Most businesses grow one customer at a time, and each new customer costs roughly as much to win and serve as the last. A few businesses grow differently: each new customer or participant makes the product more valuable for everyone else. When that happens, growth can accelerate dramatically, and the business can become very hard to compete with. This is the power of network effects.
A messaging app is the classic illustration. A messaging app with one user is useless. With a few friends, it becomes useful. When most of your contacts use it, it becomes indispensable. The value comes from the network, not the software alone. That is why a messaging company with relatively modest revenue could be acquired for around US$19 billion in 2014: buyers valued its enormous, engaged network of users.
Network effects are not only for technology giants. Marketplaces, distribution networks, professional communities, local businesses and industry platforms can all benefit. Closely related is community-led growth, in which a business becomes part of a community that spreads it from person to person. This article explains five types of network effect, the challenges of building them, and how small businesses can use networks and communities to grow.
What a network effect is
A product has a network effect when its value to each user increases as more people use it. With each new customer, ask: how much more valuable does the product become for existing customers? In a normal business, the answer is “not at all”. In a network business, the answer is “significantly”.
Two consequences follow:
- Value grows faster than cost. Each new participant adds value for many others, while the cost of adding them grows roughly in line with numbers.
- Leaders tend to pull ahead. The largest network is usually the most valuable, which attracts more participants, which makes it more valuable still.
Five types of network effect
1. Marketplace network effects
Marketplaces connect two groups: buyers (the demand side) and sellers (the supply side). Online business directories and B2B marketplaces illustrate this. A directory listing is worth little if few buyers visit, and buyers will not visit if few businesses are listed. As both sides grow, the marketplace becomes more valuable to each.
Marketplaces need both sides to stay healthy. If either side shrinks, the network weakens.
2. Partner and channel network effects
Some businesses grow through networks of partners, such as distributors, dealers, resellers, installers, consultants and franchisees, who connect the business with customers. This is sometimes described as a three-sided network: the business, its partners and customers. When customers are satisfied, partners earn more, more partners join and more customers are reached.
Partner networks depend on a strong, distinctive product and a clear benefit for partners. Training is the main lever for building them: better-trained partners sell more effectively, serve customers better and stay loyal.
Some direct-selling and multi-level marketing schemes use partner networks. Be careful: in Australia, pyramid schemes, in which participants are rewarded mainly for recruiting others rather than for selling genuine products to real customers, are illegal under the Australian Consumer Law. Sustainable partner networks rest on real customer value.
3. Communication network effects
Communication platforms, such as messaging apps, social networks and professional networks, become more valuable as more people join, because people can reach more contacts. Businesses whose products depend on information spreading quickly, such as news, media and content businesses, benefit from these networks, and depend on them.
4. Content network effects
Content platforms grow as creators attract audiences and audiences attract more creators. These networks can be built quickly with social media, but they can also collapse if creators are not rewarded or audiences lose interest. Building a content network requires long-term commitment. Initial enthusiasm often fades before the network becomes self-sustaining.
5. Local network effects
Some networks are local: a dairy delivering to households in a district, a farmer selling to local markets, a trade supplier serving builders in a region. Local networks have strengths and weaknesses:
- Strengths: once established, a local network is hard for newcomers to break into, because relationships, routes and reputation take time to build.
- Weaknesses: local networks do not scale quickly. Because news travels fast in a small market, poor quality can destroy a local position as quickly as good quality built it.
Local networks therefore depend on consistent product quality and a clear brand promise. Some dairy cooperatives and consumer brands have extended local networks by recruiting small local resellers, for example households or small shops that stock products in a fridge and serve their neighbourhood. These networks thrive when incentives are clear and fair.
The cold-start problem
Network effects create a chicken-and-egg problem: the network is not valuable until it is large, but people will not join until it is valuable. Ways to overcome it:
- Start small and dense. Build a strong network in one narrow market, such as one city, industry or university, before expanding. Density matters more than size at first.
- Seed one side. Recruit sellers, creators or partners first, often with incentives or guarantees, so buyers find value from day one.
- Provide standalone value. Offer a useful tool even before the network is large, such as software that helps businesses manage their operations and later connects them with others.
- Use existing networks. Import contacts or connect with existing communities to accelerate early growth.
Community-led growth
Closely related to network effects is the idea of community spread: a business growing by becoming part of communities whose members share it with each other. Community-led growth can:
- Create influence far beyond paid marketing.
- Reduce customer acquisition and marketing costs.
- Build trust, which increases sales.
Step 1: Identify the right community
Ask which community can take your business to many customers. For a payments company trying to reach small online businesses, the key community was not shoppers but web developers and software implementers, because they decide which payment systems their clients use. A pharmacy software company focused on chemists and the pharmaceutical industry. A tax and accounting firm focused on start-up founders and company directors.
Step 2: Reach the community online and offline
Once you know the community, find ways to engage it:
- Online events and campaigns: one payments company organised a hashtag campaign inviting start-ups across the country to pitch themselves in a short message on national Independence Day. Start-ups, investors, incubators and media joined in, the planned three hours stretched to six, and the company gained substantial free exposure.
- In-person events: the same company then ran weekend growth masterclasses for start-up founders in smaller cities, building relationships face to face.
- Dialogue series: an accounting firm created a regular event series for founders, hosted in partnership with an industry body, together with webinars and videos. The series grew to multiple countries and made the firm well known among its target community.
Step 3: Create genuine value for the community
Communities embrace businesses that give them real value, through knowledge, tools, connections, recognition or opportunities. They reject businesses that simply try to extract value. A passionate community can lift a business quickly, and can turn against it just as quickly if it feels exploited.
Even a small local business can benefit. A snack shop that does something unique, connects with a local school, sports club or cultural community, or creates something people want to share can spread through that community.
Network and community thinking for business-to-business firms
Business-to-business companies can use these ideas too:
- Industry communities: host user groups, technical forums, training days or roundtables for customers and prospects.
- Partner programs: train and support installers, consultants or resellers who serve your customers.
- Platforms and integrations: make your product work with other products customers use, so each integration adds value.
- Reference networks: connect customers with each other, through case studies, site visits and peer conversations, so they learn from one another and trust you more.
- Shared data or benchmarks: aggregated, anonymised benchmarking across customers becomes more valuable as more customers participate.
Building a referral network
For most small businesses, the most practical network effect is a strong referral network: satisfied customers, partners and professional contacts who send new business your way. Each new satisfied customer increases the chance of further referrals. To build one:
- Deliver work worth recommending. Referrals follow excellent experiences.
- Ask. Many satisfied customers would refer others but are never asked.
- Make it easy: give customers a simple way to introduce you, such as a short description, a link or a business card.
- Thank referrers, whether with a personal note, a reward where appropriate or a referral in return.
- Build reciprocal relationships with complementary businesses that serve the same customers, such as engineers and fabricators, accountants and lawyers, or designers and builders.
- Track referral sources, so you know who your best advocates are and can nurture those relationships.
Risks of network and community strategies
Networks and communities carry risks as well as benefits:
- Concentration: if one platform or community provides most of your customers, changes in that platform’s rules or the community’s mood can hurt badly.
- Quality control: partners and community members represent your brand. Poor behaviour by a few can damage reputation.
- Free-riding: some participants take value without contributing.
- Moderation and conduct: online communities need clear rules and active moderation to stay constructive.
- Privacy: communities and networks involve personal information that must be handled carefully.
Plan for these risks from the start, with clear partner agreements, community guidelines and diversification of customer sources. A community or network built on genuine value, fair rules and consistent quality is far more resilient than one built on hype or incentives alone.
A worked example
A small company builds a scheduling and job-management app for independent electricians. Rather than marketing to all trades nationally, it starts with electricians in one city, offering a free version that is useful on its own: quotes, scheduling and invoicing.
It partners with the regional electrical contractors’ association to run evening workshops on running a profitable small electrical business, demonstrating the app and inviting members to share tips in an online group. It adds a feature letting electricians refer overflow jobs to trusted peers who use the app, creating value that grows with every electrician who joins. It also integrates with a major electrical wholesaler’s ordering system, so electricians can order materials directly from jobs.
Within two years, a large share of the city’s independent electricians use the app, the referral network is valuable enough that new electricians join to access it, and the company expands city by city using the same approach.
Frequently asked questions
Can a traditional business have network effects? Some can, for example through referral networks, partner programs, communities of users or platforms that connect customers with each other. Even when true network effects are not possible, community-led marketing can deliver many of the same benefits.
Are network effects permanent? No. Networks can decline if quality falls, if a better network emerges or if participants lose trust. Keep delivering value to every side of the network.
How long does community-led growth take? Usually longer than paid advertising to show results, often several months of consistent effort, but its effects compound and last. Communities built on genuine value continue to bring customers long after a campaign would have ended.
How do we measure network strength? Track the number of active participants on each side, engagement, how often participants interact with each other, retention and how much new users rely on existing ones, such as referrals, connections or transactions.
Summary
Network effects occur when each new participant makes a product more valuable for others, so value grows faster than cost and leaders pull ahead. Types include marketplace, partner and channel, communication, content and local networks, each with its own dynamics. Overcome the cold-start problem by starting small and dense, seeding one side, providing standalone value and using existing networks. Grow through communities by identifying the community that can carry you to many customers, engaging it online and offline, and creating genuine value for its members. Business-to-business firms can apply the same ideas through user communities, partner programs, integrations and peer networks.
Sources: small-business training notes on network effects in marketing and the power of community for business growth, including examples from Indian companies, together with general strategy literature on network effects. Examples are illustrations.
