“Go Where There Are Network Effects”
“Go Where There Are Network Effects” – Zero to One book, Peter Thiel
A business that has a strong and enduring Network Effect can be a great business to invest in. It is one of my favorite tools in my mental-model toolbox, and is one that I look for and think about often. The best part about a business that has a strong network effect is just like compound interest, it only gets better as the numbers get bigger. The simplest way to describe a network effect is when a product or service becomes more valuable as more people use it. For example, companies like Airbnb, Facebook, Microsoft, PayPal, eBay, Match Group and Twitter all have strong network effects. If a business can profit on this effect the rewards can be quite enormous. It can be a great starting point for investors seeking to find a business that has a wide and deep moat and a long runway for many years ahead.
- People use Airbnb because they know there is a variety of different options to choose from when it comes to renting a place to stay, and “Hosts” list their houses on Airbnb because they know there’s an endless amount of people who are looking to rent instead of staying in a hotel.
- People sign up and use Facebook because their friends and peers are signed up and use the website as well.
- People continue to play video games on Xbox live because they know other people are gaming and competing on Xbox live.
- PayPal is convenient because it is so popular, which encourages companies to accept payments from it.
- Buyers use eBay because they know there will be a lot of sellers selling items, and sellers use eBay because they know there will be a lot of buyers buying items.
- People swipe on Tinder because they know other people are swiping on Tinder.
- People use Twitter because no one wants to miss Donald Trump’s tweets…. (I’m half-kidding here)
You get the point, right? Network effects can become significant after a certain number of users have been reached: this is the “Critical Mass” point. When the critical mass point has been achieved, the value obtained from this network effect can be greater than or equal to the price paid for the effect. What does that mean? It’s the point at which a growing company becomes more efficient, and no longer needs additional investment to remain economically sustainable. Charlie Munger always talks about learning the “big ideas” across many different disciplines, and critical mass comes from Nuclear Physics; where critical mass is defined as the smallest mass that can sustain a nuclear reaction at a constant level. When bringing this phenomenon into the investing world, it is about when a business becomes self-sustaining. Aiming to hit this critical mass point is the challenging part of business. This is why most tech companies are so focused on user growth and are often valued by user-progression, as opposed to traditional valuation earnings metrics. As the VC and Silicon Valley adage goes… “grow your user base as fast as possible at all costs.”
As I wrote above, eBay was a great example of reaching a critical mass point. After a critical mass of users chose eBay as their foundation of obtaining or selling goods, the website engrossed an even greater number of customers who knew they could reach a vast market for their goods or services. Another prime example to learn from is Airbnb. In reading Leigh Gallagher’s book The Airbnb Story (a book I highly recommend), it was evident how important it was for Airbnb to hit their critical mass point. Leigh Gallagher describes Airbnb’s network effect below:
“Airbnb’s business is fundamentally about leveraging a network effect: the more people who list on Airbnb, the more inherently attractive the platform becomes to anyone who wants to travel, because there are more choices; and the more people who travel, the more appealing it becomes for people to list on it, because there are more customers. In Airbnb’s case, because its product is travel and the very act of using it involves moving from point A to point B, it is a global network effect enabled by fast and cheap cross-pollination: when a traveler from France uses Airbnb in New York, he or she is more likely to go back to France and consider hosting, or to talk up the company to his or her friends, sparking awareness and ultimately leading to more listing activity in that market. These two points are often continents away from each other, yet new markets are seeded quickly, cheaply, and organically, without staffers or teams every having to set foot in them. This is a big difference between Airbnb and, say, Uber, which has to physically launch each new market with a heavy investment of fresh marketing, employees, and other resources. The vast majority of Airbnb’s growth, both travelers and listings, has come through these travel patterns and this global network effect.”
This global network effect that Leigh writes about is what has made Airbnb so dominant. Airbnb is still a private company, but it has been reported that they expect $2.8 billion in revenue this year and $8.5 billion by 2020. They just closed a Series F round of $1 billion, bringing the companies valuation to $31 billion; not bad for a company that started in 2008. I think Airbnb is a much better company and has a better network effect than Uber. Airbnb’s scalability is much quicker, more efficient and more profitable since they don’t have to necessarily pay for growth as much as Uber does. This leads to more profits and higher cash flow; an equation that would make any investor happy. Furthermore, since businesses with a strong network effect tend to create natural monopolies and oligopolies, it is definitely a model that you should be on the lookout for and add to your mental-model toolbox.
Key Takeaways:
- Look for businesses that become more valuable (as a platform) the more people use it
- Network effects can create a strong moat
- Businesses that have a network effect can scale quickly and more efficiently