#6 Network Effects

2041589_origSimply put, a product or service has a network effect when it becomes more valuable as more people use it/ devices join it (think of examples like the telephone network, Ethernet, eBay, and Facebook). By increasing engagement and higher margins,network effects are key in helping software companies build a durable moat that insulates them from competition.

However, there is no single metric to demonstrate that a business has “network effects” (Metcalfe’s Law is a descriptive formulation, not a measure). But we often see entrepreneurs assert that their business has network effects without providing any supporting evidence. It’s hard for us to resolve whether a business indeed has network effects without this — leading us to more heated debates internally as well!

Let’s use OpenTable as an example of a business with network effects. The OpenTable network effect was that more restaurant selection attracted diners, and more diners attracted restaurants. Here are some of the measures that helped demonstrate those network effects (we typically used measurements within one city to illustrate the point, as OpenTable’s network effect was largely local):

The sales productivity of OpenTable sales representatives grows substantially over time, due in part to large increases in the number of inbound leads from restaurants over time.  This is more meaningful than the fact that the total restaurant base grows over time, as that can happen even without network effects.

The number of diners seated at existing OpenTable restaurants grows substantially over time. This again is more meaningful than the fact that the total number of diners grows over time.

The share of diners who come directly to OpenTable to make their reservation (versus going to the restaurants’ websites) grows substantially over time.

Restaurant churn declines over time.

As you can see, most of these metrics are specific to the network that OpenTable is building.  Other network-effects businesses — such as Airbnb, eBay, Facebook, PayPal — have very different metrics.

So the most important thing in managing a business with network effects is to define what those metrics are, and track them over time. This may seem obvious, but the more intentional you are about — vs. “surprised” by — your network effects, the better your business will be able to sustain and grow them. Similarly, it’s important for prospective investors to see evidence of a network effect, that the entrepreneur understands exactly what it is, and how he or she is driving it.

Posted by