network effects

I was talking to one of my 500 Startups mentees the other week about penetrating a market where network effects are huge. For better or worse she wanted to enter a space owned by Facebook, Microsoft and Tencent. There are good reasons to stay away from that kind of place. Its like the scorched earth around a mediaeval dragon’s lair.

 She was very motivated and passionate and my job is to figure out how to solve difficult problems like this. Or at least to generate hypotheses for her to test. So here I’m going to explore some ideas on how you can take down some of the larger corporations bolstered by strong network effects.

Network Effects for Startups

A network effect is the principle that the more people use something the more valuable it is. Networks tend to run towards monopolies with one winner owning most of the economic value created by networks.

Some examples would be Whatsapp and WeChat in messaging in the geographical markets. Facebook in social networks. LinkedIn in business networks. British Telecom had a monopoly over telephony for years and Railtrack owns all the railway in the UK.

Networks like this look impenetrable for a new entrant. They are vulnerable.

Networks Effects Unravel Quickly

Firstly anti-trust laws can break them up. Ma Bell and Standard Oil were both broken up when they became too powerful. Deregulation and lowering of barriers to entry can open up weaknesses. The size of USPS’s network became a vulnerability once it lost it’s monopoly on parcel carrying.

Secondly whilst networks can grow quickly they can also unravel quickly.

I remember a great uncle telling me about the first fax in the world. It was early in the 19th century in France. It didn’t really take off until the 1970’s. Then whilst one fax was useless. A fax in every lawyer’s office became hugely valuable and a fax in every office became even more so.

Email/scanning replaced the fax and just as quickly (and far more silently) faxes began to disappear from offices. 

In 4 years fax machine sales dropped by 85% and the fax network was destroyed.

In just the same way that every user added to a network adds more value every user that a network loses takes incrementally more value away. Network effects are dependent on the number and activity of users. Break those and the business unravels. 

As users start to leave the network decline accelerates faster and faster. That was the fate of Friendster

In that case we saw a business driven by network effects get destroyed by another business with network effects. The value proposition that The Facebook offered was better.

So when we think about attacking large networks we must remember that they are far more vulnerable than they appear. There are of course powerful defensive tactics that can be used. Facebook bought Whatsapp and Instagram in defensive moves. Instagram assiduously copied Snapchat to blunt it’s growth and impact. 

Attacking Companies with Powerful Network Effects

There are several things that you need to do. 

First you need something better. Not a better mousetrap. Something that solve the problem better or changes the nature of the problem to be solved. Digital images changed the world for Kodak and not in a good way. 

 Second you need a protected space. to get product market fit, product channel fit and initial traction. These provide a place, a niche, where you can win ad it is too expensive for the existing network to enter (though they might just buy you to close you down)

Constrained Markets Offer An Entry Point

In a previous article I talked about constrained markets. These are class of people decide to do something that is inefficient compared to other groups. This could be not eating pork or beef for religious reasons. It could be deciding not to share personal data for privacy or libertarian reasons. 

In these cases you can offer value to an audience that will then reject the incumbent on terms that the incumbent cannot accept. Google for example cannot let people own their data and privacy without killing its advertising model. 

In the case of my 500 Startups mentee she had a particular feature that was for most people a nice to have and was targeting the general market.

The Users Have to Pay Switching Costs

Let’s look at this in two stages

Firstly the nice to have feature. In this case she was offering a better mousetrap. This would be an incremental improvement over existing social networks. However it would not compensate for the loss of network effects as people switched from the old network to hers.

This is an important point. When you challenge incumbents with strong network effects your core product has to offer a step change improvement that compensates the early adopters for the loss of network effects. For later adopters it’s not so important. There is a smaller switching cost. 

Target Micro Networks 

This leads me into the second factor. When you are targeting a general market what you tend to get is a lot of random or semi-random people adopting the product. The trouble is that few of their friends and colleagues use the network and so they are isolated and eventually lost as customers. 

The only way that they have a big impact is if each of these random users is able to convert several others. 

In contrast if you target a particular niche market it is easier to get local network dominance. If you are targeting teenagers one approach would be to advertise to all teenagers. That is the general approach. If instead you target high school dungeons and dragon players a quite different dynamic can evolve. 

Dungeons and Dragons players are a small tight knit community. If one person converts another person then you have a much higher percentage of the local network using your product. Pretty soon you can have dozens of schools D&D groups using your product. Everyone in those groups use it. Then they start converting other groups and subcultures.

Examples of Growing Networks Fast

This is exactly the way that Facebook, LinkedIn and Quora grew. Facebook targeted dorms at Harvard, then other Ivy league universities, then universities, the young people, then Americans, then the world.

LinkedIn targeted LA, the Californian cities, then the mountain states and the midwest. Then it moved across to the East Coast. In each phase it sent people into specific cities to get the network set up and building. Each city was easier than the one before.

Quora grew by focusing on the California entrepreneurial and tech scene. That gave it a core of famous people who drew in thousands of other entrepreneurs who wanted to learn from them. They didn’t just write about tech and entrepreneurism. Instead they created content in new areas bringing yet more users as Quora expanded to cover relationships, physics, history and of course trail running (which is what I write on on Quora)

Action Points

To enter markets where the incumbent has strong network effects you have to:

• Understand the nature of the network you are entering
• Build a product that is a step change better for at least some people
• Focus on a core group
• Plan out your path through sub and local networks

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