How to Disrupt Network Effects
Making networks redundant is one way of disrupting strong network effects, but the cost of this is to sacrifice network effects yourself — Startups with foresight should build in new forms of defensibility to compensate for this
Network effects are among the most powerful economic forces in technology and have created trillions in value. The reason for this value creation is not just compounding, but also the defensibility created by network effects. These advantages have allowed network effect-based startups to disrupt incumbent SaaS players. But there are also immensely valuable incumbents who are built on network effects themselves. Is there any way to disrupt them?
The short answer is yes. Often, incumbent networks are disrupted in the same way other types of businesses are. Startups create new value propositions that initially target novel, low-value markets, and gradually encroach on the incumbent’s market. For example, Airbnb started by allowing its original hosts to rent out spare beds to guests. Their approach unlocked new types of supply and eventually created new holiday experiences rivaling hotels. This was a true disruption to Booking.com’s hotel reservation marketplace. Startups following this approach have to contend with a near-term risk, i.e. the risk that there is no market for their product. But if they cross that hurdle, they have the opportunity to create strong network effects. The right variant of network effects can create a deep moat that not only protects them from the incumbent but copycats as well.
In addition to this, there is one more way of disrupting network effects — by making the incumbent’s network redundant and creating a better customer experience in the process. Networks typically need to introduce some element of friction to create a network effect. For example, users of an interaction network like Skype can only call other Skype users. In a marketplace, users can only transact by interacting with a seller present on the marketplace. Eliminating these points of friction can dramatically improve the customer experience but at the cost of sacrificing network effects. This is the flip side of the “managed” marketplace vs. marketplace in name only (MINO) argument. Since the incumbent has already validated the market, this approach trades the near-term risk associated with establishing product-market fit for the long-term risk associated with defensibility. Startups following this approach need to have the foresight to identify this risk and address it in other ways.
Let’s take a look at three case studies of companies that have followed this approach, the trade-offs they have had to make, and their attempts at addressing the defensibility problem.
Video Conferencing: Zoom vs. Skype
Launched in 2003, Skype was one of the first companies to bring voice communication into the internet era (VoIP). At the time, it was revolutionary and dramatically lowered the cost of voice calls by routing them through the internet. This helped Skype bootstrap an initial network of users who could communicate with each other. Then in 2006, Skype brought free video calls to its network as well and became the market leader in that space. Despite the launch of Hangouts in 2011 (then embedded in Google+), Skype remained the dominant video calling solution. This abruptly changed when Zoom entered the field.
Zoom attacked Skype by turning its competitive advantage — its network — into a weakness. It accomplished this by allowing its users to call anyone, even if they did not have a Zoom account. This was especially useful for professionals who dealt with employees of other organizations (initially salespeople). Its users no longer needed to exchange account information — they just had to send attendees a dial-in link. In other words, Zoom removed all friction associated with video calling. The combination of superior user experience and the virality embedded into the product helped Zoom rapidly overtake Skype.
Zoom’s success has sometimes been attributed to Skype’s execution failures. It is certainly true that Skype made its share of missteps. But even in the absence of those failures, Skype could only compete with Zoom by abandoning what made it successful in the first place — its closed network. This would have always been a painful decision, and one it could only make when Zoom had taken the market.
This was a classic example of disruption as defined by Clay Christensen, but it came at a cost. Zoom’s product experience left limited avenues to build defensibility. It was only in 2018 (7 years after it was founded) that Zoom attempted to address this weakness by layering on an app marketplace — the hope was that it would introduce new barriers to switching. But by this time, video calling was largely considered a utility, and bolting on integrations did not create a deep enough moat. This gave Google Meet and Microsoft Teams (which is replacing Skype) an opening to clone Zoom and catch up.
Real Estate: Opendoor vs. Zillow (Marketplace)
Zillow was one of the first companies to introduce network effects to a complex, high friction industry — real estate. The company aggregated property listings from agents and connected them to prospective buyers or renters. While buyers and renters still needed to interact with the agent, they gained visibility into available properties and asking prices for the first time. This also became an incredibly valuable lead generation system for estate agents. It was so valuable that agents paid Zillow a subscription fee to access these leads — a valuable and relatively high margin business (in addition to listing ads). Buoyed by its acquisition of Trulia, Zillow became the undisputed leader in the space and maintained its position for years. But things changed when Opendoor showed up.
Like Zoom did to Skype, Opendoor turned Zillow’s competitive advantage — the network effect between agents and buyers — into a weakness. It did this by pioneering the iBuyer model — it purchased homes from sellers, refurbished them, and sold them to buyers. In doing so, it disintermediated agents and offered customers a far better experience. Prospective buyers no longer needed to deal with agents or wait until sellers found another home to buy. Neither did they need to worry about refurbishing their purchased home — Opendoor took care of this. This helped Opendoor rapidly gain traction at the expense of real estate marketplaces like Zillow.
However, Opendoor’s growth came with strings attached. Its “home flipping” model was far more capital intensive and had much lower margins than Zillow’s marketplace business. This made it difficult for Zillow to respond when Opendoor was starting out. By the time Zillow launched its own iBuyer program in 2018 (Zillow Offers), Opendoor had already scaled and raised roughly $500M in equity and debt financing.
This, again, was a textbook example of disruption. However, Opendoor’s reliance on acquiring an inventory of homes left economies of scale as the only avenue to build defensibility. As I have previously explained, this is not a very effective moat when competitors have access to comparable levels of capital. As a result, Zillow Offers is rapidly gaining ground at the expense of Opendoor. In response, Opendoor launched traditional real estate listings in June 2020 (reminiscent of Zillow’s original, network effects-based product)— a good example of layering network effects. At this point, Opendoor and Zillow are bracing for a bruising competitive battle. That said, following this approach was the only way Opendoor could have reached this stage.
Publishing: Substack vs. Medium
Medium launched in 2012, with the goal of democratizing blogging. It was essentially a network of writers and engaged readers, based on a Twitter-like “follow” model. Its initial value proposition for aspiring writers was that it eliminated the friction involved in setting up and managing the design of a blog. This also attracted engaged readers which then helped new writers build a following. After some failed experiments with advertising, Medium also hit on a monetization model that worked for writers (and Medium itself) — paywalled content. Writers were compensated based on how paid Medium subscribers engaged with their (paywalled) articles. In other words, the network effect between writers and their followers was a core component of their monetization model. This helped Medium become the go-to destination for independent publishing… until Substack came along.
Substack turned Medium’s model on its head by making its network redundant. It accomplished this by giving writers a standardized interface (free from the burdens of blog or email design) to write email newsletters. Unlike Medium, Substack did not have an aggregated base of readers to drive traffic to writers. Instead, established writers with large social media followings used Substack’s infrastructure to attract their own audience. Users could directly subscribe to a writer’s newsletter (paid or free) without any further engagement with Substack. In other words, writers owned the relationship with their subscribers. This led to a wave of high profile writers going independent via paid Substack newsletters (incl. journalists, tech professionals, etc.)— a market that Medium could not capture.
Substack has grown rapidly since it was founded in 2017, but Medium has had trouble responding to the threat. This is because cloning Substack’s product experience would involve dismantling, or at least disintermediating, its primary competitive advantage — its network of writers and readers. Another textbook example of disruption.
So far, Substack appears to be following the same pattern as Zoom and Opendoor. However, there is one key difference. While Substack had to abandon network effects to challenge Medium, it had another effective form of defensibility baked in from the start — switching costs. Writers would lose subscribers if they abandon Substack. This is important because a writer’s relationship with subscribers is stronger than with Medium followers. And it is doubly important when they are paid subscribers. This would prevent writers from moving away from Substack even if others offered a comparable experience. So even though Medium launched a competing newsletter product in 2020, its impact is likely to be more subdued than the cloning attempts we saw in the previous two case studies. It could certainly help Medium retain more writers, but it is less likely to win over Substack writers.
Beyond these case studies, disruption could even be caused by weakening a network effect instead of abandoning it. For example, TikTok’s decision to abandon the follower graph and distribute content algorithmically helped it scale despite the presence of Facebook, Instagram, and Snapchat. However, it did so at the expense of defensibility which allowed copycats like Triller to gain traction.
Making networks redundant is a valid approach to scale a startup when competing against incumbents with strong network effects. But as these case studies show, it is only one half of a successful business model. As you scale, you need to build in some form of defensibility to sustain your position. In the absence of this, you risk losing the market back to the incumbent or to other copycats.
Keeping the risks and trade-offs in mind, would I recommend following this approach? If abandoning network effects allows you to truly disrupt a strong incumbent, then do so by all means. But be aware that you are sacrificing near-term defensibility to accomplish this. With this in mind, you need a roadmap to regain what you have sacrificed as you scale. Building strong switching costs, like Substack, is one way of doing this. Layering new network effects on top — as early as possible — is another avenue.