Commercial Due Diligence and Value Generation via Network Effects

Many attractive investments are predicated on network effects – these are businesses that connect users, buyers, and/or suppliers. Companies like Visa, eBay, and LinkedIn have famously enjoyed the benefits of network effects to accrue immense, highly durable value. Outside of software, businesses such as recruiting, retailing, media, health provider networks, and many others, enjoy network effects benefits.

Understanding where network effects will hold and where they may break down is critical for evaluating a deal. Target companies in network-effect markets face two major risks:

  1. Being overtaken in a hypercompetitive market where network effects are strong; or
  2. Being intermediated in markets where the network effects are muted

How do you know if a market is “just right”? We have found that investigating a few questions can suggest the answer.

  1. Do perceived switching costs for users increase the more they use the service?
  2. Does the service get better with each new user?
  3. Is there growth headroom? (see our pieces on conducting diligence on adoption/ growth and effective market sizing)
  4. Are the habits associated with the target company’s service easier for a user to form than those associated with a potential aggregator? Ben Thompson has a thought-provoking aggregator definition here.
  5. Are customer acquisition costs low?

Repeat these questions for each side of the market. Each “yes” increases the value of a network strength in the market.

Facing hyper-competition in a market with strong network effects: These markets can create a hypercompetitive space where winner takes all. At breakthrough moments, it may be just one product’s subtle change that unlocks easier habit formation, and these small changes can change the market overall. Myspace was a hit, until Facebook made it irrelevant – new habit formation around the “news feed” altered social network usage dramatically. Social networks are at least a “6” on our scale: buyer beware markets where winner takes all – they may be great to win but are disastrous to lose.

Being intermediated in a market with weak network effects: The relatively slow growth coupled with low barriers of entry for food delivery services like Seamless or Grubhub (founded in 1999 and 2005, respectively), left ample room for new delivery companies – Delivery Hero, Deliveroo, Foodpanda, Postmates, Uber Eats, Door Dash, Amazon Restaurants, etc. The resulting complexity can confuse consumers or service providers and create the opportunity for something like Google Maps to gain position as an aggregator. With Google, you simply search for a restaurant and discover which services deliver for that restaurant. Which habit is easier to form: searching Google Maps once or opening multiple food delivery apps? Today, we score food delivery apps around a “2” on our scale.

Network effects are important diligence items, but these same considerations can be used by investors in a variety of sectors to enhance the value of services and products they own or manage today. Can you build in greater switching costs or easier habit formation for your customers?

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