Thread by @dunkhippo33

Some thoughts on network effects and how it's a double edge sword:

First, what are network effects? Most people get this wrong, so it's important to establish definitions upfront

Read on >>

1) I like @NFX 's article on network effects (and there is no other VC IMO that understands network effects like they do)

Read this:
nfx.com/post/network-e…

2) The tl;dr from the article is:

"increased usage of a product leads to a direct increase in the value of that product to its users."

3) A lot of people confuse network effects with virality. There may be overlap - it may be that something that has virality also has network effects but they are not necessarily the same.

4) A good example of this is @Calendly.

Calendly links have virality. They are in essence marketing for the co.

But, my usage of Calendly does not make the product more valuable for other users.

(Note that may change over time as they integrate more deeply into my workflow)

5) The best example of network effects IMO is @amazon. With every users, the experience becomes better for other users because:

1) there are more suppliers for better options & pricing
2) there is more data for their recommendations
3) there are more ratings to inform buying

6) All of the above create lock in. Amazon can recommend exactly what I want and that causes me to buy more. They collect more data and improve their recommendations.

This causes more ppl to sell on the platform for more choice. etc.

More usage creates more lock-in.

7) Now let's talk about companies that don't have network effects.

Most SaaS companies. In many cases, my usage of a SaaS product doesn't affect the value forother customers. A SaaS startup w 1 customer may not be worse off than a SaaS startup w 10k customers.

8) For this reason, I often feel like the advice that VCs give to B2B SaaS companies to step on the gas prematurely and spend like crazy w/ out figuring out the unit economics first is just a waste of money.

There is no value in having 100k customers if they are net negative.

9) In contrast, for cos w/ potentially strong network effects, the value grows over time -- your customers literally become worth more because of addl customers.

So in many cases you do want to pour $$$ into a co w/ network effects.

10) As you can see these are completely opposite strategies and shouldn't be confused. But many investors do.

11) Now let's talk about how money affects strategy.

As a small fund, we haven't invested in that many cos that could potentially have strong network effects. Why?

We write small checks. If a big check writer comes along and funds a competitor, our co is basically toast.

12) Network effects businesses tend to have a winner-take-all result. That works both ways. If you are a large fund and pour in $10m in a company w/ strong network effects, that capital can be a great moat.

As a small fund, we would need to closely align w/ such big funds.

13) There are exceptions to the "winner-take-all" result. Ridesharing showed that you can have 2 big winners.

But I'd argue that if you are building a ride sharing co from scratch in the US today, it would be v hard to compete w/ Uber & Lyft.

14) In contrast look at email marketing. @Mailchimp is certainly dominant. But ppl switch email service providers all the time.

There's really no first mover advantage (or network effects to retain earlier customers).

The true moat is just a great prod & customer happiness.

15) That means that someone could come up w/ a new email service provider today and can compete with @Mailchimp

And that has happened! Mailchimp was started in 2001 - almost 20 yrs ago. Along the way you've seen new players: Hubspot, Sendgrid etc. Even Substack in 2018!

16) And I'm sure there will be more entrants. You don't need a lot of cash. And incumbents can be taken on.

There's no first mover advantage.

17) As you think about building your biz, you should think about network effects and how strong / weak they are. If you are running a biz that could have strong network effects, you will have to run fast and raise a LOT of $$ otherwise you won't survive.

18) The opposite is also true. For most B2B SaaS cos (exceptions are things like Slack or other communication tools), you have more time on your side and need less money.

It also means that you won't have a great moat behind you either when you make it big.

19) This is also why you see more bootstrapped cos with big exits / unicorn status in B2B SaaS -- because you don't need a lot of capital and have more luxury of time.

20) Final thoughts:

A) Think deeply about whether your co potentially has strong network effects & whether you are well positioned to raise a lot of $$$ easily & quickly (and want to run w/ that).

2) Don't conflate strategies. It will only be a disaster.