Software Growth

Network effects

Network effects occur when a product becomes more valuable to each user as more people use it, which makes leaders hard to dislodge.

A product has network effects when each additional user makes it more useful to the others. A phone is worthless if you are the only owner. With a million owners it is essential. For software founders, network effects matter because they are one of the few defensible advantages: once a network is established, a better-funded competitor cannot easily copy it.

NFX, the venture firm that has written the most on the subject, defines network effects as occurring when a company's product or service becomes more valuable as usage increases. It attributes the first observation of the idea to AT&T's Theodore Vail in 1908, and reports that network effects account for 70 percent of the value created by tech companies since 1994. Treat that number as NFX's own finding, not a law.

The main types

NFX's manual catalogs 16 kinds in five groups. The ones a founder meets most often:

  • Direct: value rises with the number of people you can reach, as with messaging or a shared file format.
  • Two-sided: buyers attract sellers and sellers attract buyers, as in a marketplace.
  • Data: more usage produces more data, which improves the product for everyone.
  • Social: a product becomes the norm, as with a language or a belief.

NFX stresses that types overlap and strong companies usually combine several.

Network effects versus things that look like them

A big customer base alone is not a network effect. If customer 1,000 gets no more value from customer 1,001, you have scale, not a network. Likewise, a viral coefficient above zero is a distribution trick: users bring users, but the product itself may not improve. The two often occur together, but only network effects raise the value of staying. They also differ from switching costs, which keep a customer because leaving is expensive, not because the group is valuable.

Why most SaaS does not have them

Most B2B tools are used by one company in isolation. Your invoicing software gains nothing when a stranger signs up. That is why it is common to claim network effects that do not exist. A fair test: would an existing user pay more, or be less likely to leave, because another unrelated customer joined?

The cold-start problem

A network is worth little until it has enough people. Founders solve this by starting with a small, tight group where density is achievable, a tactic similar to Geoffrey Moore's crossing the chasm advice to win one segment before the next. A niche community of 500 active users who all know one another can be more valuable than 50,000 scattered ones.

For bootstrapped founders

You rarely need a true network effect to build a good small business. Look for weaker forms: integrations that other tools rely on, templates or plugins others have built, or a data set that improves with use. They contribute to a moat without needing millions of users.

Related terms

Sources

Back to the SaaS glossary