These days, we’re hyper-focused on marketplaces, communities and social platforms. We love these platforms for many reasons, but the primary one is the power of their network effects and how they create a high degree of defensibility for startups.

What are network effects?

“Network effects” is a frequently used term and it is sometimes confused with having a large customer base.  Network effects is more than just a large number of users – they kick in when the value of a product depends on how many other users there are.

When a new user/member is added to the network, it increases the value of the product or service to all other users. This increased value can be in the form of cost reduction (in user acquisition as an example), higher liquidity (in a marketplace), stronger community or deeper relationships (in social networks), etc.

Generally speaking, network effects are categorized into two categories:  direct and indirect.

Direct Network Effects

The simplest network effects are direct: an increase in usage leads to a direct increase in value for all other users. Social sites like Facebook, Twitter and Wattpad have a direct network effect. If I’m a user, I gain some benefit if you join.

When we think about direct network effects, we consider the roles of the participants. In a marketplace, users are buyers, sellers, or sometimes both. Likewise, in a community or social platform, users can be content creators, content consumers, or both.

In a marketplace, the roles of a buyer and seller are typically distinct – effectively creating two-sided network effects. When there’s overlap between buyers and sellers, it’s easier to get your network off the ground at the beginning as you’ll achieve liquidity more quickly. For example, in Etsy, Craigslist and Airbnb, we see some overlap between buyers and sellers (or hosts and guests in Airbnb’s case).

While overlap helps a marketplace at the beginning, two-sided network effects add to the defensibility of your marketplace over time (since there’s more fragmentation). For example, with Uber, there’s little overlap between drivers and riders.

Social platforms and communities can also exhibit two-sided network effects, although they are less obvious. Participants generally follow the 100-10-1 rule, with 1% creating content, 10% engaging with it, and 100% consuming it. The defensibility of social platforms increases as users participate in the same way – when they create and consume – because, after all, content is what ultimately drives engagement.

We also need to consider how network effects fall on the local-global spectrum:

• Local network effects: The value-add of a product may not increase with the overall size of its user base, but is dependent on the size of a smaller subset. In this case, a user’s experience might be influenced directly by the number of people and actions of a small subset of users (i.e. connections through the user’s personal/professional network or neighborhood). We see local network effects at play with instant messaging and private social networks as well as in the on-demand economy.
• Global network effects: These take place with a larger-sized network with few barriers in payment or language.  We see global network effects on global marketplace like eBay and public social platforms like Figure 1 and Twitter. Keep in mind that some marketplaces, like Etsy, will fall in between local and global network effects, as there can be shipping and language limitations.

Indirect network effects

Network effects can also be indirect. In these cases, when more people use a product or network, it sparks the production of complementary products and goods – thus increasing the value of the original product. A common example is with hardware and software; the more people that use a hardware product, the more likely it is that developers will build software and apps for that hardware.

But indirect network effects can also apply to marketplaces, communities, and social platforms. For example, developers build applications and products on top of APIs of existing marketplaces and platforms – for example, Shopify has a very active developer/value-add app ecosystem. In addition, countless services sprout up to support popular platforms – like Airbnb management services (Guestly and Pillow) and lease options for Uber/Lyft (Breeze).

How are network effects different from virality?

When information can be shared rapidly and widely from one user to another, or when the rate of adoption increases with adoption, we have virality. In other words, the product grows faster as more users adopt it (to a certain limit).

Network effects and virality often go hand-in-hand, but not all network effects are viral and not all viral products have network effects. For instance:

• Marketplace network effects often have low virality.  While you can achieve some virality through incentives, the two-sided network effect does not lend itself to adoption of users on one side to come on-board with invitations/interactions from the other.
• News outlets/channels, gaming, and communication products can be highly viral products without strong network effects.

Network effects are critical to scaling and sustaining a marketplace, community or social platform.  As you build yours, think about how users benefit each time someone else participates, and in what way:  directly or indirectly.  Understanding how network effects impact your startup brings you one step closer to building a more defensible product.