Network Effect: What Is It and How Does It Work?

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What entrepreneur doesn’t dream of having a product or service so embraced by customers that it brings in more customers, who bring in more customers, who bring in more customers? That's the power of network effect.

Network Effect Definition

Network effect occurs when the intrinsic value of a good or service increases as the number of consumers using it increases. Social networking is a great example of network effect. YouTube, Facebook and Instagram all grew in value exponentially because of network effect.

Network effect is a circular phenomenon.The more people who used them, the more valuable they became. What would YouTube be with just a few dozen people sharing videos about cats, babies and how to restring weed eaters? As users added more content to YouTube, more people became interested in checking it out. This led to more videos and a wider range of videos being posted, which led to more people going to YouTube to view them. All of this increased YouTube’s value to all of its customers, not to mention its founders.

Network Effect Characteristics

The term “network effect” can apply to a good or a service. It’s most often used to describe a particular business, like eBay or Match, but you’ll also see the term thrown around when referring to an entire industry, like cars and cellphones.

In each instance, it puts a name to the process by which that business or industry grew. Rather than producing more products to increase sales or growing by merging with another company, a company’s network effect growth is fueled by customers or users. Network effect examples generally fall into five categories.

Two-Sided Network Effect

Two-sided networks are one of the more common types of businesses grown by network effect. Online marketplaces like Etsy and eBay immediately come to mind, although this kind of network can also refer to your local farmers' market.

There are sellers and there are buyers. Etsy and eBay provide the means for them to connect and do business with each other — for a fee, of course. With your local farmers' market, a local store or municipality might provide the means by allowing sellers to set up in their parking lot.

Three-Sided Network Effect

You’ll also see the term “channel partners” used to describe the three-sided network effect. Microsoft pulled this off to the tune of over $700 billion (its approximate current net worth), but Microsoft didn’t do it by focusing exclusively on buyers and sellers.

They did it in part by cultivating strong relationships with suppliers for Windows and Microsoft Office. Before long, the Windows operating system and Office software were on virtually every PC. Apple even had to get onboard.

Communications Network Effect

Communications platforms like successful online dating apps are great network effect examples. Farmers Only wouldn’t exist with just a handful of wannabe cattle ranchers and goat milk purveyors on it. Like two-sided and three-sided network businesses, each additional single person who signs up increases the value of the app to all of the people using it.

Then, there’s Instagram. Its network effect potential was so obvious that the founders didn’t have much trouble raising an initial $500,000 in venture capital money. As expected, network effect was explosive. Instagram was gobbled up by Facebook for $1 billion less than two years after it was launched.

Content Network Effect

Content network effect applies to today’s newspapers and magazines. The businesses provide content to subscribers, often for a fee. They also make money from advertisers.

Network effect occurs because you’re providing the kind of content your target market wants. There has to be plenty of it, and it has to be updated almost constantly to retain customers. Grammarly and TED are good examples of content network effect.

Grammarly goes beyond the spelling and grammar checks built into Word and Google Docs. It also offers subscribers a plagiarism detector. The nonprofit TED started out in the ‘80s as a multidisciplinary conference that covered technology, entertainment and design, hence the acronym "TED." It’s since morphed into an online forum for an endless array of subjects in over 110 different languages.

Local Network Effect

The fifth type of network effect occurs in a specific geographical area. They’re places where we connect with like-minded people, such as churches, temples and clubs. Even though we may keep in touch and learn about events through our group’s website or Facebook page, the growth of these groups is still considered local network effect.

However, some local network effect relies heavily on communications network effect companies and vice versa. Meetup and Nextdoor are good examples. Meetup is organized by interests as well as location. You can find people near you who like to do everything from quilting to shark-cage diving.

Nextdoor brings people who live in the same neighborhood together. It’s a great way to meet your neighbors if you’ve just moved into the area. You can find a dog sitter, advertise your garage sale or kvetch about how noisy the coyotes or planes were last night.

Chicken Before the Egg or Egg Before the Chicken?

As you’ve probably noticed, network effect doesn’t always fall neatly into one of these five categories. Sometimes, they overlap. One commonality is that a potential new user’s decision to buy in is based on the number of users you already have, and word of mouth is the main catalyst for growth.

Herein lies the dilemma of network effect. It particularly affects the two-sided and three-sided type: You need a lot of suppliers to attract buyers, but you need lots of buyers to attract sellers. So, how do you manage this? The answer is very carefully.

Managing Network Effect

The prospect of developing a business that will grow via network effect is so exciting that it’s tempting to damn the torpedoes and forge full speed ahead. However, you’ll have a better chance for success if you take the time to plan very carefully. A few suggestions include:

  • It’s a given that business plans are designed with their target market in mind. It’s assumed that you’ve run all the numbers a bunch of times to make sure that what you’re proposing will work. If you’re planning to tap into network effect, make sure that what you’re building is scalable. Think ahead and plan specifically for how you’ll handle network effect.
  • Define what operational excellence means to you. Lay out how you will achieve and maintain it.
  • If you’re going into an established market, what’s your strategy for conquering the competition? What’s unique, bigger, faster and better about your product or service? How are you going to get the initial word out to consumers?
  • Map out how you plan to retain customers once you have them. Remember that network effect is about increasing the value of your business by adding more customers to the ones you already have. So, you have to focus on retention as much as new business.
  • Design your business so it can evolve according to customers’ needs and interests and changes in the market. Figure out ahead of time how you will accommodate new products or services. You may want to consider partnering with other compatible businesses.

Network Effect Challenges

The biggest challenge to setting up a business for network effect is drawing in enough users to get the ball rolling but not so many that you’re overwhelmed. If you grow too quickly, the quality of your service or product will suffer, and you’ll lose whatever traction you initially gained.

Your infrastructure has to be ready to quickly adjust seamlessly to new and more customers. When more people using your product or service makes it more valuable, it’s tempting to just round them up as quickly as possible, but you have to be able to support them. If you can’t, you could wind up with outages or not enough staff to deliver as promised.

Critical mass is network effect’s sweet spot. It’s where you pass the point at which your business has taken hold and now it’s attracting large numbers of new customers. It’s tough to quantify critical mass because it’s different for different types of businesses and different types of network effect. Let’s just say you’d better be ready for it.

Network Effect Risks

Perhaps the biggest risk when you’re dealing with network effect growth is that quick growth can be overwhelming. If you’re not prepared for the warp-speed growth that may occur, your business will be over before you barely get it off the ground. While this cannot be stressed enough, there are other risk factors.

If you’re going for two-sided network effect and have a platform that connects buyers and sellers, what’s to stop them from doing future business without you? The terms "buyer" and "seller" are used loosely here because this risk applies equally to employee/employer networks like care.com and passenger/driver networks like Uber and Lyft. Who’s to stop an elderly lady who needs a ride to church every Sunday from arranging it directly with a driver?

Regulation is another risk factor. Uber may not have anticipated fighting over whether its drivers are independent contractors or employees. If it’s determined that they’re employees, then Uber will have a lot of catching up to do on U.S. Department of Labor laws, which will cost a lot of money. Let’s not even get started on each state’s labor law requirements.

First Isn’t Always Best

While we’re on the subject of behemoths like Uber, it should be noted that when it comes to network effect, being first is not as critical as you might expect. About seven years before Facebook came along, Six Degrees was an online social platform. Have you ever heard of it? Exactly.

The first business to offer a particular product or service is not necessarily the one that has figured out the best way to do it. Those who come later can learn from the first guy’s mistakes. While being the front runner isn’t necessary, be sure to define your business before the media or competitors do, and don’t forget about branding.

If you’re not first out of the gate, what you have to offer has to be an improvement on what’s already out there, and what’s better about it must be clearly communicated to potential customers.

Beware of the Little Guys

Network effect is neither organic nor nonorganic growth. It’s in a category of its own. Building a business with network effect in mind is intriguing and appealing to a lot of entrepreneurs.

One last caveat: Never underestimate the little guy who understands locals better than you. As huge as Uber is, after spending a couple of years trying to infiltrate southeast Asia, it finally gave up and sold out to the much smaller Grab. Why?

Unlike Grab’s founders, Uber didn’t take myriad local dialects into consideration. This made communication very difficult. Also, it didn’t anticipate that its credit-cards-only policy wouldn’t work in areas that rely heavily on ready cash.

Are You Still In?

Some of the companies that have grown via network effect have astronomical valuations. You may be sitting on the next great idea for a new product or service that erupts through network effect, or you may have thought of a way to vastly improve something that’s already out there. If so, create your business model and go for it, but be ready for a wild ride.