How to create & measure Network Effects [Part 2]
So hopefully we can all agree now that network effects (nfx) are precious, as a powerful source of defensibility and value creation. The real question then becomes: how to trigger them? And how to measure them?
How to create Network effects?
We’re big believers in the “node saturation strategy” (more on this here), such as what Facebook did with Harvard’s students or what Clubhouse did with Silicon Valley’s top tech leaders. Start with a niche segment and only expand once you’ve reached market dominance there. A focused go-to-market will allow you to trigger virality more rapidly and reach “liquidity quality”.
Yet, reaching this Minimum Viable Critical mass (i.e. the point from which nfx generally kick in, as defined in Part 1) could be challenging and an alternative strategy would be the famous “Come for the tool, stay for the network” coined by Chris Dixon. “The idea is to initially attract users with a single-player tool and then, over time, get them to participate in a network. The tool helps to get to initial critical mass. The network creates the long term value for users, and defensibility for the company”.
You’re basically leapfrogging the liquidity quality challenge. Good examples include Instagram that launched with a non-networked value proposition around photo filters or any SaaS-enabled marketplaces (e.g. OpenTable).
How to measure Network effects?
We look at 5 different groups of metrics to measure early signs of a potential for network effects in a business:
- 1. Acquisition KPIs: as any network grows larger and its value to its users increases, it should become more efficient in acquiring new users. So we typically look at the evolution of your % of organic traffic, your % of “direct” or “network-internal” traffic, your % of referred users etc., which should go up.
- 2. Engagement/retention KPIs: we are obsessed with those. It’s key for us to understand your users’ cohorts both vertically (i.e. the product or service is improving over historical cohorts) and horizontally (i.e. the users of the same cohort are more retained & engaged on the platform over time). To understand the quality of your user base, we distinguish between retention of first-time users (i.e. are people coming back to the platform?) and their engagement on the platform (i.e. when they come back, do they transact more?). We analyse cohorts on a blended basis and/or just looking at paid users. And we also typically check what’s happening with your power users. More on this here.
- 3. Platform KPIs: we are also very keen on the concept of Operating System and Share of Wallet. Ideally your “share of wallet” with either side of the transaction should be increasing as multi-tenanting (i.e. your users being active on other competitive platforms) should go down. We love businesses that are striving to become the Operating System of either their demand or supply side. Similarly, the platform’s match rate (e.g. drivers time utilisation) or sell-through rate (e.g. inventory turnover) should ideally go up gradually. And, finally, you should become less and less dependent on your top X sellers and buyers over time. More on this here.
- 4. Monetisation KPIs: as a result of all the above, your pricing & bargaining power should increase as users’ willingness to pay should go up: even if at the beginning you could be subsidising demand or supply acquisition, you then can introduce more expensive subscriptions, listing fees, higher take rates, or other monetisation mechanisms.
- 5. Unit economics: at the end of the day, what matters most are your unit economics (LTV:CAC & CAC payback), which should get better over time as a result of:
- i) Your customer Lifetime Value (LTV) increasing: you’re able to extract more value from your customers (i.e. declining incentives that you need to offer to different sides of the marketplace, overall improvement in pricing power) for longer (i.e. better retention patterns).
- ii) Your blended Cost of customer Acquisition (CAC) decreasing.
That being said, we invest at Seed stage in very early businesses. Most of the companies we analyse have only a few months of data so we’re fairly pragmatic in our approach! It’s obviously not a prerequisite for you to have sound unit economics when we invest; yet it’s key to show us that you think of your business in those terms and that you have a plan to make those unit economics work in the medium to long term.
What does the future hold for Network effects?
The “increasing returns” world is subject to lock-ins. Yet those lock-ins don’t last forever, and bears will say that Nfx seem less powerful than before: winner-takes-all markets are being attacked, as the recent developments in the food delivery industry reveal for instance. Nevertheless we believe that, on the contrary, Nfx are becoming more dynamic than ever: Nfx can mature and develop differently over time. And it seems that Nfx are currently changing faster than before.
So it’s key to understand the type of Nfx your company is experiencing, especially with regards to:
- The true nature of your Nfx: if your Nfx appear to be asymptotic, then you need to deepen your value proposition by pushing on brand, customer loyalty etc. vs. immediate liquidity. It’s especially important to understand if your supply is homogeneous /commoditised (e.g. Uber) vs. heterogeneous/differentiated (e.g. Airbnb).
- The quality of the new users you’re adding to your network (e.g. trolls vs. heavy contributors to the network): you need to invest in curation mechanisms to protect the discovery potential of your platform.
- How immune are your Nfx to competition: it’s key to understand networks overlaps, switching costs and multi-tenanting.
We do believe that Nfx, and as a result platform models, are here to stay. What happened with the GameStop case, is a good example of how the crowd can leverage the nfx of platforms, those platforms being Reddit, Twitter, Robinhood, and other brokerage apps. New “anti-nfx” regulation might arise to limit this growing power of platforms, yet this event reveals that their impact can be huge and that is just the beginning.
Samaipata is an early stage founders’ fund investing in digital platforms displaying increasing returns at scale, across Europe.