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The Network Effects Manual
13 Different Network Effects (and counting)
PayPal. Microsoft. Facebook. Uber. Twitter. Salesforce. These are some of the most impactful and significant companies in the world.
Each one is very different in a lot of ways, but there’s a single property that defines them all and lies behind their success.
That property is network effects.
As we’ve said, nfx are the #1 way to create defensibility in the digital world. Companies with the strongest types of nfx built into their core business model tend to win, and win big.
Our three-year study, which we released recently, shows that nfx are responsible for 70% of the value created by tech companies since the Internet became a thing in 1994. Even though they are only a minority of companies, companies with nfx end up creating the lion’s share of the value.
For Founders looking to build truly impactful companies, few areas of expertise are more valuable.
Still, because very little has been written about nfx, misconceptions abound. Many people talk about them, but few understand the hidden complexities: what they really are, how they work, the many different types, and how to build and maintain them. Moreover, very few companies want to share their valuable playbooks around nfx, so most founders don’t even recognize different types of nfx when they see them, much less understand their complex inner workings.
Today we are pleased to present the Network Effects Map and accompanying manual for the first time. It’s an ever-evolving effort, and we’re continually making changes and updates. As of early 2018, we’ve identified 13 types, each with their own complex playbook. This manual is a starting point for discussion around nfx, and for understanding those playbooks.
Each one is very different in a lot of ways, but there’s a single property that defines them all and lies behind their success.
That property is network effects.
As we’ve said, nfx are the #1 way to create defensibility in the digital world. Companies with the strongest types of nfx built into their core business model tend to win, and win big.
Our three-year study, which we released recently, shows that nfx are responsible for 70% of the value created by tech companies since the Internet became a thing in 1994. Even though they are only a minority of companies, companies with nfx end up creating the lion’s share of the value.
For Founders looking to build truly impactful companies, few areas of expertise are more valuable.
Still, because very little has been written about nfx, misconceptions abound. Many people talk about them, but few understand the hidden complexities: what they really are, how they work, the many different types, and how to build and maintain them. Moreover, very few companies want to share their valuable playbooks around nfx, so most founders don’t even recognize different types of nfx when they see them, much less understand their complex inner workings.
Today we are pleased to present the Network Effects Map and accompanying manual for the first time. It’s an ever-evolving effort, and we’re continually making changes and updates. As of early 2018, we’ve identified 13 types, each with their own complex playbook. This manual is a starting point for discussion around nfx, and for understanding those playbooks.
Nfx basics
As you probably know, the simplified definition of network effects is that they occur when a company’s product or service becomes more valuable as usage increases.
By this definition, network effects seem deceptively straightforward. But when you take a closer look, you start to notice that different types of networks are very different in how they behave. As a result, not all nfx are created equal — some are stronger and tend to produce more value than others.
Network effects are one of the four remaining defensibilities in the digital age, including brand, embedding, and scale. Of the four, network effects are by far the strongest. To date, we’ve identified 13 distinct types of nfx that fall under five broader categories.
In the map below, we’ve depicted the various nfx types (labeled) and categories (organized by color), with the strongest and simplest network effects at the center of the map. The other three defensibilities are also shown on the right.
As you probably know, the simplified definition of network effects is that they occur when a company’s product or service becomes more valuable as usage increases.
By this definition, network effects seem deceptively straightforward. But when you take a closer look, you start to notice that different types of networks are very different in how they behave. As a result, not all nfx are created equal — some are stronger and tend to produce more value than others.
Network effects are one of the four remaining defensibilities in the digital age, including brand, embedding, and scale. Of the four, network effects are by far the strongest. To date, we’ve identified 13 distinct types of nfx that fall under five broader categories.
In the map below, we’ve depicted the various nfx types (labeled) and categories (organized by color), with the strongest and simplest network effects at the center of the map. The other three defensibilities are also shown on the right.
We developed this map as an exercise over the years to help bring greater clarity to the subject. But before we dive in, there are a few things we should point out:
With that said, let’s turn to the Map itself. Below each of the various nfx on the Network Effects Map are described, with relevant examples.
- The map we’ve laid out here isn’t meant to be taken as an incontrovertible truth — it’s a beginning point for discussion and understanding. It’s one of our evolving methods to help Founders recognize and make use of powerful forces to build great companies. Because for Founders looking to build a strong competitive moat, the ability to identify and understand nfx is invaluable.
- Network effects are not viral effects. Network effects are about creating defensibility, and viral effects are about getting new users for free. They have totally different objectives and playbooks.
- You’ll often see the same companies have several nfx at play simultaneously, meaning that the different nfx types are not mutually exclusive. They are like colors, and your company is like a work of art. It helps to be familiar with the full palette as you paint.
With that said, let’s turn to the Map itself. Below each of the various nfx on the Network Effects Map are described, with relevant examples.
Direct Network Effects
The 1st broad category of nfx, shown in blue on the Network Effects Map, are direct network effects. The strongest, simplest network effects are direct: increased usage of a product leads to a direct increase in the value of that product to its users.
The direct network effect was the first ever to be noticed, back in 1908. The Chairman of AT&T at the time, Theodore Vail, noticed how hard it was for other phone companies to compete with AT&T once they had more customers in a given locale. He pointed this out in his annual report to shareholders, writing that:
“Two exchange systems in the same community, cannot be… a permanency. No one has use for two telephone connections if he can reach all with whom he desires connection through one.”
Vail noticed that the value of AT&T was mostly based on their network, not their phone technology. At the time, it was a revolutionary insight. It showed that even if a new telephone was clearly superior to their old phone on a technical level, no one would want the new telephone if they couldn’t use it to call their friends and family.
In other words, a better product wouldn’t come close to making up the lost value of the network. A new entrant would have to achieve a comparable network effect to realistically produce a comparable amount of value for its users. In Vail’s words:
“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 the other telephone — and increases with the number of connections.”
Below are the full texts of the relevant pages of that 1908 annual report. You’ll notice that Vail never uses the phrase “network effects”, although that’s the concept he’s describing. The term itself would only emerge later.
The 1st broad category of nfx, shown in blue on the Network Effects Map, are direct network effects. The strongest, simplest network effects are direct: increased usage of a product leads to a direct increase in the value of that product to its users.
The direct network effect was the first ever to be noticed, back in 1908. The Chairman of AT&T at the time, Theodore Vail, noticed how hard it was for other phone companies to compete with AT&T once they had more customers in a given locale. He pointed this out in his annual report to shareholders, writing that:
“Two exchange systems in the same community, cannot be… a permanency. No one has use for two telephone connections if he can reach all with whom he desires connection through one.”
Vail noticed that the value of AT&T was mostly based on their network, not their phone technology. At the time, it was a revolutionary insight. It showed that even if a new telephone was clearly superior to their old phone on a technical level, no one would want the new telephone if they couldn’t use it to call their friends and family.
In other words, a better product wouldn’t come close to making up the lost value of the network. A new entrant would have to achieve a comparable network effect to realistically produce a comparable amount of value for its users. In Vail’s words:
“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 the other telephone — and increases with the number of connections.”
Below are the full texts of the relevant pages of that 1908 annual report. You’ll notice that Vail never uses the phrase “network effects”, although that’s the concept he’s describing. The term itself would only emerge later.
72 years after Vail first described direct network effects, the father of the Ethernet standard, Robert Metcalfe, took the concept a step further by proposing that the value of a network is proportional to the number of connected users squared (N2). This is now known as Metcalfe’s Law.
The diagram below illustrates the basic concept of a direct network as described by Metcalfe’s Law:
The diagram below illustrates the basic concept of a direct network as described by Metcalfe’s Law:
In 2001, an MIT computer scientist named David Reed went even further, declaring that Metcalfe’s law actually understated the value of a network. He pointed out that within a larger network, smaller, tighter networks can form: for example, the football team within a high school network; siblings within a family network; tennis players within a co-worker network.
ISuch connections, and the potential to join other subgroups, cement people’s commitment to the overall network in deeper ways that the overall size and connection density of the network would imply by themselves. Because of this, Reed believed that the true value of a network increases exponentially (2^N) in proportion to the number of users, much faster even than what Metcalfe’s Law described. We now call this Reed’s Law.
The details of these laws can be debated academically, but for Founders, they provide a tangible way to conceptualize an operational truism — nfx are powerful. They are a law of nature.
Within the broader category of direct nfx, there are many different types. So far, we’ve identified five: physical, protocol, personal utility, personal, and market network.
The details of these laws can be debated academically, but for Founders, they provide a tangible way to conceptualize an operational truism — nfx are powerful. They are a law of nature.
Within the broader category of direct nfx, there are many different types. So far, we’ve identified five: physical, protocol, personal utility, personal, and market network.
Physical (Direct)
Physical Direct nfx are direct network effects tied to physical nodes (e.g. telephones or cable boxes) and physical links (e.g. wires in the ground). This is the most defensible network effect type because it not only has a direct network effect, but it also lends itself to the addition of other defensibilities; namely, scale effects and embedding. Competing with a company that has Physical Network Effects requires a large upfront investment of capital and physical constraints.
Physical Direct nfx are direct network effects tied to physical nodes (e.g. telephones or cable boxes) and physical links (e.g. wires in the ground). This is the most defensible network effect type because it not only has a direct network effect, but it also lends itself to the addition of other defensibilities; namely, scale effects and embedding. Competing with a company that has Physical Network Effects requires a large upfront investment of capital and physical constraints.
Roads, trains, electricity, sewage, natural gas, cable and broadband internet are examples of businesses with physical direct network effects. In fact, most Physical Networks are utilities: winner-take-all markets that develop into monopolies and end up being nationalized.
The best evidence for the strong defensibility of Physical Networks is that so many of them have poor or substandard services, and yet continue to lead the market. Think of Comcast and Verizon. Why do they have the lowest customer satisfaction in the US? Because they can get away with it at no risk to their bottom line. No one can compete with them. Who could spend the money to lay all that cable? And with no competitors, frustrated customers have nowhere to turn.
The best evidence for the strong defensibility of Physical Networks is that so many of them have poor or substandard services, and yet continue to lead the market. Think of Comcast and Verizon. Why do they have the lowest customer satisfaction in the US? Because they can get away with it at no risk to their bottom line. No one can compete with them. Who could spend the money to lay all that cable? And with no competitors, frustrated customers have nowhere to turn.
Protocol (Direct)
A Protocol Network Effect arises when a communications or computational standard is declared and all nodes and node creators can plug into the network using that protocol. Bitcoin and Ethereum are recent examples of protocol networks. The protocol setter can be either an individual company, a group of companies, or a panel.
A Protocol Network Effect arises when a communications or computational standard is declared and all nodes and node creators can plug into the network using that protocol. Bitcoin and Ethereum are recent examples of protocol networks. The protocol setter can be either an individual company, a group of companies, or a panel.
Ethernet is another, more traditional, example of a Protocol Network Effect. When Robert Metcalfe founded 3Com, he persuaded DEC, Intel, and Xerox to adopt Ethernet as a standard protocol for local computer networks, with a standard speed of 10 megabits per second, 48-bit addresses, and a global 16-bit Ethertype-type field. Competing proprietary protocols existed, but as Ethernet pulled away and began to capture more and more market share, Ethernet-compatible products flooded the market. This increased the value of Ethernet at a compounding rate and decreased the value of competitors, regardless of their relative performance. Soon, ethernet ports became standard features of all modern computers.
Once a protocol has been adopted it is extremely difficult to replace. Note how the fax protocol is still in use, or the TCP/IP protocol (even though other, better protocols now exist for those purposes).
It’s also true that the protocol creator doesn’t typically capture most of the value from the development of the network, as they normally do with other direct nfx.
This distribution of value in a Protocol Network can be shifted if the protocol creator can maintain ownership of a significant percentage of the tokens within a token-enabled network, or maintain central control over addressing, identity, wallets, naming, or prioritization and still get the network to adopt the protocol.
The success of such an adoption strategy is often less about technology and more about marketing, social engineering, and choice of market niche. That’s why VHS beat Betamax, even though Betamax was arguably a better standard. It’s also part of why Bitcoin has taken off as a virtual store of value, when it is more costly to operate and no more useful than many other virtual currencies that preceded it.
Once a protocol has been adopted it is extremely difficult to replace. Note how the fax protocol is still in use, or the TCP/IP protocol (even though other, better protocols now exist for those purposes).
It’s also true that the protocol creator doesn’t typically capture most of the value from the development of the network, as they normally do with other direct nfx.
This distribution of value in a Protocol Network can be shifted if the protocol creator can maintain ownership of a significant percentage of the tokens within a token-enabled network, or maintain central control over addressing, identity, wallets, naming, or prioritization and still get the network to adopt the protocol.
The success of such an adoption strategy is often less about technology and more about marketing, social engineering, and choice of market niche. That’s why VHS beat Betamax, even though Betamax was arguably a better standard. It’s also part of why Bitcoin has taken off as a virtual store of value, when it is more costly to operate and no more useful than many other virtual currencies that preceded it.
Personal Utility (Direct)
Personal Utility Networks have two distinguishing qualities. The first is that users’ personal identities are tied to the network in question, often with usernames tied to their real name as with Facebook Messenger. The second is that they are essential to the personal or professional lives of users on a daily basis.
Personal Utility Networks have two distinguishing qualities. The first is that users’ personal identities are tied to the network in question, often with usernames tied to their real name as with Facebook Messenger. The second is that they are essential to the personal or professional lives of users on a daily basis.
Ethernet is another, more traditional, example of a Protocol Network Effect. When Robert Metcalfe founded 3Com, he persuaded DEC, Intel, and Xerox to adopt Ethernet as a standard protocol for local computer networks, with a standard speed of 10 megabits per second, 48-bit addresses, and a global 16-bit Ethertype-type field. Competing proprietary protocols existed, but as Ethernet pulled away and began to capture more and more market share, Ethernet-compatible products flooded the market. This increased the value of Ethernet at a compounding rate and decreased the value of competitors, regardless of their relative performance. Soon, ethernet ports became standard features of all modern computers.
Once a protocol has been adopted it is extremely difficult to replace. Note how the fax protocol is still in use, or the TCP/IP protocol (even though other, better protocols now exist for those purposes).
It’s also true that the protocol creator doesn’t typically capture most of the value from the development of the network, as they normally do with other direct nfx.
This distribution of value in a Protocol Network can be shifted if the protocol creator can maintain ownership of a significant percentage of the tokens within a token-enabled network, or maintain central control over addressing, identity, wallets, naming, or prioritization and still get the network to adopt the protocol.
The success of such an adoption strategy is often less about technology and more about marketing, social engineering, and choice of market niche. That’s why VHS beat Betamax, even though Betamax was arguably a better standard. It’s also part of why Bitcoin has taken off as a virtual store of value, when it is more costly to operate and no more useful than many other virtual currencies that preceded it.
Once a protocol has been adopted it is extremely difficult to replace. Note how the fax protocol is still in use, or the TCP/IP protocol (even though other, better protocols now exist for those purposes).
It’s also true that the protocol creator doesn’t typically capture most of the value from the development of the network, as they normally do with other direct nfx.
This distribution of value in a Protocol Network can be shifted if the protocol creator can maintain ownership of a significant percentage of the tokens within a token-enabled network, or maintain central control over addressing, identity, wallets, naming, or prioritization and still get the network to adopt the protocol.
The success of such an adoption strategy is often less about technology and more about marketing, social engineering, and choice of market niche. That’s why VHS beat Betamax, even though Betamax was arguably a better standard. It’s also part of why Bitcoin has taken off as a virtual store of value, when it is more costly to operate and no more useful than many other virtual currencies that preceded it.
Personal Utility (Direct)
Personal Utility Networks have two distinguishing qualities. The first is that users’ personal identities are tied to the network in question, often with usernames tied to their real name as with Facebook Messenger. The second is that they are essential to the personal or professional lives of users on a daily basis.
Personal Utility Networks have two distinguishing qualities. The first is that users’ personal identities are tied to the network in question, often with usernames tied to their real name as with Facebook Messenger. The second is that they are essential to the personal or professional lives of users on a daily basis.
People use Personal Utility Networks to communicate and interact with their own personal networks, so not being online or being part of the network has a steep downside. Opting out would become a significant impediment in daily life and could greatly harm people’s important personal or work relationships.
Personal (Direct)
Personal nfx are in play when a person’s identity or reputation is tied to a product. Often people on a Personal Network are influenced to join by people they might know in real life. If people you know from the real world are all using the same product to house their identity and reputation, there’s a large value add (to you) if you join the network yourself.
Personal nfx are in play when a person’s identity or reputation is tied to a product. Often people on a Personal Network are influenced to join by people they might know in real life. If people you know from the real world are all using the same product to house their identity and reputation, there’s a large value add (to you) if you join the network yourself.
Personal Networks differ from Personal Utility Networks in two main ways. As explained in the previous section, Personal Utility Networks are typically used for things that need to get done. There is a substantial amount of practical utility to the user. Second, Personal Utility Networks are typically more for private communication, rather than public communication. Personal Networks are less vital. You can stop using them and your life won’t alter that much. Networks like Facebook or Twitter or Linkedin (when you’re not job hunting) aren’t usually essential for your day-to-day life.
However, Personal Networks are still very strong. You aren’t running to join another friend network or professional network now that you have FB and LinkedIn. It’s also true you could stop using both and be fine on a daily basis.
There’s a difference between sending an IM to your significant other telling them to not miss picking up your Mom at the airport and posting a status update about your Mom visiting on social media. In both cases, your own identity is tied to the communication and your audience is your personal connections. But one is a private need-to-have and the other is a public nice-to-have.
The Personal Network Effect arises from the interpersonal, tribal impulse to build connections with others. It’s this impulse that compels people to join and stick with a network (e.g. Facebook, LinkedIn, or a religion) because their friends/co-workers/neighbors are also part of that network. A user’s “social graph” in a personal network are usually closely mapped to their in-the-flesh relationships.
However, Personal Networks are still very strong. You aren’t running to join another friend network or professional network now that you have FB and LinkedIn. It’s also true you could stop using both and be fine on a daily basis.
There’s a difference between sending an IM to your significant other telling them to not miss picking up your Mom at the airport and posting a status update about your Mom visiting on social media. In both cases, your own identity is tied to the communication and your audience is your personal connections. But one is a private need-to-have and the other is a public nice-to-have.
The Personal Network Effect arises from the interpersonal, tribal impulse to build connections with others. It’s this impulse that compels people to join and stick with a network (e.g. Facebook, LinkedIn, or a religion) because their friends/co-workers/neighbors are also part of that network. A user’s “social graph” in a personal network are usually closely mapped to their in-the-flesh relationships.
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