6.

MY STRATEGIES FOR NETWORK EFFECTS | Entrepreneur 07/12/22, 6:28 AM

6.
MY STRATEGIES FOR
NETWORK EFFECTS
The most powerful business models often build on the creation of efficient networks
between existing entities. But why is this often so effectual, and how do you achieve
it?

In the hyped dotcom bubble in the 1990s, many start-ups were following a
mantra saying that you had to gain lots of ‘eyeballs’ first and worry about revenue
models later. Many of those companies disappeared after the bubble burst in
2000, thus closing their access to new funding. However, among the survivors, it
was often a powerful trait that saved the day: they had strong network effects.

So what is this? A network effect means that the utility of participating in a net-
work increases when more participants join in. For instance, it's pointless to be
the only one in the world with a telephone, but great when more and more others
get one. Today, these effects are especially well known from social networks,
which of course will be better for each user, the more other people are using the
platform – Facebook is an obvious example. Often, when a network effect starts to
kick in for a company, it will experience explosive growth without needing too
much marketing, if any. Why? Because the clients or users are recruiting each
other.

Viral effects

One of the consequences of network effects can be so-called viral effects. Among
the best-known examples are video clips on YouTube, which sometimes are so
good that people on average share them with more than one friend, which makes
them spread like wildfire.

In such cases, marketing people refer to a ‘viral factor’. If people are watching a
given video on YouTube, for example, and on average forward it to 0.5 others (for
instance, every second person shares it with a single friend), the viral coefficient
is 0.5 and thus the distribution will gradually die out as follows (if we ignore the
overlap between receivers): 10 000 → 5000 → 2500 → 1250 → 625 → 313 → 156 →
78 → 39 → 19 → 10 → 5 → 2 → 1 → 0

The sum of these figures is 19 998, so if your company sends 10 000 people a link
to a video clip via YouTube, and if that clip has a viral coefficient of 0.5, it will, due
to viral effects, reach nearly twice the original number of receivers.

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Ok, let us now take 14 steps again, but this time where the viral coefficient is 2.0.
Here we go: 10 000 → 20 000 → 40 000 → 80 000 → 160 000 → 320 000 → 640 000
→ 1 280 000 → 2 560 000 → 5 120 000 → 10 240 000 → 20 480 000 → 40 960 000 →
81 920 000.

Wow! If we again ignore the effect of some people receiving the clip multiple
times, this video will be shared with the sum of these figures, which is 163 830 000
people! In fact, here you don't need to send it to 10 000 people to start with – prob-
ably sending to 100 or even 10 will have exactly the same result, just a bit slower.

The point is, of course, that quite small differences in viral coefficients can have a
huge impact on the overall impact you create.

The combination of network effects and viral effects explains why Instagram was
sold for $1 billion when it was 15 months old and had 13 employees: its tremen-
dous value was justified by the fact that it had network effects plus some viral ef-
fects as well.

Instagram's tremendous value was justified by the fact that it had network ef-
fects and/or viral effects.

This is an example of business models – or parts of comprehensive business mod-

els – that can be very effective, where the keywords are network effects and viral
effects. Because of these, you may quickly obtain a dominating network position
and/or become a de facto standard for a lot of associated businesses.

Multi-sided platforms

A special case of network effects occurs when you have multi-sided platforms. For
instance, a platform such as the company Just Eat connects two different types of
entities: restaurants and consumers. This is a two-sided network, enabling inter-
actions between interdependent groups of customers. A network effect will there-
by build up, but only if both sides grow big. This is challenging to build up be-
cause you get a chicken-and-eggs problem, but it can become very robust, once it
works. Credit cards, online market places and stock exchanges are other
examples.

Another special case of network strategies is peer-to-peer (P2P) networks, where-

by you set up a platform such as an online database or other communication ser-
vice that connects players with each other – eBay, Craigslist, Airbnb, Uber and
TaskRabbit are examples.

The third special case of networking strategies is to use an open business model
and/or open source software. This is where you deliberately give external access
to your business or software platform, so that others can add to it or build on it. In
software, this is ensured by releasing the software source code and perhaps a sys-
tem development kit, so that anyone can understand what it does and can manip-
ulate it.

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Finally, we should add that many large businesses end up operating complex mul-
ti-sided networks combining, for instance, app providers, content providers,
third-party resellers, advertisers, and end users. Just as you can do a detailed fi-
nancial analysis or legal audit of a complex company, you may also do an audit of
its network effects and find how they drive the growth and give it its robustness.

The chicken-and-egg problem

From the time that you begin the task of creating network effects, as a rule of
thumb you have 1–2 years to achieve ‘ignition’, which means self-perpetuating
growth in network-motivated sign-ups. If you don't, people who previously signed
up will start dropping out and then it may all unravel very quickly. Here are 10
traditional ways to increase the likelihood of ignition when you launch multi-
sided networks:

Self-supply. You sponsor one side to ensure its presence. For instance, new
nightclubs might initially offer free drinks to girls to attract men. Or when You-
Tube was launched, the founders posted the first videos.
Free/paid. You make the service free for one side, then charge the other. For in-
stance, on a commercial ‘yellow pages’ network you charge the sellers but not
the buyers.
Two-step. You deliberately focus entirely on one side first and approach the
other only when the first is reasonably populated. For instance, OpenTable fo-
cused initially entirely on signing up the best restaurants for online booking
before then turning to the consumers with targeted advertising.
Scarcity by design. Make it attractive to sign up via selectivity, for instance:
‘During the first year we will have only what we believe are the 10% best
restaurants signed up. Do you want to be included in this exclusive group?’
Trojan horse. You give potential users a free tool, product or service, which
happens to connect them to the network. Once there are enough passive net-
work participants, you try to activate them.
Piggyback. You launch your network as a service within another network that
already has critical mass. For instance, PayPal got its ignition because it was
launched within eBay.
Niche approach. Choose a small market niche and get it to work there. Then ex-
pand. Facebook, for instance, was initially available only for students at
Harvard.
Encourage bilateral recruitment. Pay all participants from one side of the net-
work to recruit people for the other side. For instance, the mobile payment sys-
tem M-PESA in Kenya paid senders of money to recruit receivers.
Early sign-up benefits. ‘It's free now; if you want to sign up later, you will have
to pay’.
Pioneer stakes. Tattoodo initially offered some of the best tattoo artists in the
world stock options for signing up.

In addition to these traditional strategies to build up complex network effects, a

new one has emerged, especially through 2017: blockchain.

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Using initial coin offerings

A fairly new way to build network effects in start-ups is to use Initial Coin Offer-
ings (ICOs), an approach that solves several issues simultaneously. It usually
works like this:

1. You write a white paper describing the business you are planning (typically
one depending on network effects). It describes that you will fund the develop-
ment and the build-up of the network with ‘tokens’, and you describe how
these can be bought by the initial investors and during which period. Techni-
cally, your tokens will be based on blockchain, and they will in many ways be
rather similar to cryptocurrencies such as Bitcoin or Ethereum.
2. The white paper also describes the purpose of the business, how it will work
and its expected funding requirements and revenues.
3. Then you start the campaign and people buy the tokens. If you fail to raise the
minimum required according to the plan, all investments will be returned to
the backers.
4. Since the token will be based on blockchain, it becomes instantly tradable
across the globe, 24/7. This is like taking your company public from day one,
but on a global, decentralized, unregulated exchange. If you issue the tokens
from California, someone in Korea can trade them instantly after. This is be-
cause cryptocurrencies and thus tokens work entirely P2P and independent of
banks, exchanges and borders.

The first ever such token sale was held by Mastercoin in July 2013. In 2014, the
Ethereum project raised $18 million in Bitcoins, or $0.40 per Ether in an ICO. The
project went live in 2015, and in 2018 the value of the coins broke above $700, giv-
ing initial investors a gain of more than 17 000%. For the issuer, the tokens have
many advantages:

Buyers have no voting rights.

There is not a huge contract with venture capital (VC) or angel investors.
There is an immediate global market.

This is obviously countered by less protection for buyers, and it seems that a large
proportion of early ICOs have been based on very bad ideas, if not fraud. Having
said that, ICOs give investors the advantage of being able to invest directly in
start-ups and get an immediate market for their investment. You can think of it as
a combination of (i) crowdfunding through, for example, Kickstarter and (ii) an
immediate global market for your tokens, which makes it easy to sell and makes it
more likely that their price goes up.

Token network effects

However, here comes the point about the network effect. Blockchain is based on a
system of anonymous participants automatically managing a ‘distributed ledger’
of every transaction anywhere (they act as if they were collective notaries). But
what do they gain by doing that? The answer is that they benefit from a related
right to ‘mine’ new currencies by letting their computers solve mathematical puz-

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zles. For instance, please note from the description of the Filecoin ICO: ‘70% being
held for miner rewards’. This means that 70% of the coins are given to the people
who build up and run the network.

This overall structure is called a ‘shared incentive network’. In reality, you can
view the tokens/cryptocurrencies issued in connection with ICOs such as the
Ethereum project as bets on the expectation that the organization will be able to
create an efficient network effect. However – and this is where it gets really smart
– you can be a miner only by contributing to this network effect, which you do by
running a part of the distributed ledger.

What happens in a successful project is that you initially have a lousy network ef-
fect but issue a lot of tokens to initial backers and miners. Then, as the network
effect kicks in over time, the value of the tokens goes up and the numbers issued
to the miners go down.

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