Traditional companies are structured as pipelines. A company acquires a raw material, transforms it, and then sells it to customers. Products travel one way through this pipeline while money travels in the opposite direction.
For a pipeline company, profitability means being able to sell a product for more than the cost of acquiring the raw materials plus the cost of transforming them, a fact which has two important effects: Gross margins and operating margins are important metrics for valuing the company; and value is created inside and by the company.
Platform-type companies work differently. They do not create value, but rather provide a place for other producers and consumers to transact. A medieval market is a good example. The market itself would not grow vegetables or sell milk, but it would provide a place where others who do that could interact with demand.
This means that value is created outside a platform company, by those who use the platform. To that end, the assets that create that value are also outside the platform- although from the perspective of any value the platform itself obtains from its users, the users themselves are the assets of the platform.
This inversion of value and assets allows platforms to scale more easily than pipeline companies, for four particular reasons.
- Bottlenecks in internal processes are removed
- Value creation is done by users, so the energy and resources of the combined userbase is available, not just a proprietary employed workforce
- Community feedback provides ongoing market information about the direction in which growth should aim
- Corporate functions can be taken on by the community; for example, Facebook didn’t have to (pay to) market itself as its users would tell their friends about it
Exponential Value Growth
Consider a pipeline company which takes in N amount of product (input) and increases the value of that product by a factor of 2. The value of output is 2N. Increasing N by one unit of input, to N+1, means the value of output is 2(N+1), which is 2N+2.
Now imagine a platform company with N users, each of which can interact with any other user. There are a total of N(N-1)/2 possible links, which is (N2-N)/2. Now add another user and he or she can interact with every single one of the N existing users, creating N more possible links (the number of possible links increases to (N+1)N/2, or (N2+N)/2, which is N larger than (N2-N)/2).
So while for a pipeline company growth is linear and increases by a function of the value-increase multiplier, for a platform company growth is exponential and grows by a function of the existing number of users. The bigger you are, the bigger the value of each new user.
For example, imagine a watch company has 1,000 employees, each of whom can make 1 watch per year, for a total of 1,000 watches. Add one employee, and the total output goes to 1,001 watches. Now imagine a platform for the buying and selling of watches, with 1,000 users on it. A new user joins, and this person can contract with any of the existing thousand users; 1,000 new links are now possible.
Network Effects
This exponential increase in value from every new buyer and seller in a market is the source of what are called network effects. Once a platform reaches a certain number of users, other users will obtain a large value based on the number of users, so they too will join it. An identical platform set up to compete with it- same prices, same UX, same everything- will be less valuable because a new user will have less people to interact with.
Network effects are a powerful source of defensibility for platform companies. They allow first movers or those with an advantage in marketing or brand to grow to a size where, by the time the competition has heard of them, it is too late to replicate what they have done and take their customers.
Huge valuations in recent tech company sales and IPOs partially reflect the fact that one of the only ways to remove a competitor with entrenched network effects is to buy it.
Two caveats about using network effects for business planning. First, network effects do not apply to pipeline companies. Dominating a market through an efficient production process and brand does not stop a competitor replicating your production model and thus your market share.
Second, achieving a number of users such that defensible network effects begin to operate means a platform company has succeeded (subject to it one day being able to find a way to monetise those users). Thus, network effects can be thought of as an output of success, an indicator that you have reached a milestone; don’t include them in the business plan as a way to reach success, i.e. as an input for it. You need to explain, convincingly, that your platform has all the features that will bring in users- “network effects” is not a magic phrase to guarantee anything!
Platform Features
Three things happen on a platform.
- Information is exchanged
- Goods are exchanged
- Payment is exchanged
Note that payment does not have to be money for every user, for example on YouTube just watching an ad might be your payment. But somewhere among the tangle of interactions (producers and consumers of videos, producers and consumers of adverts, and then their relationships with each other and the platform) money is changing hands, and the platform is taking a part of that.
On either side of these exchanges are users, who in any given interaction will be either producer (Uber driver) or consumer (Uber rider), or for a non-financial transaction, both (Facebook friends sharing photos).
Users are exchanging units of value. As mentioned, that can be time, goods, services or money.
And for the huge number of users to find the exact one they are looking to interact with, and the exact unit of value they want to exchange for, there is a filter.
This means a platform must contain users, value units, and filters, allowing for exchanges of information, goods, and payment. We know that on platform companies it is the users who create the units of value, so that is not necessary for the company to do. The roles of the platform provider then become:
- Bring in users
- Allow them to find what they want
- Facilitate their exchange of value units and payment
Monetisation
Clearly the more value a user gets from this experience, the more they will interact on the platform and the more other users will join up. You can then take a small amount of money from each transaction. A few things to consider regarding the monetisation plan:
- One of the great benefits to a platform company is that it allows for so much market feedback. Keep any monetisation plan flexible, as the market might lead you to a better plan, and will almost certainly direct your pricing.
- Maintain a core interaction that is simple and cheap. Fancy add-ons and nuanced curation should always remain just that- add-ons.
- Both producers and consumers value curation. That is the platform’s role in keeping out bad or unbalanced users. Think rotten apple sellers in the medieval market, or Tinder with 90% men.
- Monetisation should be as little of a friction as possible, because every friction is a blocker to the exponential growth that will drive your platform’s value. The more signing up and card details users are made to do, the more they’ll not bother at all.
- Keep a close eye on your user journeys to determine the stages at which users fall off the intended user journey.
- Don’t start to charge for things people previously had for free, as they get angry and leave. Charge for new things, better curation, more access, and so on.
Most of all, listen to the market. Ensure you have good channels for users to feedback to you what they do and don’t like, and keep an open mind as you read the data that comes in, which is how they tell you their real feelings.