5 min read

3 Benefits of Network Effects

3 Benefits of Network Effects
Bruce McFadden
Bruce McFadden Code2 / Seasoned Taskmaster

3 Benefits of Network Effects

Our last blog post established that network effects have been integral parts of products and services that have created most of the value created in the last few decades. But why do networked products generate more value than products without network effects? Are there any specific problems decision-makers can use network effects to solve?

Here are three major benefits companies hope to gain by taking advantage of network effects:

Helping solve the cold start problem

Achieving the product-market fit (PMF) is the bane of all founders and corporate decision-makers launching a product. Finding the way to PMF is more of an art than science, and people who came up with viable solutions to this problem are regarded as gurus. Geoffrey Moore describes the struggle to find traction and reach PMF as 'crossing the chasm.' But I think Andrew Chen, in his book The Cold Start Problem, does a better job of naming it by calling it 'the cold start problem,' as in getting a car started on a winter morning, and offers network effects as the solution.

According to Chen, there has to be an atomic network, the smallest possible network that is stable and can grow on its own, in place for network effects to kick in. The good people at NfX call this unit a "minimum viable cluster," but the idea remains the same. This small community consists of people who share a common pain. Solving that pain in a simple, frictionless manner wins these people over and turns them into evangelists. The size of an atomic network is the smallest allowing its members to fully experience the product and extract the intended value. For Slack, the atomic network is made up of three users, meaning that it's only with the addition of the third user that one gets to enjoy the benefits of Slack.

The idea is to multiply the number of these atomic networks and bring it up to a certain density in a specific city, campus, or market segment to create a critical mass. Reaching that critical mass gives rise to word-of-mouth and starts a flywheel effect among people with similar needs. The more users join the network, the better the experience for everyone. Effortless customer acquisition that does not need marketing resources—it's every entrepreneur's dream.

Building a moat around the business

An economic moat refers to the competitive advantage a business enjoys over rivals, which helps it protect its profits and market share. Network effects, when successfully implemented, can work like a water-filled ditch surrounding a castle, allowing a company to preserve its hard-won market position.

Entrepreneur and NfX general partner James Currier counts network effects among the four sources of defensibility, together with economies of scale, brand, and embedding (increased switching costs). Products leveraging network effects become more than a sum of their features. People use these products because they offer the best experience while solving a problem. As the network grows with the addition of like-minded people, it becomes a source of value for users. Unfortunately for competitors, while features can be copied, networks can't.

Think about all the Facebook and Twitter clones you have seen, none of which went anywhere. They offered functionality similar to the original idea but failed to dislodge the incumbents because social media platforms are nothing without their networks. As a user, you want to be where your contacts are. If your friends start quitting a messaging app you use, you, too, will be on your way out before long.

Increased customer lifetime value

Companies taking advantage of indirect network effects are known for the products or services they give away for free. The idea is to achieve spectacular levels of growth in user numbers, get people hooked on the product, and then use this user base to generate other sources of revenue.

Meta used its social media platform (Facebook), and Google capitalized on its dominant search engine to create an ads business that earned them billions of dollars. They did this without charging their users for using their main products. The better the user experience on Facebook and Google, the more Meta and Google are able to charge another group (media buyers) for their ads. This model increases the customer lifetime value by preserving the already top-notch user experience and increasing the users' engagement through different levers.

Gaming companies have masterfully combined the freemium model with network effects to earn billions of dollars every year. These companies initially release free-to-play games to attract casual gaming fans. As a casual gamer becomes part of a network and the game becomes more competitive, he is more likely to pay for extra features and in-game items. This model replaces a one-off purchase, which the player will stop playing in a few days and remove from his device, with a long-lasting, dynamic model leveraging the engagement generated by a network.

Final thoughts

There is a reason startup founders and corporate decision-makers are dying to incorporate network effects into their services and products. Network effects cure the traction issue from the get-go, give your product defensibility vis-à-vis the rivals, and extract more lifetime value from each customer—killing many birds with one stone. Turning great products into generational trends, network effects are the closest thing to Iron Man's armor you can hope to have.

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