Why Network Effects are King in Tech
Network effects have been shown to be an extremely important component in the development of high-powered tech companies in the last two decades. In an article published by NFX, a venture capital firm investing in pre-seed and seed stage startups, the author explores the relationship between network effects and company valuation in the tech space. The study found that network effects accounted for nearly 70% of the value creation in tech over the past 23 years, an impressive figure given that only 35% of the companies examined had network effects at their core.
In this study, the author inspected 336 digital companies founded since 1994, when the Internet became widely available, and that went on to become worth more than $1 billion. This set of companies included tech giants like Google at the $100+ billion market cap and smaller tech companies like Stripe at the $1-10 billion market cap. Each of these companies’ business model was compared to a list of 13 known network effects to determine the presence of a network effect at their core and their corresponding valuation. While only around 35% of these companies had a network effect in their business model, they were typically more valuable than those without network effects and their valuation contributed to 68% of the total value of all these companies combined. In other words, having a network effect was the single most important predictor of value in tech companies.
The results of this study are consistent with the model of network effects discussed in class. In lecture, we formulated a basic model for network effects and user adoption, where the reservation price of user X is r(x)f(z). Here, f(z) represents a network effect that is an increasing function of z, the fraction of the population who buys the product. This indicates that as long as z reaches some certain threshold or “tipping point”, r(x)f(z) > r(x) meaning that the reservation price of user X is higher in the presence of a network effect. Not only does this imply that network effects can increase the value of a company, but also that companies with network effects at their core are able to command a higher price for their products.
So next time you’re thinking about creating a tech startup, make sure to incorporate network effects and structure your product around allowing users to add value to other users. By allowing your users to participate in value creation, with customer 2 adding value to customer 1, you’re able to maximize value generation, maintain a sustainable competitive advantage, and stay one step ahead of your competitors.
Article: https://www.nfx.com/post/70-percent-value-network-effects