May 3, 2021 • 36min

Anu Hariharan: How to think about network effects for your startup, from the beginning

Pattern Breakers

In this episode, Mike Maples interviews Anu Hariharan, a partner at Y Combinator's Continuity Fund and an expert on network effects. They discuss how startups can design network effects into their business models from the very beginning to create sustainable competitive advantages. Anu provides an in-depth look at what network effects are, how they differ from other business model advantages, and practical strategies for founders to cultivate network effects. She draws on examples from companies like Facebook, Airbnb, and WhatsApp to illustrate key concepts.

0:00

-0:00

Key Takeaways

Network effects occur when a product or service becomes more valuable as more people use it. This can lead to winner-take-all markets and significant competitive advantages.
There are three main "laws" of network effects:
- Sarnoff's Law (broadcast networks): Value grows linearly with number of users
- Metcalfe's Law (true network effects): Value grows as the square of number of users
- Reed's Law (group-forming networks): Value grows exponentially with number of users
Key steps for building network effects:
- Identify product utility and potential to connect users
- Develop growth tactics to reach critical mass
- Determine engagement triggers that drive retention
- Design for "irregular" network topologies beyond obvious clusters
- Create high barriers to exit for users
Focus on retention metrics specific to your product, not just growth. Improving retention as you scale is a key indicator of network effects.
Be patient and lean in the early days. Network effects often take time to develop. Too much funding or hiring too quickly can be detrimental.
Examples of successful network effects companies include Facebook, Airbnb, WhatsApp, and Zapier. Each made critical early decisions that enabled network effects to take hold.

Introduction

In this episode, Mike Maples interviews Anu Hariharan, a partner at Y Combinator's Continuity Fund and an expert on network effects. They discuss how startups can design network effects into their business models from the very beginning to create sustainable competitive advantages.

Anu provides an in-depth look at what network effects are, how they differ from other business model advantages, and practical strategies for founders to cultivate network effects. She draws on examples from companies like Facebook, Airbnb, and WhatsApp to illustrate key concepts.

Topics Discussed

Defining Network Effects (02:03)

Anu defines network effects as occurring when "as more users join a network, the service becomes valuable to all the users, including the existing users." She gives the example of Airbnb:

As more guests join, hosts can book more rooms and make more money
This attracts more hosts to join
More hosts means more options for guests, attracting even more guests

She emphasizes that network effects can lead to winner-take-all markets and pricing power, making them a powerful competitive advantage for startups.

Network Effects vs. Other Business Model Advantages (09:58)

Anu and Mike discuss how network effects differ from other business model advantages:

Economies of scale: Traditional "supply-side" advantage from mass production and distribution
Network effects: "Demand-side" advantage as value increases with more users
Virality: Rapid organic growth, but doesn't necessarily increase value for existing users

Anu notes that many people confuse virality with network effects, but they are distinct concepts. Virality can help reach critical mass, but doesn't inherently create increasing value for users.

Laws of Network Effects (18:14)

Anu outlines three key "laws" describing different types of network effects:

Sarnoff's Law: Value grows linearly with number of users. Example: Broadcast networks like Yahoo
Metcalfe's Law: Value grows as the square of number of users. Example: Facebook's friend connections
Reed's Law: Value grows exponentially with number of users. Example: WhatsApp groups

She notes that Reed's Law networks like WhatsApp can grow extremely quickly once they take hold.

Case Study: Facebook's Network Effects (05:24)

Anu discusses how Facebook cultivated network effects from its early days:

Started with clear utility as an online class directory for college students
Expanded strategically to other universities
Enabled cross-university connections, leveraging existing high school friendships
Focused on retention metrics like daily active users
Identified key engagement triggers (e.g. getting 10 friends in 14 days)

She notes that Facebook's focus on retention rather than just growth was critical to building true network effects.

Case Study: Airbnb's Network Effects (21:15)

Anu outlines how Airbnb built network effects despite initial challenges:

Identified clear utility: cheaper lodging when hotels sold out for events
Used events as growth hack to target specific cities/times
Added trust features like photography and social connections
Made critical decision to expand internationally early on

She emphasizes that Airbnb's decision to go global quickly was key to establishing a truly global network effect, rather than remaining US-focused.

Strategies for Building Network Effects (27:11)

Anu outlines several key strategies for startups looking to build network effects:

Find your "beach" - Identify a specific cluster to start with (e.g. a university, city, or industry vertical)
Define retention metrics specific to your product's intended usage
Identify engagement triggers that lead to long-term retention
Design for "irregular" network topologies beyond obvious geographic clusters
Create high barriers to exit for users to increase defensibility

She emphasizes the importance of focusing on retention and engagement, not just growth, in the early stages.

Leveraging "Irregular" Network Topologies (30:11)

Anu discusses how some companies have built powerful network effects by identifying non-obvious connection points:

WhatsApp: Leveraged international connections for cheap messaging
Flock Safety: Connected law enforcement across jurisdictions to track crime

She notes that thinking beyond obvious geographic or industry clusters can uncover unique opportunities for network effects.

Advice for Founders Building Network Effects (33:02)

Anu offers several key pieces of advice for founders looking to build network effects:

Be patient - Network effects often take time to develop
Stay lean - Too much funding or hiring can be detrimental early on
Focus on product and retention rather than paid marketing
Pay attention to barriers to exit for users, not just barriers to entry for competitors

She emphasizes that many successful network effects businesses took years to reach their tipping point, contrary to popular perception.

The Importance of Barriers to Exit (33:29)

Anu discusses how barriers to exit for users are critical for defensibility:

High barrier to exit: Facebook (photos, history, all connections in one place)
Medium barrier to exit: Airbnb (unique supply, but users could switch if alternatives had similar inventory)
Low barrier to exit: Uber/Lyft (users can easily switch between apps)

She notes that higher barriers to exit make network effects more defensible long-term.

Conclusion

Network effects represent one of the most powerful competitive advantages in modern business, particularly for digital platforms. By understanding the mechanics of how network effects work and following key strategies for cultivating them, startups can design products and growth plans that lead to winner-take-all outcomes.

Key takeaways for founders include: