The Cold Start Problem summary

Those crazy cats in Silicon Valley love their buzzwords and slogans. But right now there’s one phrase eclipsing all the others: network effect. It’s used so often, by hopeful entrepreneurs and established CEOs alike, that it’s become something of a joke.

When start-ups pitch to investors, they kinda use “network effect” as an answer to every question. They’re asked How will you deal with competitors? Their answer? Network effect. They might get the question: How will you scale in foreign markets? They’ll answer: Network. Effect.

But what on earth is network effect and why is everyone talking about it?

To explain network effect, let’s take a look at Uber. Uber grew, district to district, city to city, all across the US, until it became the massive global company it is today. And it grew through the network effect.

It worked like this: as more users joined the Uber app, the more likely it was that they’d find others to share a ride with. Naturally, this also meant that drivers found it easier to locate someone who needed a ride. As more and more people interacted with the technology, the more exponentially the network grew. And the more lucrative Uber became. This is network effect.

But to understand things even better, let’s go back in time and look at an earlier technology: the telephone.

At the beginning of the twentieth century, there were fewer than 5 million telephones in the US. These 5 million phones had to serve nearly 90 million Americans. But one phone company, the American Telephone and Telegraph Company – today’s AT&T – was growing fast.

At the heart of that growth was company president, Theodore Vail. He understood network effect better than anyone at the time. In 1900, he observed that a telephone without a connection is one of the most useless things in the world. If no one else has a phone, how on earth can you call them? You need other people to have a telephone for it to be of any worth.

Vail put it this way: its value depends on the connection with the other telephones and increases with the number of connections.

And that is the network effect in a nutshell. Whether we’re talking about apps, from Instagram to Snapchat, or rideshare companies like Uber and Lyft, the product is only as valuable as the network using it.

Take the network away and the product simply ceases to exist.