Network-based platforms have been with us for a long time. There are many examples of such successful scaled platforms, but many more examples of ones that died trying to become as such.
Among the imperative ingredients needed in the secret sauce of a successful a network-based business, is the Network Effect.
You will find a network-effect present among all successful marketplaces. From the pioneering eBay and Craigslist to Skype, Etsy, YouTube, Facebook, Twitter, Kayak, eLance-Odesk, Landing Club, Taskrabbit, Yelp, LinkedIn, Uber, Airbnb, Quora, Ashley Madison and Tinder, just to name a few.
It is enlightening to examine companies across their lifecycle from the network-effect achieving perspective. Most interestingly are the ones in the pre-phase of nailing it, companies "suspected" of being close to nailing it and ones who are have recently achieved it and getting into their velocity phase.
Some examples of such companies are StyleSeat, DogVacay, Roomer, EatWith, Beepi, 1stdibs, Periscope, Via and others.
What's so unique about a network-based businesses?
In its core, a network-based business or marketplace, has two or more sides (of constituents) that “transact” in some way, where the business itself is the mediator or facilitator. So take Google - Google’s search engine is a network: it facilitates interaction between searchers and advertisers.
There are many names to the sides of the network: Supply-Demand, Producer-Consumer, Buyer-Seller...you get the point - one side have something it wants to share/sell and the other wants to consume/buy.
So what is a Network Effect?
Network Effect is a definition first known to be coined by the president of Bell Telephone Company, in its annual report, around the 1900. Simply put, with every new user joining the platform, the platform is strengthened and enhanced thereby, the participants in the network gain additional value as a whole.
So for example, the more people joining Whatsapp, the more people its current users can reach.
The network-based business allows for value creation (or the exchange of it) by both producers and consumers participating in the network.
It does so by facilitating an N-sided platform that allows for all sides to participate and engage with other participants, usually under pre-defined set of rules that puts in the framework for the engagement.
What a network business is not
A network-based business does not create the end value like the standard e-commerce business, selling a product or a service (i.e. the end value) to the end customer.
One additional thing needs to be cleared out fairly early as well: many people tend to confuse network effect with virality - they are not the same. While both are derivatives of product-marketing, they are totally different animals. Network effect is measured by value is created in the network. Virality is about users growth-rate or the acquiring new users/customers and measured, classically by the how many new customers acquired via the existing customer base invitations (also known as the K factor).
Simple right? Well, it does get a bit more complicated...
The evasive ways of value creation and measuring it
Networks takes different shapes and forms. Sometimes tracing the value creation or the ability to measure it properly, is not simple. Networks can be multi-sided, they can be local (e.g. DogVacay or Uber), the supply side can be also the demand (so I consume reviews on TripAdvisor but I also share my own), to name a few.
Each of these add layers of complexity to its behavior, and being able to identify and measure the value creation, is imperative throughout launching a network platform, building its growth and maintaining a healthy ecosystem with sound liquidity.
"Normal" eCommerce businesses are saved from tackling these complex issues, but will miss the prominent edge of the network-based business, a true competitive edge.
It's no secret that a big issue for every online business is retaining customers. eCommerce businesses are fighting to keep customers and maximize on their potential, investing immensely in technology, marketing and man-power along the way, so their hard earned acquired customers will not ditch them to their competitors within a two-click distance.
Platforms with network effect inhabit an innate retention engine. The ecosystem itself does a big part of the retention creating emotional, rational, monetary or hassle barriers that will reduce their desire to shift to another service.
Think about your iTunes account with all its purchased songs, movies etc. The decision to move to an Android device because it has some new interesting features that your iPhone lacks, may make you seriously doubt making the move. Leaving Whatsapp while it is still the main messaging app of all your friends, will take you much more convincing. It is more likely that you will wait to see if the new app is getting adopted more widely. Platform with network effect creates captured customers, making it hard for them to leave. These platforms innately retain them - a priceless and solid way to measure the strength of a network.
Building a network-based platform takes a lot of expertise and the guts to embrace an aggressive experimental attitude.
The Value Phases of a Network Effect
The value function is not as straightforward as you may expect.
Theoretically speaking, the value is heuristically described as exponential, following the MetCalfe’s Law: Value = (Network-Size)^2. Though, in practice the value-increase is not exponential throughout the spectrum.
Like other economic value function, the change in value behaves differently in key points. In our case, value created to the network is affected by the platform’s user base (or network size). Here are the main cases:
Zero Users - if you are the first one to join the network, in our example, you don't have anyone to call to, so no value created.
Below Minimal Critical Mass - so you are the 100th user of Whatsapp. You happen to live in California but the other 99 users already listed (because of a test acquisition campaign) are from Lesotho, a small country in Southern Africa. Though you can theoretically contact them, it probably will not benefit you in any practical way and chances you will bring value to them, is slim to none.
Above Minimal Critical Mass - this is it. There are already people you know using the platform you just joined and the value to you and them is immediate. Moreover, in wider circles, an additional value is formed (officially called positive economic externality), in which you can access/engage with more people, that you never met, based on shared interests.
Saturation - Practically, there are finite amount of people who will join the network. With the declining rate of new users also comes overuse within the platform and the value starts diminishing (hence the “Mute” option in Whatsapp…). In such cases, the platform is defined as saturated or congested.
I'm discussing additional aspect of network effect and how to for value here.