Sometimes a company’s most powerful asset doesn't appear on the balance sheet. One such intangible asset is known as a network effect: a company’s connections or network of users. It is the backbone of many new business models—and it can make or break a startup.
“A positive network effect occurs when the value of the product, service or platform increases with an increase in users,” says Ed Stanley, Morgan Stanley’s Head of Thematic Research in Europe. “When successful, network effects create outsized returns and a business with pricing power and scalability.”
These days, the success of many brands depends on having a critical mass of users to connect and engage with the brand, whether it’s via a social media app or a marketplace of buyers and sellers. In fact, about 70% of global tech equity value is derived from companies relying on network effects, according to research by NFX, a venture firm focused on pre-seed and seed stage startups.
It’s no surprise that companies with the most active users often have the greatest value. Although these networks are now common, creating and sustaining one is not easy or cheap.
“Network effects are powerful tools to make a business model defendable. However, they are typically very difficult and resource-intensive to create,” says Stanley.
Networking With Unicorns
E-commerce sites, rideshare apps, online marketplaces and portals for real estate listings all rely on their powerful connections to users to execute their business models. The most successful bring on millions of users. But if a startup fails to develop a solid network, it could flame out before it ever reaches its full potential. Since companies’ success depends on network effects to bring value to consumers, they have to compete for users. But once captured, added users result in compounding benefits for companies.
The accelerated use of digital communication services across different sectors and businesses, plus the recognition by companies and investors of the value of network effects, have been the key drivers behind the increasing pervasiveness of this strategy. In 2021, more than 50% of unicorns—or privately held startups that have a valuation north of $1 billion—relied on network effects in their business models. That percentage dropped in 2022, reflecting a slowdown of venture capital activity amid steeper capital cost, but the approach is still valid.
“Successful platforms using network effects have a layer of insulation from failure provided by their very users. A thriving network can bring security to businesses, creating economic moats to protect them, just as economies of scale and brand equity do,” says Stanley.
Because so many successful startups now rely on network effects, both entrepreneurs and venture capitalists have taken notice, leading to an increase of network effects in the private space.
“Given this manifestation in private markets, we expect public markets, and as a result public investors, to see an increasing number of companies with network effects in the future,” Stanley says.