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Facebook is a beast when you consider the business and revenue it generates. But, Facebook also beautifully integrates various types of Network Effects and defensibilities which makes it so valuable!
We are understanding different types of Network Effects to better understand how the concept works. Additionally, in this part, we will value Facebook using all the concepts we have learned in the series.
THIS IS PART 3 OF MY NETWORK EFFECTS SERIES.
- WHAT ARE NETWORK EFFECTS AND WHY ARE THEY IMPORTANT – PART 1
- HOW YOU VALUE A NETWORK AND THE LAWS OF NETWORK – PART 2
- TYPES OF NETWORKS EFFECTS AND VALUING FACEBOOK USING NETWORK EFFECTS– PART 3
- BUILDING, MAINTAINING AND HOW TO UTILIZE NETWORK EFFECTS IN DAILY LIFE – PART 4
If you haven’t already, read Part 1 and 2 of the series before reading Part 3.
PART 1 & 2 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 provide 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
If there is one thing you have to remember about this concept it is that the value of the network increases as more people use it.
TYPES OF NETWORK EFFECTS
It wasn’t easy to understand the various types of effects that are explained in different articles and videos. After sifting through some material, I was able to categorize them in two ways.
BASIC TYPES: These are really high-level types of effects that can be further sub-categorized if required. But to have a general idea of different types of Network Effects this is a very good start
COMPREHENSIVE TYPES: The basic types are further sub-categorized into different categories and channels. I call them Comprehensive Types of effect. I am leveraging the model created by NfX who has done some solid work in this field. A lot of inspiration and ideas come from the articles that NfX have published on their blog.
Please note that these effects s are focused mostly on Digital businesses in today’s age. They may still apply to other businesses but would be more practical to technology businesses.
BASIC TYPES OF NETWORK EFFECTS
If you want to have a basic level understanding of the different types of Network Effects, start here. They will provide you a high-level category of different types with an example for application.
Direct Network Effects (same-side)
Direct Network Effects also called same-side effects provides direct value to the network as more users use it. The value of the service goes up as the number of users goes up.
The value of the internet increased only as more users joined the network. This provided a direct value to all the existing users.
Indirect Network Effects (cross-side)
Indirect Network Effects also called cross-side effects and provides an indirect value to one user group when another user-group joins the network. As such, there needs to be a minimum of two user groups.
A good example of this is Uber. If a new rider joins the Uber network, the value of the network remains the same for the other riders. But it increases for the drivers as they can service a new rider.
Data Network Effects
For a Data Network Effect, the value of the network increases when more data goes into the system and benefits all the users. In most cases, more users equals more data equals more value!
Waze, the navigation application acquired by Google is a very good example to understand this. The data is captured automatically or fed by the other users and it increases the value for other users. Yes, as more users join the network, there will be more data that could be fed. But the value of the network (i.e. Waze) is based on the data available in the network rather than the number of users on the network.
COMPREHENSIVE TYPES OF NETWORK EFFECTS
These are the basic types that are further categorized for different reasons. I have learned this model from NfX where they are doing some ground-breaking work in understanding Network Effects.
Note that a product/network/company can have multiple types of effects from the below categories.
Physical (DIRECT EFFECTS)
This is a type of direct effect where the nodes and links are physically connected. They are the most defensible type and have the strongest effect as the nodes are literally connected!
Phones, Broadband Internet, Railways are some examples of Physical effects.
Protocol (DIRECT EFFECTS)
As the name suggests, is an effect that occurs when an individual, company, or group creates a protocol that could be utilized by everyone on the network.
Metcalfe, when he created the Ethernet, worked on marketing his protocol to all computer businesses such as Xerox and Intel. Soon, Ethernet became a standard and all the devices started using it. Protocol effects have a tendency to embed in all products using the protocol once it has hit the critical mass. Really strong defensibility!
In recent times, Bitcoin is a good example of an idea showing this effect. The protocol around Bitcoin is set up in a way that requires it to be followed by everyone on the network such as the miners and wallets.
As you can imagine, the success of this type of effect is dependent on the adoption and marketing of the protocol itself plus it doesn’t always create value for the creator. However, as a type of Network Effect – it is really powerful.
Personal Utility (Direct effectS)
Networks with this effect has two important qualities –
- It ties the personal identity of the person to the network
- It is essential for daily personal or professional use
Whatsapp would be the first application that comes to the mind. In fact, most of the messenger type applications have a Personal Utility effect.
Personal (Direct Effects)
NfX states, Personal effects involve personal identity and reputation, connecting the persona of each user with other user personas. Each additional node represents both an additional potential audience member as well as an additional content producer for all the other nodes.
Personal and Personal Utility effects are different. Personal Utility needs to have a daily utility in a person’s life and is usually a lot more private (iMessage vs. Facebook). These two properties mean you cannot stop using products with Personal Utility type effects spontaneously.
The same doesn’t apply for products built with Personal effects. Yes, additional nodes increase value for the network but you don’t have a compulsion to use them daily. Your life will continue.
Personal Utility is a public-need-to-have network and Personal is a public-nice-to-have network.
A user’s “social graph” in a personal network are usually closely mapped to their in-the-flesh relationships.
NfX
Personal Network Effects are seen in social networks such as Facebook, Twitter, LinkedIn, and so on as they act as an extension to your real life.
Market (DIRECT EFFECTS)
These are networks like marketplaces but with communication aspects of Personal networks. Here is a very interesting read about Market effects by NfX who predicts that the next 10 years will be about these networks.
These are n-sided marketplaces. Seen in the image above, Naval Ravikant’s AngelList is a good example of Market Network.
Marketplace (INDIRECT Effects)
This is a type of indirect network effect where there are two sides complementing each other. These Network Effects are strong but not as strong as Direct or same-side effects.
It is difficult to break such businesses because you have to create a competing network providing value to both sides of the network. It is difficult to build this type of effect because of the chicken-and-egg problem explained in PART 2.
eBay or Craiglist are good examples. Ads and audience is also an example (readers going to blogs to consume content, businesses selling their ads to these users).
Platform (INDIRECT EFFECTS)
The two-sided Platform indirect effect and provides value to both the supply and demand side.
A good way to understand is by imagining iOS. iOS as a platform is available for developers and users. Developers can develop and sell their apps on the platform. Users can use the app and the platform which provides value.
Asymptotic Marketplace (INDIRECT EFFECTS)
This is a effect where the initial value increases rather quickly but it flattens after hitting a threshold.
Uber and Lyft are examples of this type of Network Effects. The businesses with Asymptotic Marketplace effects are vulnerable to competition.
The value proposition for it’s users diminishes after a threshold and can be provided by a similar smaller network, hence, it’s a weak effect.
Data Effects
The Data effect is seen where the network adds value to the users by the data in the product/service/business and as new users provide more data. Waze and Yelp are examples of businesses with Data Network Effects.
The relationship between product usage and the amount of useful new data gathered can be asymmetrical. Yelp has a Data Network Effect because a greater number of reviews for a greater number of restaurants makes the product more valuable. But its network effect is weakened by the fact that only a small percentage of users produce the data; most people read from the Yelp database but don’t write to it.
NfX
Technology Performance Effects
Networks with Technology Performance effects become better, the bigger they get. As more nodes join the network, the performance of the whole network improves. Peer-to-peer file sharing applications like uTorrent have this Network Effect.
NfX puts Technology Performance in a separate category of Network Effects.
Social Effects
Social Effects is the final category introduced by NfX. This type of Network Effect works through psychology and human interaction.
There is an unseen network among people, where our physical bodies are the nodes, and our words and behaviors with each other are the connections. These are the original networks if you will.
NfX
Language, Belief (i.e. Religion), and Bandwagon (a person joins a network, creates pressure for others to join) are the three types of Social Network Effects.
These were the different types of Network Effects. Here is a video explaining all of them if you don’t prefer reading.
APPLYING TYPES OF NETWORK EFFECTS WHILE VALUING A BUSINESS – FACEBOOK CASE STUDY
Okay, so you have understood the types of Network Effects. How do you apply it?
Let’s take Facebook as an example and understand it based on the case-study provided by NfX.
As I have already said multiple times before in the series, Facebook is the best example to understand Network Effects. Since its launch in 2004, it has leveraged different types of Network Effects and defensibility in its product making it a good case study.
[2004] Facebook, when it started, had a Personal Effect; students could form a link with each other on the network after registering as a user. The network became stronger as more users started using it.
[2006] After which, Facebook expanded to other colleges and outside of colleges. This created a Bandwagon Effect which is a social-type effect. It caused pressure for others to not miss out. FOMO, you know?
Facebook then worked on creating more defensibility outside of just Network Effects. I have explained the other types of digital defensibility in PART 1 of the series. Facebook started scaling up, using login features to embed itself into other programs, and finally became a brand for networking!
[2011] Facebook launched Facebook Messenger which gave its users a utility to connect and message with their friends & family. A lot of people use this as a primary source of messaging thus leveraging Personal Utility Effect.
[2012] Facebook purchased Instagram which was at the time building strong Personal Effects. Since then, Instagram has built new functionalities to double down on Marketplace Effects (user and business accounts). Instagram has also helped Facebook in maintaining a Personal effect for a younger age-group. After the Facebook network was polluted with unwanted connections and relatives, Instagram has acted in a way for the younger generation to connect with each other and socialize. Basically, what Facebook was in 2004.
[2014] Facebook bought Whatsapp which allowed users to chat and create groups. This makes a network really powerful based on Reed’s Law (explained in PART 2) because of the concept of Group-forming Networks (GFN). This made the Personal Utility Effect stronger.
[2016] Facebook then moved to create more defensibility with other categories of Network Effects. It created a Marketplace Effect by allowing users to act as buyers and sellers to sell their products on Facebook. It started competing with businesses such as Craigslist and eBay but since Facebook is a social network, it gave buyers confidence in the sellers they were interacting with.
Facebook now had a lot of users who were providing them a breadth of data that Facebook could show to other users. Each individual like, comment, the share was a new data point. Facebook could leverage the Data Effect.
Facebook is a beast. It has a lot of value for investors and there are a lot of ways to evaluate Facebook’s business model. Understanding its Network Effects could be a new way to approach valuation. As we have seen above, it uses different categories of effects to make the business more powerful.
That was it for this part! Understanding Network Effects, how are they formed, their applications and types has been a revelation for me. After understanding the concept, I have started observing it in a lot of areas in my life. I will discuss these ideas and how to develop Network Effects in the next part!
In the next parts, we will cover more of Network Effects –
- WHAT ARE NETWORK EFFECTS AND WHY ARE THEY IMPORTANT – PART 1
- HOW YOU VALUE A NETWORK AND THE LAWS OF NETWORK – PART 2
- TYPES OF NETWORKS EFFECTS AND VALUING FACEBOOK USING NETWORK EFFECTS– PART 3
- BUILDING, MAINTAINING AND HOW TO UTILIZE NETWORK EFFECTS IN DAILY LIFE – PART 4
