Why businesses with network effects should be backed by a focus investor
With Speedinvest x we launched our first focus fund under the Speedinvest umbrella. While we continue to believe that we have to stay open to all ideas in order to be able to fund the best startups in Europe, we also believe that there are categories that warrant their own focus. One of them are platforms with network effects: they are (1) highly attractive, (2) not covered enough yet and (3) complicated to build. That’s why we started Speedinvest x (read more about the background in Mathias’ launch blog post)
What we’re talking about when we say “network effects”, and a brief history
At Speedinvest x we want to invest in businesses that rely on and gain from network effects. In order to have a common basis, let’s start off with a definition of what network effects encompass for us.
The most traditional network effects businesses were actually marketplaces: physical locations where goods were traded between two sides. The digital world basically just copied and transferred this model: online platforms were used to facilitate and intermediate the exchange of goods and services.
A combination of changing consumer behavior and evolving tech has made the simple marketplace landscape more difficult and ambivalent. On the one hand, this development (and crowded markets) has forced a lot of simple intermediaries to start providing additional value-add via a SaaS component (a model called SaaS-enabled marketplace). On the other hand, the plethora of available content online has added data as another component that can be traded on a platform (versus only traditional goods and services).
It’s obvious that online marketplaces today can’t be diminished to e-commerce platforms as historically was the case. To avoid this narrow definition of marketplaces, these businesses are now often called “businesses with network effects”, “network orchestrators” or “market-networks”: we call ourselves “Speedinvest network effects”.
More broadly put, I would then define our investment focus as any platform that allows its users to share and exchange something, be that in form of products, services or content/data. “Network effects” describe the fact that the value of this platform increases with every user that joins and contributes to the network (actively or passively). Once you consider this definition of “modern marketplaces”, you will realize how many companies actually exhibit some sort of network effects (think of reviews on TripAdvisor, likes on Facebook, photos on Instagram, profiles on Tinder,…).
1 Network effects are an impressive and defendable value driver
It turns out that having a network effect is the single most predictable attribute of the highest value technology companies — other than perhaps “having a great CEO”. NFX, 2017
The GP Bullhound’s 2016 Report shows that 19% of all European unicorns can be categorized as marketplaces, only topped by the software category. The true relevant number is even higher though, as another 19% is attributed to e-commerce which also includes marketplaces such as Auto1 and HelloFresh. And even more than that, in a recent study of today’s most successful tech companies, NFX came to the conclusion that an estimated 70% of value created in tech today is attributable to network effects. So, not only are many of the highest value technology companies marketplaces, marketplaces also tend to be more valuable than other businesses.
In a 2014 study published in the Harvard Business Review, the authors determined that so called “network orchestrators” were able to receive valuations two to four times higher than other companies.
Network Orchestrators outperform companies with other business models on several key dimensions. These advantages include higher valuations relative to their revenue, faster growth, and larger profit margins. HBR, 2014
The authors believe that the biggest advantage of network effects lies in decreasing a company’s marginal costs. More specifically, as Mathias puts it: once you’ve hit a certain threshold of liquidity, your costs of acquiring customers can decrease significantly because users act as multipliers and get other users onboard. And the more users are active on your platform, the more valuable it becomes (without you having to spend any additional resources) — network effects are in place. Once you’ve achieved that critical mass, your marginal costs for growth are comparatively low in a marketplace business, making this a highly defendable model with strong barriers to entry: NFX found that network effects (as one of four possible ways of staying competitive in today’s environment) are crucial for 35% of internet companies founded after 1994 and worth more than $1bn today (worth 70% in value).
2 There’s still lots of blue ocean categories out there
Marketplaces are not a short-term trend or fad: looking at the Speedinvest portfolio, a total of 22 of our investments since 2011 (or roughly a quarter of our portfolio) can be classified as platforms with network effects, some examples being Gronda,TourRadar, Wikifolio, Tripmakery and Inkitt.
And we’re also convinced that there are still lots of industries out there that can be disrupted with a network effects approach. Changing consumer behavior and preferences, supported by an evolution in tech, has made many previously traditionally-operated industries ripe for disruption by network effects models. Over the past 4 months, almost a quarter of the Speedinvest dealflow was made up of marketplaces — and that was before we announced the launch of our focus fund. Most of this was concentrated in the following industries:
- eCommerce and Retail
- Logistics & Mobility (we invested in on-demand warehousing: Stowga)
- HR (we invested in a learning & development marketplace: Sunlight)
- Health (we invested in a sports club aggregator: myClubs)
- Travel & Tourism
However, we’re also always proactively on the lookout for interesting areas to invest in (check out this great article for some ideas). And lots of business ideas that will pop up in our dealflow we haven’t even thought of ourselves yet.
3 It’s hard to build businesses with network effects, and there’s not enough dedicated support out there
Anyone who has read anything about building platforms with network effects will know: it’s really, really hard. Not only do you face the usual challenges that other founders have (mostly resource-constraint in any form and potentially having to deal with investors 😉). In addition to that, marketplace founders have to build up two sides for liquidity while keeping a healthy balance between supply and demand. In case of SaaS-enabled marketplaces, they also have to take care of two business models, i.e. the marketplace itself as well as the SaaS component. Let’s not forget the risk of bypassing. And all that in a race of time, because they most likely also face winner-takes-it-all markets (at least on a local basis).
There are lots of resources out there to support first-time network effects founders (e.g. great online marketplace builders), but you probably don’t appreciate how difficult it really is until you’ve worked on your first marketplace. These challenges alone warrant the existence of dedicated marketplace investors.
However, with Point Nine Capital in Berlin, Madrid-based Samaipata and Piton Capital out of London there are only three VC funds in Europe that focus on the topic, while there are already countless other dedicated funds (esp. SaaS). We didn’t believe the investment landscape, especially in Europe, accurately reflected the specific challenges of marketplace businesses. That’s why we assembled a team at Speedinvest x with deep strategic and operational expertise in building successful network effects driven platforms and technologies (learn more about our team and approach).
We actually co-organized our first conference focused on marketplaces last month in San Francisco. It was completely sold out, validating our view that marketplaces are still a thing. If you didn’t have a chance to go there this time, you can watch the speeches here — and keep your eyes and ears open for our next Marketplace Conference.
If you agree that network effects warrant their own spotlight and want to learn from founders and investors with deep expertise in creating and sustaining a network effects business, reach out to me or directly send us your pitch deck.