HOW TO CREATE NETWORK EFFECTS & APPLICATIONS

We have learned a lot of things about Network Effects. So it’s time to understand how to start creating them.

We already know – what are Network Effects? Why are they important? How do you value a network? Types of Network Effects?

In this part, we will understand how successful companies with Network Effects have created their network. We will also see if you can use it outside of building a business in your personal life!

THIS IS PART 4 OF MY NETWORK EFFECTS SERIES. READ THE PREVIOUS PARTS BELOW.

If you haven’t already, read the previous parts of the series before reading Part 4.

Onwards!

HOW TO CREATE NETWORK EFFECTS?

So how do you create a network with Network Effects? Not all businesses/products/ services can form Network Effects. But reflecting on the businesses that have successfully created it, we can learn a few strategies.

Here are the strategies on building Network Effects and reaching that critical mass.

START AS A SINGLE PLAYER PRODUCT

This is the most common way to start Network Effects.

The product should add value to the user. If it does, then only the users will join. Once the users hit a critical mass, Network Effects can be seen.

Charles Dixon in his article wrote, “The idea is to initially attract users with a single-player tool and then, over time, get them to participate in a network. The tool helps get to initial critical mass. The network creates the long term value for users, and defensibility for the company.”

What is a single-player product? NfX describes a single-player product as “[a] product helps the user alone and can be used without other users there. The user gets value from a product/service in isolation.”

Imagine Instagram before it became the mammoth of social-media it is today. It had a single-player product – photo filters. Users just used Instagram to put filters on their photos and share them on other platforms. Once that became successful, Instagram started creating a network where people could share, like, and comment on photos. A community. That was the beginning of the creation of Network Effects.

Most of the products with Network Effects start this way. YouTube as a product is really powerful, you can create channels and upload your videos. The community on YouTube makes Network Effects even more powerful; users can like, comment, share their favorite videos. YouTube has further strengthened it using community membership where users can pay and be part of the YouTuber community!

SMALLEST VIABLE MARKET

If you don’t have the scale or the capital, starting small is the best approach. Seth Godin has written a book explaining the idea of the smallest viable market (you can check it on Amazon here).

Target the smallest viable market, a niche. If you fail in a niche market, it is easy to get feedback on why you fail and what can be improved. When you start in a big market, it is easy to blame the market infinity for your failure.

*Minimum Viable Product (by Greenheart.io)*

Additionally, small markets have a stronger community sense. People are more engaged in understanding and helping out others.

Can you imagine if Facebook had directly launched as a social network for the mass public instead of building an initial audience at Harvard?

Once you are successful in a niche market, you can scale up! The users from the niche will also help you reach the critical mass easily.

Uber started in San Francisco with luxury rides. Pinterest started by targeting the creators and DIY tribe. Amazon initially was only a marketplace for books.

SWITCHING COSTS

Any product which has high defensibility will have a high switching cost.

High switching cost means it is difficult to switch which in term relates to customer lock-in. Switching costs are high for products that are difficult to replicate or are embedded in the user’s ecosystem. They could also be high if the product/business has data that you don’t want to move.

It is very difficult to switch to a new phone or software or watch if you’re already part of the Apple ecosystem. Apple has embedded its products in our daily life that we need them to go about our day-to-day life and be productive. Additionally, each of their products complements the other product.

Once you’re part of the ecosystem, the cost of switching out of the network is very high. You’ll have to change your phone, watch, TV, speaker, and so on.

RETENTION

Powerful networks with Network Effects not only have a high number of users/nodes but each node has very high engagement.

Once your user joins the network, can you retain them on the network?

Remember that network effects don’t only come from the size of the network, but from overall engagement. That’s why growing a network’s size isn’t enough, it’s also important to focus on increasing engagement.

Engagement is one of the key metrics on Instagram for a reason! More engagement means more retention!

INCENTIVE

What incentive does a user have to be on the network compared to being an individual? How are they gaining value before the network hits critical mass?

Instagram users see value in posting photos and videos because they can obtain external validation in the form of likes and comments from people they know and also, the community that has similar interests.

After hitting critical mass, Instagram also allows creators with a large following to set up their business so they can work with potential customers.

This incentivizes the customer to stay on the network.

PERSONAL LIFE APPLICATIONS OF NETWORK EFFECTS

Apart from the obvious building a product with Network Effects, here are different ways you can utilize Network Effects in your daily life.

EVALUATING BUSINESSES FOR INVESTMENT

We have already learned how to value a network. This understanding can be utilized to help you invest in a business.

Does the company utilize Network Effects as defensibility? You already know Network Effects provide one of the strongest defensibilities – PART 1
Are they using single-player mode or multiplayer? Can a user use the network on their own (Google Drive to store documents) or they need more users for the network to function (a telephone – you need someone to call)
How are they solving the chicken-and-egg problem? – PART 2
How valuable is their network? Have they reached the critical mass? What are the levels of defensibilities and types of Network Effects integrated into their business? – PART 3

Once you find the answers, you will understand how powerful of a service/product the company has and if you should be investing in it.

There are other criteria to consider while investing and you just added one more!

COMPETING IN A MARKET WITH NETWORK EFFECTS

Even after you’ve built a business and product with effective Network Effects, it is essential to compete in the market with similar products.

If you understand Network Effects, it will be easier to compete with similar businesses.

Here are some strategies discussed in Information Systems: A Manager’s Guide to Harnessing Technology

Promotion – leveraging existing users to drive growth while using the Network Effects; making them feel a part of the community and driving growth through more content and curation.
Redefine the market – redefine your niche in a big market. Nintendo releasing Wii targeting a different set of an audience instead of directly going head-to-head with Sony and Microsoft is an example.
Alliance and Partnerships – Collaborations are big in today’s world because there are obvious benefits. You can market your business/product to a different target audience using partnerships. You are essentially targeting similar networks but independent from you.
Develop Complementary Goods – As said before, complementary goods help you embed your product in the user’s process and provides additional defensibility. Embedding makes the network stronger.

NETWORK EFFECTS AFFECTING YOUR LIFE – RELATIONSHIPS

Network Effects are prominent in our lives, especially, the relationships we form. Our life is driven through networks. They are defined by the following factors-

Frequency: how often do you meet a person? The frequency can define the strength of the link between nodes (i.e. person)
Density: have you ever thought about how you form a friend circle? A person knows another person and they introduce you to a third person, and so on. The number of people in your network affects how many more people you know which creates an opportunity to form more links
Identity: Our life, if we reflect properly, is based on milestones. Your choice of college, work-place, the city you choose to live in, outside of work activities, all these and more define you and your network. Each of these networks creates more links and might form interconnected links (your workplace colleagues meet your college friends)

We already know, the value of a network increases with each additional node. Now apply it to your relationships, if you have formed a valuable network, the value of the network will keep increasing as you add new users (i.e. add friends/create relationships).

Hence, the saying you are just as valuable as your network.

In this article, James Currier shows mathematically why rich nodes keep getting richer using their network!

A fun way to use Network Effects in relationships is Dunbar’s Law. If you want to have a successful dinner party and want to have one conversation at a dinner table, 6 people are about the right number. Maybe 8, max. This is proven mathematically by the law.

CRYPTOCURRENCY

Cryptocurrency works over a network and benefits from Network Effects. Let’s take the crypto’s poster child, Bitcoin, as an example.

Bitcoin users benefit because Bitcoin doesn’t utilize the traditional banking infrastructure; they can transact over their devices. If more people use Bitcoin, more merchants will allow using Bitcoin. If more merchants allow, more users will join the network. New users will add value to the network!

As Bitcoin gains traction, you will start seeing complementary services that allow ease of transaction. As more activity happens, Bitcoin miners will see even more lucrative returns for their mining activity and ledger maintenance.

NETWORK EFFECTS SERIES SUMMARY

Network Effect occurs when an additional node (user) has an impact on the network. The value of the network will increase as more users use the business/product.
Each new user node has different properties. These user nodes and the network between them define a network.
Network Effect is important because the value of the network grows exponentially while the cost might increase linearly.
Network Effect provides strong defensibility to businesses while being comparatively cheap to implement compared to other defensibilities for Digital Businesses.
There are 3 major laws to value a network (Sarnoff, Metcalfe, and Reed).
You should consider additional factors such as Critical Mass, Negative Effects, Asymptote Effects when valuing a network.
There are various types of Network Effects (13 per NfX) but broadly you can categorize them into 3 – Direct, Indirect, and Data.
You can study successful companies with Network Effects to understand some set strategies in building and maintaining Network Effects for your own company, product, or service.
Network Effects can be seen in companies with curated content, communities, and connections.
Apart from the obvious reason of using Network Effects to create a business, you can use your understanding of Network Effects to value a business, relationships, cryptocurrency, and to compete with other businesses.

RESOURCES TO LEARN MORE

Network Effects was a new topic for me. And as the saying goes, I completed this series while standing on the shoulders of giants. Here is the resource list –

Anu Hariharan from Andreessen Horowitz. Here is an amazing video of Anu explaining Network Effects.

James Currier at NfX has led my research on Network Effects. The website has a lot of good resources on Network Effects. Must follow on Twitter if you’re interested in Network Effects or entrepreneurship.

I have linked the sources of information, as applicable, in the article.

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