What Is the Network Effect in Business & How Do You Use It?

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What is the network effect in business? Why does it create rapid growth? How do you build a network-based business?

In The Cold Start Problem, Andrew Chen explains how to leverage the network effect in business to build a rapid-growth startup. He claims the network effect gives entrepreneurs the power to build billion-dollar companies from the ground up.

Read on to learn about the network effect in business and how to use it for growth, according to Chen.

Chen on the Network Effect in Business

According to venture capitalist and former Uber executive Andrew Chen, using the network effect in business means creating any product or service that involves interactions between users and gains value as more people use it. For instance, the more users a social media app has, the more likely it is that you’ll have friends who use it, and the more connection and enjoyment you’ll get out of using that app. Therefore, the more valuable the app is to you.

All of the most ubiquitous and profitable tech products are network-based: Social media platforms, online marketplaces, and multiplayer video games all take advantage of the network effect, and they often have enormous networks of millions of users. 

(Shortform note: In Exponential Organizations, Salim Ismail offers another explanation as to why many tech companies grow rapidly and succeed. Ismail argues that while traditional organizations profit from scarce resources—for instance, how many computers they can build and sell—today’s rapid-growth tech organizations generate value from the information they get from users, which is a never-ending and infinitely valuable resource. This may in turn explain why the most profitable tech products are all network-based: Companies with large networks have a huge user base from which they can harvest valuable information.)

In this article, we’ll explain how to leverage the network effect in business to for business growth, according to Chen’s book The Cold Start Problem: How to Start and Scale Network Effects.

Create Your First Subnetwork

Chen argues that the first step of creating a business based on the network effect is to create a single network that’s as small as possible and still functional. Different types of businesses will require different sizes of networks to meet this threshold: Products that only involve isolated one-to-one interactions can function fine with just two users, while products focused around group interaction and networking may need a few dozen people interacting before the experience becomes satisfying enough to function well.

Over time, you’ll create countless independent yet interconnected networks, which we’ll call “subnetworks” (Chen refers to them as “atomic networks”). Collectively, these subnetworks will make up your massive, profitable network. Starting with a single successful subnetwork and expanding is far easier than trying to launch an enormous, market-dominating network all at once.

Here are a few tips for how to get your first subnetwork up and running.

Tip #1: Attract a Group of Users All at Once

First, to leverage the network effect in business, Chen asserts that you need to get a group of users to join a subnetwork all at once to achieve network stability quickly. Otherwise, that subnetwork is doomed to fizzle out and fail. As we’ve seen in earlier examples, the minimum number of users you need to have a functional subnetwork differs depending on your product. Chen refers to this minimum number of users as your subnetwork’s “Tipping Point.” 

(Shortform note: Chen uses the phrase “Tipping Point” to describe two similar, yet distinct ideas. The first, as we’ve established, is the point at which a subnetwork has enough users to function well. The second, which we’ll cover later, is the point at which you have enough subnetworks accelerating the growth of your whole network to dominate the market. For clarity, we’ll use the term “subnetwork stability” to describe the former idea and “Growth Explosion” to describe the latter.)

Once you hit subnetwork stability, users will regularly use your product and may share it with others, giving you a stable or growing user base. However, Chen warns that if at any point a subnetwork doesn’t have enough users to achieve stability, the few users it does have will flee the dysfunctional product and the subnetwork will collapse. For example, if enough people from a friend group leave a social network, there will no longer be enough content from friends for the app to be enjoyable, and the rest of the friend group will all delete it.

Tip #2: Target a Niche Group (at First)

As we’ve established, to reach subnetwork stability, an entire group of interacting users must join at the same time. Chen argues that the best way to accomplish this is to design your product for an extremely specific group of users—this could be an internet community of users who share a niche hobby, a single team within a company, or even the attendees of a single event. 

By designing your product for a single existing group, you can ensure that 1) your product fits their needs, and 2) the users in your subnetwork will have several other people in the subnetwork they want to interact with. With these conditions met, Chen asserts that your users will form a stable subnetwork, making it far easier for you to expand your network in the future. 

Your product doesn’t have to serve a niche audience forever: Eventually, once you’ve attracted enough subnetworks of niche users, greater network effects will take effect in your business, and your network as a whole will be valuable enough to attract a broader audience

Tip #3: Keep the Product Simple

How do you design a product that makes users want to keep using it and form subnetworks? Chen advises you to make your product extremely simple—simple to understand, simple to use, and simple to explain to others. In particular, your product should perform one simple function perfectly rather than aim to do many things well.

Why focus on a single function? Chen states that keeping your product simple makes it easier to attract and retain users, expanding your network and vastly increasing its value. Maintaining simplicity makes it clear exactly what your product does, and users who easily understand what a product is are more likely to use it. Further, making the product simple to use increases the likelihood that they’ll learn how to use it and continue to use it. Finally, making the product simple to explain increases the chances that users will share it with each other.

Tip #4: Cater to Your Difficult-to-Attract Users

Often, the users of network-based products form two distinct categories, according to Chen’s explanation of the network effect in business. For instance, online marketplaces serve both sellers and buyers, rideshare apps serve both drivers and riders, and social networks serve both people who post content and “lurkers” who just consume it. In most cases, one of these types of users will be more difficult to attract to your product than the other. Because you need both types of users for your subnetwork to succeed, a lack of these scarcer, difficult-to-attract users (which Chen calls the “Hard Side” of your network) will often be what holds you back from achieving network stability. Therefore, design your product to appeal to these users as much as possible.

To win over your difficult-to-attract users, Chen recommends deeply understanding their motivations. What are they looking to get out of your product, and how can you give as much of it as possible to them? They may be using your product to earn money, to claim attention or social status, or to just have fun. Making your product as rewarding and enjoyable as possible for these users is key to achieving network stability.

Exercise: Brainstorm a Startup Strategy

Chen asserts that you can start a business from scratch and leverage the network effect to scale it into a threatening competitor to any established business. To prepare to do this, plan out the first few steps of your startup strategy.

• The first step in building a network-based startup is to set up a stable, functioning subnetwork. To do this, you need a simple product that serves the needs of a specific niche group. What simple product could you make, and what group could you design it for? (For example, you may decide to create an app that lets runners host, discover, and register for races near them. You decide to recruit the participants of a nearby 5K race to be your first subnetwork.)

• Next, you need a repeatable strategy to recruit enough subnetworks to reach the Growth Explosion. What strategy could you use to spread your product, and what groups could you spread it to? (For example, after the participants from your first race have continued to use your app and established a stable subnetwork of runners in your city, you could seek outside investors for enough money to sponsor large-scale races in other cities, encouraging new runners to join your network.)

• Finally, identify your difficult-to-attract users, if you have any. How can you adapt the strategy above to appeal specifically to those users? (For example, you may identify “race hosts” as your difficult-to-attract users and decide to offer $100 to any user who wants to host a race as prize money for the winners.)

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Here's what you'll find in our full The Cold Start Problem summary:

• How to build a billion-dollar tech company from the ground up
• Why you need to understand the network effect if you're in the tech industry
• How to overcome the negative effects of rapid growth

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