Investors are increasingly looking at the power of companies’ network of users, which can make or break a start-up.
Key Takeaways
- A network effect is a situation in which the value of a product, service or platform depends on its number of users.
- Network effects are difficult and expensive to create, but a startup’s success depends on them.
- About 70% of global tech equity value comes from firms that rely on network effects.
- As funding tightens in 2023, investors should focus on market leaders with mature network effects.
Sometimes a company’s most powerful asset doesn't appear on the balance sheet. One such intangible asset is known as a network effect: a company’s connections or network of users. It is the backbone of many new business models—and it can make or break a startup.
“A positive network effect occurs when the value of the product, service or platform increases with an increase in users,” says Ed Stanley, Morgan Stanley’s Head of Thematic Research in Europe. “When successful, network effects create outsized returns and a business with pricing power and scalability.”
These days, the success of many brands depends on having a critical mass of users to connect and engage with the brand, whether it’s via a social media app or a marketplace of buyers and sellers. In fact, about 70% of global tech equity value is derived from companies relying on network effects, according to research by NFX, a venture firm focused on pre-seed and seed stage startups.
It’s no surprise that companies with the most active users often have the greatest value. Although these networks are now common, creating and sustaining one is not easy or cheap.
“Network effects are powerful tools to make a business model defendable. However, they are typically very difficult and resource-intensive to create,” says Stanley.
Networking With Unicorns
E-commerce sites, rideshare apps, online marketplaces and portals for real estate listings all rely on their powerful connections to users to execute their business models. The most successful bring on millions of users. But if a startup fails to develop a solid network, it could flame out before it ever reaches its full potential. Since companies’ success depends on network effects to bring value to consumers, they have to compete for users. But once captured, added users result in compounding benefits for companies.
The accelerated use of digital communication services across different sectors and businesses, plus the recognition by companies and investors of the value of network effects, have been the key drivers behind the increasing pervasiveness of this strategy. In 2021, more than 50% of unicorns—or privately held startups that have a valuation north of US$1 billion—relied on network effects in their business models. That percentage dropped in 2022, reflecting a slowdown of venture capital activity amid steeper capital cost, but the approach is still valid.
“Successful platforms using network effects have a layer of insulation from failure provided by their very users. A thriving network can bring security to businesses, creating economic moats to protect them, just as economies of scale and brand equity do,” says Stanley.
Because so many successful startups now rely on network effects, both entrepreneurs and venture capitalists have taken notice, leading to an increase of network effects in the private space.
“Given this manifestation in private markets, we expect public markets, and as a result public investors, to see an increasing number of companies with network effects in the future,” Stanley says.
Successful platforms using network effects have a layer of insulation from failure provided by their very users. A thriving network can bring security to businesses, creating economic moats to protect them, just as economies of scale and brand equity do.
Focus on Market Leaders
There may be an app for everything, but no one wants every app.
Many leading platforms were pioneers in their space, but now markets are saturated with options. “As network effects become more common across different industries, we believe competition for a finite number of users will only increase,” Stanley says.
Kick-starting a network effect is all about growing the user base. Incentives are the way to turn lurkers into users, but that takes resources. Those resources are often acquired through venture capital or crowdfunding, which has been more limited since the stock market started to get bumpy in 2022. Some drawbacks to basing a business model on network effects include the resources required to enable them, and the fact companies relying on them face either reaching critical mass or remaining subscale.
As funding continues to tighten in 2023, newcomers may struggle to build a robust network, creating an opportunity for industry leaders to further solidify their role and grow even larger. “The shift in focus to profit and the limited resources available indicate that investors should focus on market leaders with the strongest, most mature network effects in their respective segments, Stanley says “The ability to preserve cash and manage working capital are critical as well.”
