The Power of The Network Effect

The Power of The Network Effect

A look into what Network Effect businesses are and how they are successful

The idea that the innovation within a single product cannot make up the value of a network has been around for a long time. In fact, the idea was conceptualized in 1908 by Theodore Vail, the Chairman of AT&T. Vail noted in AT&T's 1908 Annual Report that "A telephone - without a connection at the other end of the line - is not even a toy or scientific instrument. It is one of the most useless things in the world. Its value depends on the connection with the other telephone - and increases with the number of connections."

Now in the world of digital, seeking out businesses that can successfully harness the power of the network effect has been the holy grail for investors.

In the past 10 years, the number of network effect marketplaces worth more than $1 billion - marketplaces enabling both buyers and sellers to mutually benefit from increases in usage on both sides - has grown from only two to more than a dozen in the US. That number is expected to double by 2020.

So what is a network effect?

A network effect occurs when a company's product or service becomes more valuable as usage increases. Each additional user makes the service more valuable for every other user. 

Most of the time, users on the same side do in fact subtract value directly from each other. For instance, the more suppliers introduced to the marketplace the more competition among sellers will exist. However, the positive indirect benefits end up outweighing those direct negatives. For example, shopping malls bring competitors under one roof in a highly concentrated area which therefore drives up competition but simultaneously attracts more buyers as a whole and therefore collectively benefits the sellers. 

Network effects have generated 70% of the value created for digital companies.

Why?

The primary reason this business model is so coveted is because it provides true defensibility in the digital world - once a company gets ahead, users wont find as much value in competitors smaller networks.

However, this does not mean that you just have to be the first mover to get ahead. In fact, there are 4 factors that far outweigh the importance of first mover advantage. Four values that are at the core of Equiprent's business model:

1. Enable mutually beneficial transactions between the suppliers and buyers.

Groupon and Living Social are prime examples of a business facilitating non mutually beneficial transactions. Once suppliers realized that Groupon's discounts were not bringing in repeat customers, it became obvious that the transaction was not a mutually beneficial one. This led to their market cap going from $18 billion at the time of its IPO in 2011 to less than $2 billion today.

2. Support the right type of growth

When eBay first launched, they had a real problem with "power sellers", sellers that demand the ability to do automated bulk listings. Despite being more efficient from the sellers point of view, this created problems. For one, power sellers skewed incentives towards commodity goods therefore crowding out more unique products. Two, power sellers were able to negotiate lower per listing fees from eBay creating an unfair competitive advantage in a marketplace built to be a transparent, even playing field for suppliers of all sizes.

3. Trust and safety

There must be mechanisms in place to ensure that participants feel like they can safely and confidently conduct business on the platform. Ratings and reviews, which are essentially a requirement in any online marketplace today, were the first mechanism created to build trust between buyers and sellers. However, solely relying on ratings and reviews is not enough. When dealing with high ticket items such as machinery; proper insurance, participant certifications & vetting, and payment security services are a must. 

4. Handle disintermediation the right way

The first and most logical question when people ask us about Equiprent is "what happens if participants agree to conduct business outside of the marketplace?" This risk, especially for high value items, is certainly prevalent. The natural instinct is to impose penalties. However, it is our belief that if this is happening at the rate to threaten the health of our business, that means that we are not creating enough value for the market participants.  With the right fees in place, the preference to conduct business in a transparent, convenient marketplace will outweigh the temptation to bypass transacting through the platform. Without abiding by the first three steps to provide convenience, comfort, and security, any network effect business will be bound to fail.

Equiprent delivers on these four values to empower both buyers and suppliers big and small while the value of Equiprent lies in the power of the network who relies on us and supports us.

sources
https://www.nfx.com/post/10-years-about-market-networks
https://medium.com/@nfx/the-network-effects-manual-13-different-network-effects-and-counting-a3e07b23017d
https://hbr.org/2016/04/network-effects-arent-enough
https://techcrunch.com/2016/09/15/defensibility-creates-the-most-value-for-founders/

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