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Ep. 1 - Why Network Effects Are Mission Critical — Transcript

by NFX · 2,242 words · 324 segments · language en · Watch on YouTube

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0:04(upbeat music)
0:06- [James] So the world can often seem chaotic
0:08but underneath that apparent complexity,
0:10there's actually some wonderful, simple math.
0:13And once you see it and understand it, the world gets calmer
0:15and you can follow that math to your destination.
0:18If you're gonna be spending your life's energy
0:19building a startup,
0:21it's gonna take 100% of your effort.
0:22You're trying to defend the business area
0:25that you've carved out.
0:26You might as well be working on a business
0:28that has network effects
0:30because then you'll have a shot
0:31at going the distance and making a real impact in the world
0:34and creating true value for your employees,
0:37for your investors and for your whole network.
0:40(upbeat music)
0:42I'm James Currier and welcome
0:43to the Network Effects masterclass.
0:47(upbeat music)
0:52Over the last 20 years,
0:53we've built 10 companies
0:54that have exited for over 10 billion.
0:58We've also invested in hundreds of companies.
0:59Most of which also had network effects.
1:02Companies you've heard of like Lyft, and DoorDash
1:05and Patreon, and Goodreads
1:06that used network effects
1:08to grow and build their defensibility
1:10and went on to great success.
1:12So we've seen the failures and the successes.
1:14We've seen the tactics and the details
1:16of what it takes to grow these network effects.
1:19And with all of that company building,
1:21with all those investments, what we noticed
1:23was that when the companies had real network effects
1:25their success was 10, 20, 30x
1:28what companies were when they didn't have network effects.
1:31It was the most important factor
1:33in determining what would be a successful startup
1:36and what wasn't.
1:37In fact, between 2012 and 2018, we studied it.
1:40We kept track of it,
1:41and noticed the math is that 70% of all the value
1:45created in the technology sector.
1:47Is created by companies with network effects.
1:49And only 30% was created
1:51by companies without network effects.
1:53And once we saw the network effects
1:55playing out in these startups,
1:57it was clear to us that they were also playing out
1:59and how our lives went, and how the politics was going
2:01and how economics actually worked.
2:03We started seeing this everywhere.
2:05Once we saw it, once we understood it, we couldn't unsee it.
2:09And that's why we're doing this masterclass for you.
2:10Once you learn this way of seeing,
2:12you will not be able to unsee it.
2:15You will see these patterns everywhere.
2:17And the world that looks kind of chaotic
2:19on the surface is actually not as chaotic.
2:22It's actually quite understandable
2:24once you understand the network principles.
2:27And we're gonna teach you about the tactics and the nuances,
2:29all the different types of network effects.
2:31But the fundamental idea about network effects
2:34is that the more users a product has,
2:36the more value every user gets from that product.
2:40That's the kernel of the idea of network effects.
2:43Now, how that blossoms in flowers
2:45and its multiplicity of expressions,
2:48you will learn in this masterclass.
2:51Okay, so let's get started.
2:52(upbeat music)
2:58Network effects are important
3:00because they're really at the engine
3:03of what's creating economic wealth in the world today.
3:06They're at the engine of how politics works,
3:09how society works, economics works,
3:11yet so few people see them and understand them.
3:16It's like this hidden engine of the world
3:18that people aren't discussing
3:20and we hardly have the language for it.
3:22And so what we wanna do is bring out that language,
3:24bring out that understanding.
3:26I first learned about network effects in 2004.
3:29I sold my first company, Tickle, to Monster.com.
3:33And we were a fast growing user generated content site
3:37with matchmaking and social networking,
3:39and test taking a lot of user generated content.
3:42We were bought by this $7 billion company.
3:46And when we got there, after we'd been acquired,
3:48we realized that they were horribly run.
3:51The way they talked to each other,
3:53the processes they had in place,
3:55the metrics they were using
3:56were inferior to the way we were doing it
3:58yet they were buying us and not us buying them.
4:02And what we realized is the reason
4:03they were able to do that
4:04was because they had stumbled into a network effect in 1997.
4:10And that network effect allowed them
4:13to run the company horribly
4:14but still make a billion dollars in revenue a year.
4:18And they could go to sleep
4:19and they would wake up the next day
4:21and their business would still be there.
4:22And when we saw that,
4:23we realized we've gotta study this stuff.
4:26We've gotta understand what makes this work
4:28because we've discovered something important.
4:30You list out the companies you admire,
4:32you list out the companies you think have impact.
4:35I will bet you they've got network effects in them.
4:38Salesforce even developed a network effect over time
4:40even though they started without one.
4:42Very impressive.
4:43Apple started without one.
4:44Eventually, they got to iOS.
4:46Eventually, they got to their network effect businesses.
4:49And now they went from 40 billion
4:51to almost two trillion in value.
4:53Built on top of these network effects.
4:55We saw the pattern again and again,
4:58and that's why we called our firm Network Effects.
5:00And that's why we've been publishing about it
5:01for the last few years.
5:03These things are incredibly important to value creation.
5:05You're trying to defend the business area
5:08that you've carved out.
5:09And the network effects are the best way to do that
5:12in the digital age.
5:13Durable, competitive advantage.
5:15Where's that gonna come from?
5:16It's gonna come from four different defensibilities
5:18but generally it's gonna come from the greatest of those,
5:21which is network effects.
5:23(upbeat music)
5:27We wanna be very clear in this masterclass
5:30about what network effects are and what they're not.
5:33They are not viral effects.
5:35Viral effects are things like Candy Crush and whatnot,
5:38where your existing users send out the product
5:42to another user and you get a new user for free.
5:45And those are very exciting.
5:46And there are playbooks for viral effects
5:49but they aren't network effects.
5:50Network effects are about defensibility and retention.
5:54So the core idea of network effects is that
5:56every new user who joins a product
5:59increases the value of that product to every other user.
6:03Because of that value, they just won't leave.
6:06That creates stickiness.
6:07That creates defensibility.
6:08That creates longevity,
6:09which creates most value in startups in the long term.
6:13That's not virality.
6:15You're gonna learn that not all network effects
6:17are created equal,
6:18and that not all nodes on your network are created equal.
6:22And you're gonna learn to differentiate
6:23the different types of network effects
6:26and the different types of nodes
6:27that are gonna be on your network.
6:29You're gonna learn tactics for how to manage or grow
6:32each of your network effects and tactics for how to bond
6:35each of these nodes onto your network.
6:37(upbeat music)
6:41So network effects have always been important.
6:43Thousands of years ago,
6:44you would have a marketplace
6:45where buyers and sellers would come.
6:47And the more buyers that sellers that came,
6:49the more value everyone would get out of it.
6:51And so more would come.
6:53That's a basic network effects.
6:54We've always had network effects.
6:56You then move on to things like AT&T,
6:59which was the first time it was really written
7:01about in 1907, right?
7:02The chairman of AT&T says,
7:03"You should probably buy our stock
7:05because once we go into a town
7:07and we establish a network of telephones,
7:09once we get seven or eight people on that network,
7:12no one seems to be able to compete with us."
7:13Because everyone wants to join
7:16the biggest network available.
7:17The more people use in the telephone,
7:19the more valuable the telephone becomes,
7:21the more valuable AT&T.
7:23So we kind of said, you should probably invest.
7:25This was the first time it was written about.
7:26So then fast forward to 1976, when Microsoft stumbles
7:30into an operating system platform network effect
7:33what we call a two-sided platform network effect.
7:36They didn't know what it was.
7:38They'd never seen it before, but they stumbled into it.
7:40And it was incredibly durable
7:41because the more people they had using their OS,
7:45the more people wanted to build software on top of their OS
7:48so they could get access to the market
7:50of people who were already using that OS.
7:52And the more software was built on top of that OS,
7:56the more those people wanted to adopt the OS.
7:59Fast forward to 1998,
8:00when Microsoft is so powerful with this network effect
8:03and all of their competitors are screaming bloody murder
8:06that they can't compete with these guys.
8:07No one understands why.
8:09So the Department of Justice
8:11in the United States starts investigating Microsoft
8:13and looking to break them up
8:14'cause they're starting to appear
8:16like some kind of a monopoly.
8:17The academics started studying network effects.
8:19They started writing about it.
8:20People were trying to pull from the air.
8:22What is going on here?
8:24Why is this company so powerful?
8:25Now once the DOJ decided not to break up Microsoft,
8:28a lot of the investigation into network effects
8:31really died down.
8:32But starting in 94 because of the internet,
8:36it's like the tide went out
8:37and we could see the rocks and we could see the things
8:39underneath the water for the first time
8:42because the internet made it possible
8:45to measure and to see the network effects happening.
8:48And it made it possible to build lots and lots of businesses
8:51with different types of network effects.
8:53So by 2001, 2003, you do have some people
8:57starting to really study these network effects in academia,
9:00but it wasn't until the early 2010s
9:04where there were such a preponderance of companies
9:06that were dominating through these network effects,
9:08that we and others started really investigating
9:10what was going on.
9:11We're just now able to discuss them,
9:13were just now able to put language to it.
9:15We can now see them and use them
9:17as tools to actually construct these network effects,
9:20to construct these startups
9:22and direct them toward the destination
9:24we want to drive them to.
9:25That just starts happening maybe 10 years ago.
9:28Okay.
9:29Now, more recently because of Web3
9:32we are able again, to see,
9:34the tide goes out further
9:35and we can see more of these rocks,
9:38more of the things underneath the surface
9:40that were not sealable before.
9:41And we start to see the detailed construction
9:45of networks leading us to network bonding theory,
9:49which we started noticing in 2016
9:51and have been writing about only in 2021.
9:54And we'll get to that in this masterclass.
9:57But you should understand the historical context
9:59of the evolution of what we can even see
10:02and what we can discuss.
10:03That the internet, let us see stuff.
10:05We can discuss it to a certain point.
10:07And now Web3 has happened.
10:08Crypto has happened and we can see even more
10:11and see the real mechanics of it.
10:12We're just on the edge
10:14of this new discovery of network effects
10:17in the same way that people were just on the edge
10:20of understanding scale effect businesses back in the 1850s.
10:24And you had a lot of writing about capitalism
10:27and scale effect manufacturing
10:29and the laborers and the proletariat.
10:31And we had this new language that emerged back then
10:34when that new business model was discovered.
10:36We now have the same thing happening around network effects.
10:39(upbeat music)
10:43Another way of understanding
10:44how powerful network effects are
10:45is to look at the Goodreads' story.
10:47So Goodreads built a network of people
10:49who were reading and sharing their thoughts about books.
10:52Now, Amazon had owned the concept of books
10:56in the American mind for about a decade
10:58and long comes Goodreads.
10:59They got a big article in the Wall Street Journal
11:01saying they now represented book reading.
11:04At this point,
11:05Amazon could not lose their brand position to Goodreads.
11:09And so they made an offer to buy Goodreads.
11:12The day before they were supposed to close,
11:14Goodreads said, you know what?
11:16We don't really wanna sell, but if you paid twice as much
11:18as you just offered us, we'll do it.
11:21And Amazon, they yelled and they screamed
11:23but in the end they ate it.
11:25They had to eat it
11:26because they couldn't create the network effect
11:29that Goodreads had made
11:30between the millions of members of people on that.
11:34Amazon had bought the two competitors to Goodreads
11:36but they were much smaller than Goodreads.
11:37And so in order to own the jewel,
11:40they had to pay whatever it took.
11:42And this played out again with Facebook.
11:45Zuckerberg woke up one day
11:48with what we call a direct network effect around Facebook.
11:51A personal direct network effect
11:53because it was about the people
11:54on the network with their real names.
11:56A few years later,
11:57he woke up and notice that someone had gotten
11:59what we call a personal direct utility network effect,
12:03which is even more powerful
12:05than his personal direct network effect called WhatsApp.
12:09And WhatsApp only had 50 people
12:11and had very little revenue if any,
12:13but Zuckerberg was still willing to pay about 20 billion
12:17for that company because he saw
12:19that they had a stronger network effect
12:21and would eventually be able to attack him
12:24from a stronger position.
12:26And so he needed to buy them at any cost and he did.

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