sports teams, church group
Tech: Meetup.com, Tinder, Nextdoor
Strengths of local networks
- Easy to interact with early adopters/customers
- Brand ambassadors help with much of marketing
- In-person events drive greater emotional attachments
- Every new city/expansion increases business defensibility
Weaknesses of communication networks
- Scaling presents logistical challenges
- Once it “works”, users may no longer need app (example: Tinder, Match.com etc…)
- Culture fit/demand differences between regions
- Need to compete with increasingly digital world
Closing Thoughts
Network effects are one of the strongest indicators of business model success. Organic growth eats paid acquisition for breakfast.
Unfortunately designing network effects isn’t exactly easy. Hopefully the concepts discussed in this post help you better understand your business model.
For investors: What are you investing in and how do network effects play into your investment philosophy?
For founders: What are you building and how can you leverage organic growth, virality and most importantly networks effects to build an enormous business?
Answer those questions successfully and this insanely long blog post will have been worth it.
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