An Introduction to Network Effects

What's up, crew. This is Alex Lieberman, co-founder and Executive Chairman of Morning Brew. Welcome back to Founder’s Journal, my personal audio diary, where I give you, the business builder, the tools you need to think better in order to build better, whether that's building a business, a team, or a new product. Today, I'm giving you the always important introduction to a little thing called network effects. Let's hop into it. 

Network effects in a nutshell: Glitch and Slack

So I've been reading an amazing book this week, which by the way I posted on my Instagram, you should follow me on Instagram if you don't already. And I want to tell you about the book. The book is called Cold Start Problem and it is by Andrew Chen. Andrew Chen is like the god of growth. He ran growth at Uber. He's written thousands of essays about growth. He's involved with Reforge, which is a growth marketing based education company. And he's now a partner at Andreessen Horowitz, where he focuses on network-based businesses. And so I want to summarize some of the things that I've learned from his book, by telling you a story to start. It's a story that starts sad, but gets happy. In 2009, there was this company and it was a little itty-bitty software company called Tiny Speck. You probably haven't heard of Tiny Speck. It’s okay. They're not around anymore. Tiny Speck had this amazing team, an amazing founding team that had previously sold a business for tens of millions of dollars, so they had a ton of credibility and they raised $17 million to start Tiny Speck. And their goal was very simple. They wanted to build the next massive multiplayer game. The game was going to be called Glitch and it was supposed to change the face of gaming forever. Unfortunately, if you fast forward, Glitch did everything but that. People absolutely hated the game. 97% of people who signed up for Glitch left within five minutes. If you don't have a reference point, just know that is shitty. The business was a leaky bucket. They could not keep users. And the only way, unfortunately, for a multiplayer game business, also a network business, was to get a lot of people joining, staying, playing the game, interacting, and chatting with each other. And they were not able to do any of that. Basically the business needed network effects and it could not achieve network effects. So after four years and 10 months from when they founded the company in 2009, this all-star team threw in the towel and they shut down glitch. The team did not give up though. They ended up launching a second product.

That product was called Slack. Maybe you've heard of that one. As you probably know, Slack became an absolute behemoth. It generated $800 million of revenue. The CEO of the company, Stewart Butterfield, ended up selling the business to Salesforce for $26 billion in 2021. And the reason I tell this story is Slack is the anomaly. For most network-based businesses, the story ends with something like what happened with Glitch, just a total failure. And Slack is the anomaly in the sense that the first network-based business failed, but the second network-based business succeeded. But make no mistake, building businesses with network effects is incredibly difficult. It can be wildly fruitful given if you look at the 10 largest companies in the world right now by market cap, largest public companies, five of the top 10 leverage network effects in some way. But it is incredibly difficult to build up. And so what I want to do the rest of this episode is summarize for you what network effects are, what is important to keep in mind about them as you look at network-based businesses, and also the different stages of networks, and whether you are building a business yourself that has networks, or whether you are an angel investor or a public stock investor, or you're just trying to nerd out on startups so that you have a more holistic picture as you're running your business, it is so important for you to understand businesses with network effects, because it is such a relevant strategy for business building in 2022. 

Network effects defined

So what is a network effect? Very simply a network effect is what happens when products get more valuable as more people use them. So for every additional user, the product gets more valuable for every user who already was on the product or the platform. So a few examples that you will definitely know: The more drivers that joined Uber, the more quickly that riders would be able to find a ride. And the more quickly that riders would be able to fund a ride, the more riders that ended up joining because previous riders have had a great experience. The more riders that ended up joining leads to more drivers joining the platform, because drivers are able to earn more since there are more riders on the platform. That is a network effect. Different contexts: dating. The more people that join Tinder or Bumble, the more options that each individual data has to choose from and potentially find their lifelong match, which means more daters will join the app because they're seeing more people have success with matching and dating. One final one in the world of hospitality: The more people with extra bedrooms that join Airbnb, the more selection that users have to book places, the more that users have a good experience, the more users that will join and the more users that are on the platform, the more that people who own properties and are thinking about renting their properties are incentivized to join because there's a higher probability of them being able to rent it out. That is the power of network effects. It is a self-fulfilling prophecy if you can hit a critical mass or a tipping point. Now, the interesting thing about network effects is I feel like they've become really hip and part of the startup vernacular in the last 10 years, but networks are as old as time. 

An early network-based business: AT&T

Let me just start with a relatively old example, but they're even more old examples than that. Let's go back to 1908. In 1908, there were 5 million phones in the United States for more than 90 million people. And most of these phones were operated by a company called American Telephone and Telegraph, also known as AT&T. And AT&T and its president and its founders understood networks, but they just were not called networks at the time. So here is a quote by Theodore Vail, who is the president of AT&T in 1909, discussing basically how they think about AT&T strategy. This is an exact quote from him, “A telephone without a connection at the other end of the line is not even a toy or a scientific instrument. It is one of the most useless things in the world. Its value depends on the connection with other telephones and increases with the number of connections.” All that to say that Theodore Vail, what he was talking about, was AT&T and really telephones being a network. And the fact that the more telephones you have on this network, the more valuable the telephones are for every individual user of a telephone. He was describing network effects, there just wasn't a fancy name for it. And so as I continued to read Andrew Chen's book, and I still haven't finished it, it's an amazing read.

Alex’s top 3 thoughts on network effects

And I keep going back and underlining and trying to make sure I really understand the concepts, but there are a few really important points about networks and network effects that I want to call out in my reading so far. 

#1: Networks connect millions or billions of people, but don’t own the underlying assets

The first really important point: Networks and especially the most valuable networks are fascinating in that they connect millions or even billions of people, but they do not own the underlying asset that is exchanging hands. Airbnb doesn't own any homes, which is obviously very different from traditional hospitality where Marriott or Hilton or Sheraton do own the hotels. Uber doesn't own any cars, which is very different from traditionally taxis and town cars, the companies own the cars. YouTube doesn't own creators, Apple doesn't own the developers that are creating games or apps that are offered on its app store. And so we live in this world where the value of the network is truly being the intermediary for exchanging value, but not actually owning that value yourself. 

#2: Network-based businesses tend to be winner-takes-all

Second really important point: In this era that we live in, where there are a lot of network-based businesses and with markets that have leaders that are network-based, it generally is winner-takes-all, like it is hard to be the business that is in second, third, or fourth place. The business that is in first place generally takes the vast majority of the value, launching a new startup in these markets is actually really difficult. And this actually kind of juxtaposes or is dissimilar from what I've said in a previous Founder’s Journal, where I've said there's no better time to be an entrepreneur. There's no better time to build a business. And I still agree with that, but there's nuance. It has never been easier to build a product because of the acceleration of technology and the low cost of building any new product. Finding talent to work on your product is easier than ever because just, you know, amazing marketplace that exists online for finding talent from LinkedIn to Upwork to Angel. But the thing that has not changed, it has actually gotten harder, because there's been the acceleration of businesses being created is attention. Getting people to pay attention has never been harder. And when you think about it, because network businesses attract so much supply so quickly, you are put in competition with millions of other apps, creators, homes, or sellers. So to give you an example, you have the Apple App Store, right? When the app store was created, if you were an iOS developer and you built an app or a game, it would have been really easy to stand out to the, I don't know exactly, you know, when the App Store was created, how many iPhone users there were, but let's just say tens to hundreds of millions of iPhone users. Today, again, because of the strength of the network, because so many developers want to create apps to get in front of the several billion iPhone users, there is wild competition. There are millions of apps on the App Store so to stand out has never been harder. 

#3: Networks have been around way longer than Big Tech (think: electricity)

Third and final interesting thing that I've learned and thought about from what I've read in Andrew Chen's book so far, and this is actually kind of the, shot-chasers to what I was just talking about before with AT&T: Networks have been around for way longer than Big Tech companies, there's just more opportunity to grow them faster than ever before and at larger scale. So if you talk about some of the largest network-based businesses today, you're talking about businesses that have billions of users. Back in the day, you were talking about things in the tens of thousands, hundreds of thousands, or millions. And so I'll just give you an example of networks that have been around forever, just maybe not at the scale that technology has afforded to network based businesses today. Money is a network, the more people using a currency, the more demand there is for that currency, the more merchants that accept that currency, and the more merchants that accept that currency, the more people that want to use that currency so that they can then pay in that currency. Religion is a network. Roads are a network. Electricity is a network. And so networks have been around forever. The vernacular just hasn't been around and the scale and the speed of networks just hasn't been as accelerated as it is today.

The 5 stages of network effects

Now one final piece to my introduction on network effects before we call it an episode, and that is the stages of network effects. And this is basically how Andrew Chen lays out The Cold Start Problem is he starts the book by saying, network effects are really powerful. You need to understand what they are, and also to build a network-based business, you need to understand that there are stages to the network that you build. And he basically dedicates a part of the book to every stage of a network. So I want to walk you through what the stages are and then next episode, I'm going to talk about one of the stages. Stage one is the cold start problem, hence the name of the book. And the cold start problem, very simply, is in the initial days of building a network, it is incredibly difficult to get users to stick around when you do not have that much product to offer your early users. Stage two is what is known as the tipping point. And the tipping point is the point at which a network has built enough momentum through robust supply and demand, so both sides of the market, where the network can actually grow on its own. Third stage is what's called escape velocity. So at this point you've built a network and you are trying to basically prove to yourself that you can do three things: that you can sustain user acquisition, i.e., new users coming to your network, that you can drive retention and engagement of existing users, so you can get users to continue to come back and offer them new products that extends the value of your existing users. And that you can actually keep your users on your platform profitably, actually hitting positive unit economics, because for many network-based businesses, they have to spend tons of money to build up their network and they never get to the point where they actually can make money on any given user. Fourth stage of network-based businesses is what's known as hitting the ceiling. And that is when growth stalls in a network, which it inevitably does for every network-based business. No network-based business is basically free and clear of hitting the ceiling. And at this point it's when your network is stalling in growth because customer acquisition costs are the cost of you acquiring new users is going up. And that generally happens when you have saturated the market that you're playing in. And so you either need to find ways to drive acquisition costs down. You need to find ways to extend the value of your existing users, so you're willing to pay those higher acquisition costs, or you need to find new markets to go into. And the fifth and final stage of network businesses is what's known as the moat, and the moat is the final stage of network effects. Very few network based-businesses get to this stage, but is the point at which you have built a valuable enough network that not only has momentum, but you've been able to prove those three things of continued user acquisition, continued retention and engagement, and profitability of your users. And you've done so in a way where you can fend off competitors because of the power of the network effects that you've built.

Looking ahead

And so that is the introductory session by me about network effects, obviously drawing a ton of inspiration by Andrew Chen, who is the absolute expert on network-based businesses and marketplaces. And so next episode, I'm going to chat more about the hardest stage of those five stages that I just named in building network effects. And that is stage one, which is the cold start problem. Very simply, how can you get traction with a network when you have the chicken and the egg problem? So in the case of Uber, drivers don't want to join Uber if there are no riders and riders don't want to join if there are no drivers. We're going to talk next episode about how to solve this problem, not just for Uber, but for any business that operates as a network or a marketplace As always, thank you so much for listening and I'll catch you next episode.