Investing in Tech Companies: Identifying Network Effects
As an intern for a VC firm I source a list of companies for the firm to look at each week, and I have been taught to look for companies that are not just good, but also investible as well. However, what does “investible” mean? There are certain characteristics that make a company a good investment, and a16z, a well-known VC firm that has invested in companies like Airbnb, writes about how “network effects” is incredibly important for the success of tech companies, particularly for software-based companies. One of the main reasons why network effects is so crucial is because understanding it will help companies build better products, as well as protect itself from competitors. It’s not as easy as saying “if we build it, they will come”. There are actually ways to deterministically create these network effects for a business.
Airbnb Case Study: Airbnb is a two-sided marketplace and a network effect is created from both sides of the network. For instance, having more hosts on the platform attract more guests and vice versa. Having more hosts would mean a larger selection for guests, and having more guests mean more business for hosts. So how did Airbnb achieve its network effect? First of all, it addressed an existing problem — limited or expensive hotels. By providing the Airbnb platform, the company was able to provide a value for users. Airbnb first targeted cities that had lots of large-scale events which required accommodation for lots of event attendees. These test cities were the first “clusters” of Airbnb users who eventually shared with their friends about their experiences. This built a natural network effect, as more users meant more business for hosts, and more hosts meant more options for guest.
The network effects that Airbnb witnessed was incredibly helpful for its growth in the short and long run. They were able to amass a large following, which all started from smaller clusters of users. Additionally, their platform required more users to have more benefit for each individual user, hence the power of the network effect was a true propeller for Airbnb’s growth. This definitely ties into the concept of network effects that was discussed in class, and Airbnb was a great example of how companies can grow dramatically through this very effect. Each additional user of the platform makes it more beneficial for all users.
Reference: Andreessen Horowitz’s Article: “All about Network Effects” (http://a16z.com/2016/03/07/all-about-network-effects)