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Business Growth Paradigm: The Network Effect

By Fernando Castilleja - Genethic Services by Sohin


By Fernando Castilleja | CEO - Wed, 03/01/2023 - 17:00

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For a business to thrive it is necessary to have a good product, at the right time and with a very clear business model that allows users to receive the added value of the company and for the company to have the profit to grow toward its purpose. However, strategic plans to grow in number of users, interactions between clients and service providers, sales and profits are critical for the company to succeed. There are several models of growth, but two have become major trends in business expansion: virality and network effect. 

Growth should be the target of strategic planning in order to reach a critical mass of users and payers that could allow the company to thrive with no additional or external investment. One reason, according to John Mullins, author of The Customer-Funded Business, is that a great opportunity exists from getting money directly from the customer, through sales, instead of looking for financial investments that can dilute stock, a risk  that is feared by startup founders. 

So, how do you get to the critical volume of transactions and sales that give rise to financial success?  

Malcolm Gladwell, in his bestseller The Tipping Point, suggests how to find the boiling point where any additional customer helps the company grow exponentially.  Gladwell describes three rules — the law of few, the stickiness factor and the power of context — to help executives build the arena in which their business should run to increase the number of users and profitability.  Nevertheless, this tipping point could be far from critical mass since that “trigger customer” is commonly located below the point where profit exceeds costs. For businesses to grow, we must expect to cross over that point.

In his book The Rules of Contagion, Adam Kucharsky describes how a viral disease like ebola, could easily spread as part of an outbreak if the proper conditions are met.  It depends on the characteristics of the “virus” (the biological or the product), the recipient’s ability to accept the message (the disease) and the capacity of the carrier to spread the value or damage the message could do. From epidemiology to business and financial standpoints, that is the way an agent of change could affect how we see our lives and our business success. Although virality can increase the number of users and can decrease client acquisition costs, since word of mouth is very important in this model, it is short-lived, flashy and unidirectional. As in disease outbreaks like COVID-19, at any given time, most people will be exposed and eventually immunized against the message, unless you add value to it in every economic cycle in favor of being continuously impacted. Adele’s Hello video hit the top of the fastest videos on Youtube to reach 1 billion views just 102 days after its premiere; that was certainly a business success, and it could even be a masterpiece like a Bach or Mozart sonata, but I can’t be sure. Adele´s performance and entertainment success is based on the recurrent offer of added value to her artistic proposal, so it must be a cyclical virality. That is the complexity of taking virality as a model to grow in other industries like healthcare.

Embracing the three rules of Gladwell, they promise to increase customer loyalty through the empowerment of people with a particular set of “gifts” that promote, consciously or unconsciously, a specific message that renders a memorable impact on others, giving the circumstances that surround that great business idea a chance to impact the whole process. In other words, giving credence to the involvement of people creating continuous value for others is fundamental for a product or idea to reach massification.  That’s one of the cornerstone principles of network effect.

Several authors state that network effect is a phenomenon whereby increased numbers of people improve the value of a good or service. Think about Facebook. Having access to thousands of contacts gives you the added value of having the space to spread your own message, no matter what it is.  Amazon’s platform provides value for customers by exposing them to millions of products, and for vendors, Amazon expands the customer base at a client acquisition cost lower than they could get on their own.

Network effect relies on the idea that building a multiple node network with an incremental number of interactions between nodes can increase the value for every participant, and for the company; if the churn rate remains low because of an impeccable service, it is the fastest way to reach critical mass.

Currently, 70% of the value created by tech companies is related to network effect. To support business growth, companies should rely on defensibility strategies like brand, scaling and embedding techniques; however, network effect contributes at the highest level with business strength. No one would refute the idea that fighting a company with 2.9 billion monthly users is likely  a losing battle.

According to Reed’s law, the network’s value is increased not only by a progressive number of nodes, but with the interaction between them conforming user communities. Adding value to every interaction makes it more attractive to additional users and so on.  The density of the interactions between users, or even between nodes, amplifies the opportunities for the business to grow. Uber’s success is based on intense — dense — local interactions but it has been struggling with the fact that regional nodes do not have interaction among them since operations are local. Airbnb on the other hand, promotes interactions that jump over regional boundaries, allowing renters to reach clients overseas. Facebook and Amazon are the main examples of network effects on one-sided or multi-sided business models. Adding value to clients on every interaction produces long-term revenue, increases profitability and retains customers. More importantly, a company could reach critical mass in a shorter period and also crossover the boundary between cost and exponentiality. 

Perhaps product market fit and customer segmentation are the main targets for product development, but growth strategies are cornerstones for long-term business success. Network effect could be a strong ally in getting there.

Photo by:   Fernando Castilleja

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