The Power of Network Effects: How to Identify and Invests in Companies with Strong Network Effects

This happens because the more users there are, the more value is added to the product or service for everyone. The network effect is a cumulative process that increases benefits for existing users every time a new user joins the network.

3 min read
Network Effect refers to a phenomenon where current users of a particular product or service gain advantages when new users adopt it. This happens because the more users there are, the more value is added to the product or service for everyone. The network effect is a cumulative process that increases benefits for existing users every time a new user joins the network. This effect can be further amplified through co-creation, where users automatically opt-in to the additional value they receive.
Every company aims to attain a critical mass: the number of users required for the network effect to take place. Once this threshold is reached, the quality of the products and services improves, and the company focuses on becoming self-sustainable and prioritizing customer satisfaction. This leads to the creation of better and more valuable products and services. Additionally, achieving critical mass helps companies to determine a pricing strategy. In the initial stages, businesses must consider the customer's ability or willingness to pay to set high prices. 

How to measure Network effects

To assess early indications of potential network effects in a business, we analyze five different groups of metrics.

Acquisition KPIs
When a network grows larger and becomes more valuable to its users, it should become more effective in acquiring new users. Therefore, monitoring metrics such as the percentage of organic traffic, direct or internal traffic, and referred users is essential to determine if these metrics are increasing.

Engagement/retention KPIs
It is crucial to understand users' cohorts vertically (i.e., historical improvement in product or service) and horizontally (i.e., increased retention and engagement of users within the same cohort over time). To assess the quality of the user base, it is essential to distinguish between the retention of first-time users and their engagement on the platform. Cohort analysis can be performed by analyzing paid and power users, and it can be done on a blended basis.

Platform KPIs
Be very keen on the concept of Operating System and Share of Wallet. One of the company's goals should be to increase the company's share of wallets with both sides of the transaction while reducing multi-tenanting, which means users are active on competitive platforms. The company should focus on becoming the Operating System for their demand or supply side. Additionally, the platform's match rate, such as driver utilization, and sell-through rate, such as inventory turnover, should gradually increase.

Monetization KPIs
The company's pricing and bargaining power should improve, and users' willingness to pay should increase due to the abovementioned factors. If the company initially subsidizes demand or supply acquisition, it can introduce more expensive subscriptions, listing fees, higher take rates, or other monetization mechanisms. Ultimately, the most critical factor is unit economics (LTV: CAC & CAC payback), which should improve over time due to customer Lifetime Value (LTV) and blended Cost of Customer Acquisition (CAC) optimization.

Unit Economics
In the long run, the most critical aspect is the unit economics comprising LTV: CAC and CAC payback. These should improve over time due to two factors. Firstly, customer lifetime value should increase, meaning the company can extract more value from customers for extended periods. This can be achieved by offering fewer incentives to different marketplace sides and having better pricing power. Secondly, the blended cost of customer acquisition should decrease.
When conducting research or investing, evaluating if a company has adequate resources to develop a large-scale ecosystem is crucial. To maintain its leadership status, a business must prevent new entrants from creating a comparable value proposition for the ecosystem by building its supply and demand. Familiarity with Network Effects and the ability to identify critical indicators can significantly increase investment returns and enable selecting only internet-based companies for inclusion in one's portfolio. The network effect is experiencing greater dynamism than in the past, with the potential for different patterns of maturity and development over time. Presently, Nfx is evolving more rapidly than previously observed.
© Figg Africa 2022. All right reserved