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70% of Value in Tech is Driven by Network Effects

Apple, Google, Microsoft, Facebook, and Amazon have reached and continue to purse all-time high valuations. Airbnb is worth more than Hilton in the private market. Uber is worth more than GM. The IPO track includes Spotify, Slack, Didi Chuxing and Dropbox.

According to a post on Medium by James Currier, Managing Partner at NFX, all the mentioned companies are mentioned in the same breath, because other than Amazon, their business DNA is amazingly similar. They are all network effect businesses, and it turns out that most of the outsized returns of companies since 1994 have used network effects.

NFX made a study around the value of the network effects that have been created in the digital world, and the short answer seems that over the past 23 years, network effects have accounted for approximately 70% of the value creation in tech.

NFX did a study of the digital companies that were founded since the Internet was widely available in 1994 and that went on to become worth more than a $1 billion.

336 companies between 1994 and 2017 met this criteria.

By looking at each of the companies’ business models and comparing them to 336 companies between 1994 and 2017 that met these criteria,  it is estimated that 35 percent of those companies had network effects at their core. They were, however, typically much more valuable than companies without network effects so they added up to 68% of the total value in our spreadsheet.

In other words, companies that leverage network effects have asymmetric upside. They punch above their weight. They are the Davids that beat the Goliaths, and then become the Goliaths. 

The other 65% of $1B+ companies used other defensibilities to create their value — namely embedding, scale and brand. These are good approaches and created 219 $1B+ companies. 65% of the total. But those companies’ valuations typically top out in the $1-$2B range, leading to the results of the study by NFX.

 

The Single Most Important Predictor of Tech Value

It turns out that having a network effect is the single most predictable attribute of the highest value technology companies — other than perhaps “having a great CEO.”

If Your Startup Doesn’t Have Network Effects, You Need to Rethink Your Strategy.

According to James, most founders fail to design network effects into their businesses because they don’t understand them well enough. And not understanding them, they don’t build them in from the beginning.

“It’s sad to watch because just as the Big Five are now consolidating their dominant threat to startups, and just as startups have lost the favorable winds of the Internet and mobile tech shifts, most founders are missing a key ingredient they will need to have a dog in the fight. Unless founders wise up to the importance and discipline of network effects, the scales will be heavily tipped in favor of those who have.” continues James.

 

Network Effects and the Next Big Thing

The top companies of 2017 have network effects, but many of those companies were founded 5–20 years ago, however the power of the network effects will continue with new startups as well.

In fact, network effects will increase in importance because the new platforms — and the re-invented verticals — are being born networked:

  • Crypto-Assets
  • Synthetic Biology
  • Augmented Reality
  • Artificial Intelligence
  • Virtual Reality
  • Internet of Things
  • Robotics
  • Drones
  • Transportation
  • Smart Cities
  • Agriculture
  • Health Care
  • FinTech

Learn more about the study here.