sales and $10 million in gross margin than it is to have to sell and service a million customers who generate $100 million in sales to achieve that same $10 million in gross margin. That’s eight times as many customers and eight times the revenues, which means eight times as many salespeople, customer service representatives, accountants, and so on.
Designing a high-gross-margin business model makes your chances of success greater and the rewards of success even greater. As we’ll see in a later section, high gross margins have helped even nontech businesses, such as the Spanish clothing retailer Zara, grow into global giants.
GROWTH FACTOR #4: NETWORK EFFECTS
Market size, distribution, and gross margins are important factors in growing a company, but the final growth factor plays the key role in sustaining that growth long enough to build a massively valuable and lasting franchise. While the past twenty years have driven improvements in the first three growth factors, the rise in Internet usage around the world has pushed network effects to levels never before seen in our economy.
The increasing importance of network effects is one of the main reasons that technology has become a more dominant part of the economy.
At the end of 1996, the five most valuable companies in the world were General Electric, Royal Dutch Shell, the Coca-Cola Company, NTT (Nippon Telegraph and Telephone), and ExxonMobil—traditional industrial and consumer companies that relied on massive economies of scale and decades of branding to drive their value. Just twenty-one years later, in the fourth quarter of 2017, the list looked very different: Apple, Google, Microsoft, Amazon, and Facebook. That’s a remarkable shift. Indeed, while Apple and Microsoft were already prominent companies at the end of 1996, Amazon was still a privately held start-up, Larry Page and Sergey Brin were still a pair of graduate students at Stanford who were two years away from founding Google, and Mark Zuckerberg was still looking forward to his bar mitzvah.
So what happened? The Networked Age happened, that’s what.
Technology now connects all of us in ways that were unthinkable to our ancestors. Over two billion people now carry smartphones (many of them made by Apple, or using Google’s Android operating system) that keep them constantly connected to the global network of everything. At any time, those people can find almost any information in the world (Google), buy almost any product in the world (Amazon/Alibaba), or communicate with almost any other human in the world (Facebook/WhatsApp/Instagram/WeChat).
In this highly connected world, more companies than ever are able to tap into network effects to generate outsize growth and profits.
We’ll use the simple layman’s definition of network effects in this book:
A product or service is subject to positive network effects when increased usage by any user increases the value of the product or service for other users.
Economists refer to these effects as “demand-side economies of scale” or, more generally, “positive externalities.”
The magic of network effects is that they generate a positive feedback loop that results in superlinear growth and value creation. This superlinear effect makes it very difficult for any node in the network to switch from an incumbent to an alternative (“customer lock-in”), since it is almost impossible for any new entrant to match the value of plugging into the existing network. (Nodes in these networks are typically customers or users, as in the canonical example of the fax machine, or the more recent example of Facebook, but can also be data elements or other fundamental assets valuable in a business.)
The resulting phenomenon of “increasing returns to scale” often results in an ultimate equilibrium in which a single product or company dominates the market and collects the majority of its industry’s profits. So it’s no surprise that smart entrepreneurs strive to create (and smart investors want to invest in) these network effects start-ups.
Several generations of start-ups have tapped these dynamics to build dominant positions, from eBay to Facebook to Airbnb. To accomplish these goals, it’s critical to develop a rigorous understanding of how network effects work. My Greylock colleague Simon Rothman is one of the world’s premier experts on network effects from building eBay’s $14 billion automotive marketplace. Simon warns, “A lot of people try to bolt on network effects by doing things like adding a profile. ‘Marketplaces have profiles,’ they reason, ‘so if I add profiles, I’ll be adding network effects.’” Yet the reality of building network effects is a bit more complicated. Rather than simply imitate specific features, the best blitzscalers study the different types of network effects and design them into their business models.
Five Categories of Network Effects
On his industrial organization of information technology website, the NYU professor Arun Sundararajan classifies network effects into five broad categories:
1) Direct Network Effects: Increases in usage lead to direct increases in value. (Examples: Facebook, messaging apps like WeChat and WhatsApp)
2) Indirect Network Effects: Increases in usage encourage consumption of complementary goods, which increases the value of the original product. (Example: Adoption of an operating system such as Microsoft Windows, iOS, or Android encourages third-party software developers to build applications, increasing the value of the platform.)
3) Two-Sided Network Effects: Increases in usage by one set of users increases the value to a different set of complementary users, and vice versa. (Example: Marketplaces such as eBay, Uber, and Airbnb)
4) Local Network Effects: Increases in usage by a small subset of users increases the value for a connected user. (Example: Back in the days of metered calls, certain wireless carriers allowed subscribers to specify a limited number of “favorites” whose calls didn’t count against the monthly allotment of call minutes.)
5) Compatibility and Standards: The use of one technology product encourages the use of compatible products. (Example: within the Microsoft Office suite, Word’s dominance meant that its document file format became the standard; this has allowed it to destroy competitors like WordPerfect and fend off open-source solutions like OpenDocument.)
Any of these different network effects can have a major impact; Microsoft’s ability to tap into multiple network effects with Windows and Office contributed greatly to its unprecedentedly durable franchise. Even today, Windows and Office remain dominant in the PC market; it’s simply that other platforms like mobile have achieved similar or greater importance.
A key element of leveraging network effects is the aggressive pursuit of network growth and adoption. Because the impact of network effects increases in a superlinear fashion, at lower levels of scale, network effects actually exert downward pressure on user adoption. Once all your friends are on Facebook, you have to be on Facebook too. But conversely, why would you join Facebook if none of your friends had joined yet? The same is true for the first user of marketplaces like eBay and Airbnb.
With network effects businesses, you can’t start small and hope to grow slowly; until your product is widely adopted in a particular market, it offers little value to potential users. Economists would say that the business has to get past the “tipping point” where the demand curve intersects with the supply curve. Companies like Uber subsidize their customers in an attempt to manipulate the demand curve to reach that tipping point faster; the bet is that losing money in the short term may allow you to make money in the long term, once you’re past the tipping point.
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