The Most Powerful Force in Startups: Network Effects

Why they matter, and the 5 step process to leverage them

Network effects are the most powerful force in startups. They help small companies grow fast and big companies to retain users.

They're the holy grail of the startup world (especially in competitive markets).

I helped grow new products at Uber Eats and Airbnb and have studied them extensively.

Here's the details on how to leverage them for your startup πŸ‘‡

Network Effects and Why They Matter

Network effects are a phenomenon where the product or service becomes more useful or valuable to each user as additional users use it.

Some examples:

  • Uber -> more drivers = shorter wait times

  • Slack -> more team members = more valuable archive of conversations

  • Airbnb -> more hosts = more options for travelers

Not all products experience network effects. For example, your experience using a personal todo list app does not get better when someone else starts using it.

But for the ones that do, network effects provide both the best defense against competition and the strongest way to disrupt existing products in the market.

The 5 Stages of Network Effects

To fully harness network effects, a startup must go through 5 stages:

  1. The Cold Start Problem

  2. The Tipping Point

  3. Escape Velocity

  4. Hitting the Ceiling

  5. The Moat

a16z General Partner Andrew Chen first identified them in his book the cold start problem. here's how each stage works:

The Cold Start Problem

New networks must first solve the chicken-and-egg problem. How do you get the first users to join a network, when no network exists yet?

To understand this, you have to first understand the concept of an atomic network.

An atomic network is the smallest self-sustaining version of a network using the product that can possibly exist. For example, slack famously identified that a team would use slack if it had 3 or more people (not less).

Additionally, each network has a type of user that is harder to attract but essential for a network to survive. For example:

  • Facebook's atomic network was a college. The hard type of user was social connectors on campus.

  • Uber's atomic network was a city. The hard type of user was drivers.

  • Slack's atomic network was a team. The hard type of user was managers.

Lenny Rachitsky wrote a great post about how some of the biggest consumer apps like TikTok, Uber, and Spotify got their first 1,000 users onto the platform. Not all of the products he investigated leverage network effects β€” see if you can identify which ones do and don't.

The Tipping Point

The counterintuitive lesson about network growth is that it doesn't happen from a single atomic network expanding.

Instead, a startup should craft a strategy to build as many atomic networks as possible, as quickly as possible (while not sacrificing user experience).

There are 2 common strategies to do this:

  1. Make the network invite only. Facebook, Gmail, LinkedIn and Clubhouse all did this in the early days. This strategy drives hype / fomo and tends to provide a better experience for early adopters.

  2. Build a tool users want first. Instagram first built a tool for editing photos. Then it rapidly added social features to become a massive network. Chris Dixon coined this "come for the tool, stay for the network".

Escape Velocity

Once you have a strategy to build atomic networks at scale, your focus needs to shift to sustaining growth. As Paul Graham says, "everything else we associate with startups follows growth".

Sustained growth comes by building out 3 things:

  1. Acquisition -> leverage your network to grow it. Dropbox famously developed a referral program that helped them grow 3900%.

  2. Engagement -> increase the number, types, and depth of user interactions in your network. An easy example here is adding recommendation features.

  3. Economics -> pursue additional monetization opportunities (i.e. pricing tiers) and improve your unit economics (i.e. efficiency gains).

If you can nail all three of these while balancing all the other challenges a startup comes across, you have a shot at becoming a unicorn.

Hitting the Ceiling

No matter how fast you're initially growing, though, at some point growth will slow down. Common reasons for hitting a ceiling are:

  • Market saturation with your target persona

  • Degradation of marketing channels (aka the law of shitty clickthroughs)

  • Increased churn

  • Lower quality engagement on the platform (typically due to trolling and/or fraud)

Startups can solve this by either creating new products (like Amazon with AWS) or through acquisitions (like Facebook buying Instagram and WhatsApp).

The Moat

Even if you do well to break through the ceiling, any mature network will need to fend off competition.

If you choose not to acquire an upstart, an incumbent can successfully fend them off by either:

  • Improving unit economics / monetization

  • "Fast-following" their features (like instagram launching reels and stories after tiktok and snapchat gained traction)

But, even then, upstarts can succeed by picking off niche segments and building their own atomic networks. The fact is that a mature network won't be able to solve every type of user perfectly, or better than a product specifically targeted to them.

With that said, network effects are incredibly sticky β€” it's hard to leave a social network if all of your friends are on it.

Additional Resources

πŸ’‘ How I Can Help

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