How can start-ups create a network effect?

There’s a million start up ideas out there that would be awesome, if only enough people would get on board!

And that’s the rub, it is very hard and often costly to build critical mass.

Below are Uber’s financial numbers for 2014-2015 as reported by Business Insider.

Uber are building their network effect by attracting drivers to sign up, which provides a service for passengers, which attracts more drivers, which attracts more passengers…

Amazon did the same with first selling books, from a wholesaler, to build up a customer base, which allowed them to sell more products, which attracted more customer, which attracted resellers, which attracted more customers…

The value of the network effect was first postulated by Bob Metcalfe, later to be known as Metcalfe’s Law, when he realized that to sell more of his start-up’s, 3Com, Ethernet cards he needed to create critical mass inside his customers.

Metcalfe started by selling bundles of three cards which provided email, printer and storage sharing for three people. But he found his customers were not happy because it was only three people. He used an explanation of the network effect to explain to his customers why they needed to buy more cards. They would only gain value once they achieved a critical mass of users.

Bob Metcalfe presenting at Texas Engineering, Cockrell School

In his diagram above, Metcalfe’s shows the cost to add users follows a straight line while the value you gain from each additional user follows a curve. This is why Uber is spending large amounts of money to get to the critical mass point, where there is enough drivers and customers to generate a positive cash flow.

Another reasons why Uber is spending and moving fast is because their business model is not disruptive, even though they topped the CNBC 50 Disruptor list for 2016. As Clayton Christensen points out in his December 2015 HBR article, Uber is not a disruptive business model;

According to disruption theory, Uber is an outlier, and we do not have a universal way to account for such atypical outcomes. In Uber’s case, we believe that the regulated nature of the taxi business is a large part of the answer. Market entry and prices are closely controlled in many jurisdictions. Consequently, taxi companies have rarely innovated. Individual drivers have few ways to innovate, except to defect to Uber. So Uber is in a unique situation relative to taxis: It can offer better quality and the competition will find it hard to respond, at least in the short term.

Why Christensen finishes with the words, “at least in the short term” is because the incumbent Taxi companies around the world can play catch up, which they are trying to do. Uber needs to get to critical mass before the incumbents improve their service.

By the way this is all good for us, the customer!

Within Christensen’s words there is the clue as to how to create a network effect without the large sums of money required by Uber and Amazon. That clue is to focus on the individual. This is what Facebook, Apple, What’sApp, SnapChat, Linkedin have done.

Too often when we have a great “network” based idea we target the incumbent controlling hubs of the network. We try to get these hubs on board, hubs such as Health Departments, Stock Exchanges, Banks, Telecoms and Retail Chains. The problem is these organizations are operating from the left hand side of the Integral Organization Model and the clever sign below just about sums up the reason why they don’t innovate. See more at, “What is a Perfect Organization?” and “Why can’t we innovate – disruptive new products or services?

If in our business plan is the step: “Need to get the large players signed up”, then forget it, we won’t get there. Or if our business plan is to take the big players head on, then start raising lots of money, see “What makes a start-up successful?

A lesson from Apple, that is not often written about, is that the go-to-market success of the iPhone was driven by their focus on the individual. Traditionally mobile phones where sold through the phone companies and built to the phone company’s specifications. Apple built a mobile phone for the individual. The rest, as they say, is history.

Inside organizations this created a major shift in decision making for mobile technology. Previously the IT department would control what devices would be used and by whom, usually only the executives. The centrally controllable Blackberry was the favored choice by IT Departments.

Apple changed all that, or at least their customers did.

It started with the “bring your own” device movement where employees started using their own devices which were better than the ones their companies were providing. But it really changed when the CEO brought in their iPhone, and later their iPad, and told IT to put their email on it.

The customers changed the IT Department, we didn’t need to get them to sign up!

Let’s look at two industries, Health Care and Financial Services, to see how we can go about building the network effect. The key is to focus on the individual along the lines of a "bring your own solution" model because the incumbents won't. They will want to play using their model.

Health Care Industry

If ever an industry needs help it is health care.

There have been billions of dollars spent on improving patient record; keeping, sharing and processing systems, by governments and large IT service and product organizations. Yet when we unfortunately have to access the multiple vertical silos of health care it still feels like we would be better off applying leeches to our bodies.

A major impediment to doing anything within Health Care is the hugely fragmented nature of the industry. It is an industry made up of many, many different players, organizations and groups; health departments, doctors, specialists, nurses, pathology labs, hospitals, treatment centers…

If we think that we can get all of these people to work together, we need to think again.

But if we focus on the patient, the customer, we have a chance. Instead of building a patient record system for the doctor, hospital or the health department what if we were to build one for the patient.

The parts are all there, wearables that can track our heart rate, level of exercise, blood pressure, glucose levels, heart rhythms, as well as Apps for our mobile phones to look at MRIs, store information, track calories and provide exercise routines. With so much health information on the Internet, some great, some not so much, we are now seeing the growth of certification standards to help people work out what to believe.

What seems to be missing is an app that is built specifically for the patient (please add in examples you may know that does this in the comments section).

The disruptive change is to make the patient an expert in their medical condition.

If we connect the already available existing parts, create an intuitive way of accessing and sharing information, we are well on the way of meeting the patient’s needs. By focusing on the patient and not the medical industry we are more likely to build the critical mass of users that we need to create.

Our next step is to begin to connect the industry. This can be done by starting with industry standard APIs for sharing information. The patient’s app is able to collect and store the patient’s personal information. The permission required to do this is coming from the patient themselves. It is not a medical organization asking for permission because the app is focused and controlled by the patient and not the other way around.

Therefore, it is the patient that is connecting the dots, building the network effect, and not some centralized IT system being implemented by a Health Department, Hospital Group or technology start-up.

And because the patient is the person who is most interested in connecting the dots it has the best chance of being successful.

Financial Services Industry

Fintech is the latest buzzword. Every day we read about another start up that is disrupting the financial services industry.

And the buzz technology inside the Fintech industry is Blockchain. A key dynamic of blockchain is that it enables peer to peer markets. This provides a fantastic opportunity to focus on the individual.

However, the major banks are climbing on board the blockchain band wagon. They have their innovation projects underway. Most of these projects are working on using blockchain to lower their costs of processing. If our Fintech start up’s value proposition is processing efficiency, it will run head on into the banks’ blockchain efficiency projects. Start raising some serious money.

Banks play a key role in the financial services industry. They are the hubs that help distribute money between organization and individuals. They provide the hub and spoke connections of the financial world.

The disruptive change with blockchain is that you don’t need hubs.

A peer to peer network doesn’t operate through a central hub, it doesn’t need the role banks play today. It will be interesting to see how many innovation projects at banks have as their mission to cannibalize themselves.

For our Fintech start-up to grow critical mass and leverage a network effect it has to use technology, like blockchain, to create a peer to peer network, focusing on the individual. The key point here is that the business model cannot be based on our start-up being a virtual hub which clips the ticket of every transaction. That’s how banks work.

We will need to make money in other ways and there are a lot of clever people working on how to do that right now.

The critical mass of people is waiting to sign up to the right peer to peer solution. We saw them protesting on Wall Street, calling themselves the 99 percent. Our solution therefore must focus on them and not be a replica of the 1%.

Back to Metcalfe’s Law

To close out where this began. Forty years after Metcalfe first talked about the network effect he was asked to actually try and prove it. In his lecture at Texas Engineering Metcalfe used the average monthly users of Facebook and compared it to the revenue Facebook generated.

Metcalfe was able to show that the resulting diagram matched his law, that the value of a network was equal to the square of the number of participants. Value = n2. Q.E.D.

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