Dennis Schaal, from Skift, explains that claims of an unyielding network effect are often so much hot air such as when Expedia claims that it has “mutually beneficial supply agreements” that reinforce its global marketplace. Still, when companies such as TripAdvisor, which attracts more than 100 user reviews and ratings per minute, truly achieve a network effect, their growth can be exponential.
It is sometimes a wonder that so many travel startups fail and that even mature travel businesses slump when you consider that companies such as Expedia, GoPro, TripAdvisor, and Sabre make it all look so easy as they tout their purported “virtuous circles” or “virtuous cycles,” and paint a portrait of seemingly unrelenting growth.
What is the “virtuous cycle” and why does it matter?
Consider that Expedia over the years has published depictions of its virtuous circle and virtuous cycle (2010), noting that “scale drives opportunity to enhance supplier, traveler & advertiser value propositions,” and this, in turn, “rewards stakeholders.”
It is ironic that despite the network effects of Expedia’s “volume and global reach” and the consequent impact on travelers, supplier partners and advertisers, Expedia’s king-of-the-hill status has been toppled by TripAdvisor as the “largest online travel company in the world.”
TripAdvisor touts the attractiveness of its business model, where content brings eyeballs, “audience drives leads,” and community builds content, which leads to ever larger audiences.
The stock-market IPO darling, GoPro, which raised $427 million at its Nasdaq debut, states: “We believe our business focus results in a virtuous cycle and a self-reinforcing consumer acquisition model that fuels our growth. Our products in the hands of our customers enable compelling, authentic content that organically increases awareness for GoPro and drives demand for our products.”
Note to GoPro: As a mobile and video-gadget company, couldn’t you have come up with a virtuous cycle graphic that was a bit more visually appealing?
Scale Doesn’t Equal Network Effect
If numerous travel companies tout their potential for endless expansion a bit too vociferously in these virtuous cycle/circle graphics, then Rich Barton, venture partner at at Benchmark Capital and founder of Expedia, argues that many companies confuse the distinction between scale and a network effect.
“Some businesses really have these virtuous cycle network effects, e.g. TripAdvisor, Yelp, Glassdoor, Google, SnapChat, Uber, Ebay, Grubhub, and Trover (we’re on our way),” Barton says. “Most businesses do not really have a true network effect.”
Inside and outside travel, a network effect is often the holy grail.
“However, everyone wants one, and what happens is they confuse economies of scale with a network effect, conveniently,” Barton says. “They think, well, business gets better as we get bigger, costs go down etc. No. To have a true network effect the value of the nth user must bring non-linear benefit to the whole system, entrenching a platform.”
A Bit Fluffy, But Some Truth in Virtuous Cycles
Jeff Richards, managing partner of GGV Capital, says virtuous cycles sound a “bit fluffy,” but they can be “accurate to some degree. Scale is a big deal in Internet and mobile businesses. I’m not sure how ‘virtuous’ they are (virtuous means ‘having or showing high moral standards’).”
“Scale enables economies of scale,” Richards says. “It tends to drive down prices for consumers, which is a good thing. Prices going down for consumers means somewhere margin has come out of the system. Travel agents — gone. Hotels charging consumers full price at the last minute — gone.”
When companies reach scale, Richards says, this spurs technology investment, which can “drive better experience for both supply and demand.”
But scale, Richards says, isn’t the be-all and end-all.
“There is constantly room for innovation in a category as large as travel,” Richards says. “Qunar has risen despite Ctrip’s early leadership in China. HotelTonight has risen despite a seemingly crowded hotel booking category. Uber has risen despite a seemingly crowded taxi market.”
In other words, innovation can trump virtuous circles and damage the perfect circle.
“Perhaps it is ‘virtuous’ for the innovators, consumers, and suppliers who embrace the innovation,” Richards says. Not so virtuous for incumbent players who can’t adapt. Unless you have a fixed supply with high cost of entry and regulation (see airlines).”
Among other examples of travel businesses and organizations waxing on about the benefits of the virtuous cycles they embrace:
U.S. Travel boats of the virtuous cycle inherent when travel advertising triggers an increase in visitors, visitor spending, as well as new jobs and tax revenue.
On the virtuous cycle of travel marketing and promotion, Chicke Fitzgerald, CEO of Solutionz Holdings, says “the challenge is that all investment in innovation in the industry continues to focus on inspiring vacation travel (which represents just 8% of overnight travel in the US) and capitalizing on business travel (25% of overnight trips), when travel spending really comes from the other 67% of travel that is pure ‘life’ (care travel, event travel, life event travel).”
“Investment in the niche that is vacation and business travel is simply not sustainable long term,” Fitzgerald says. “You can’t serve 32 people in a room of 100 and ignore the other 67. “It just doesn’t work.”
Getting virtuous about travel marketing and promotion “means focusing marketing and promotion on those that drive, as well as those who fly and those that are traveling for the many reasons beyond vacation and business.”
Sabre’s Virtuous Cycle
Travel tech com pay Sabre didn’t publish a graphic, but described its own alleged virtuous cycle in its IPO papers:
“In addition, we believe that our business benefits from a virtuous cycle,” Sabre stated. “As we add more supplier content to our marketplace, we experience increased participation from buyers of travel. This, in turn, encourages travel suppliers to contribute additional content to our marketplace, driving a virtuous cycle.”
Consultant Daniel Edward Craig of Reknown argues that the reputation management industry is one big virtuous circle where user reviews trigger hotel improvements, which lead to greater guest satisfaction, better reviews and increased demand — and so on.
Whether it is the purported virtuous cycles of Expedia, TripAdvisor, GoPro, Sabre or other travel businesses employing this online travel meme, creating and maintaining a network effect is never as simple a proposition as they portray.
But we cannot forget that these kind of travel companies -and all that are appaering in the last years, as Airbnb, Uber, etc..- are really internet companies, so we must contemplate the network effects from that perspective. And they’re the holy grail of online business.
What is a network effect? It’s what happens when the value of a product to one user depends on how many other users there are, as economists Carl Shapiro and Hal Varian put it.
Examples include Microsoft Windows and the phone network. Windows is valuable because most other software is made for Windows, which makes more people buy Windows, which makes more developers build their apps for Windows, and so on and so forth in a virtuous circle.
Network economics online get people’s hearts racing so much for two reasons: first of all, because the internet is at its base a communications network and so network effects tend to happen more there, and second of all, it’s one of the few strong barriers to entry in a market where there are so few.
But one way that network effects can be defeated is through what we’ll call «verticalization.»Craigslist is perhaps one of the best network effects businesses: the reason why everyone goes there is because everyone is already there. Plenty of people have pointed out how awful Craigslist’s design can be, how many things are wrong with it, and yet plenty of well-funded startups that have tried to take Craigslist on frontally with slicker offerings have foundered.
And yet… And yet, Craigslist’s traffic seems to be plateau-ing. Why? This graphic by VC Andrew Parker shows why:
Andrew Parker
While no service has been able to defeat Craigslist head-on, plenty have built «niches» in specific verticals, with a more tailored offering, and now Craigslist seems to be stalling. And some of these «niches» are big: Etsy, AirBnB and Ashley Madison are huge businesses.
It’s worth pointing out here that the two most successful online companies–Google and Amazon–don’t benefit from network effects, but from economies of scale. Google search gets better the more people use it because it gives Google more data about what people search for and how, which helps them refine their algorithm. But Google search isn’t a network. Amazon also benefits from economies of scale like any other retailer: their size allows them to get better prices from suppliers and operate more efficiently, which allows them to pass on savings to consumers which makes them even bigger. These are scale externalities, not network externalities.
Which brings us to why did Facebook win and not Friendster and MySpace? Gross incompetence on the part of the incumbents, Sean Parker says. Which begs the question: if Facebook won thanks to better execution, how is that different from any non-network effects business? The answer is that it’s not black or white. Facebook was helped by superior execution AND network effects in highly dense and active social networks called college campuses.
But it shows the limits of network effects as well. What the story of Craigslist and Facebook shows is that online network effects are strong barriers to entry to FRONTAL competition but not to LATERAL competition. And lateral competition can be just as dangerous–perhaps even more, because it’s easier for the incumbent to miss.
This overblown faith in network effects can lead investors and analysts to make mistakes. In a now-paywalled PEHub interview, a parnter at Founders Fund, a big Facebook investor, said they had the opportunity to invest in Zynga but didn’t because they thought social games were a hit-based business without strong network effects. They were right. It just happens that social games are a very profitable business and that Zynga was able to parlay its first-mover advantage into economies of scale by spending more than anyone to acquire players for its social games. To be fair, hindsight is 20/20 and every top VC has turned down at least one startup that went on to become a huge success. The point here isn’t to pick on anyone, it’s to show that people may pay too much attention to network effects.
Groupon, we’re told, has no barriers to entry and therefore can’t be worth so many billions of dollars. It turns out that building a business with 50 million subscribers in dozens of countries selling to thousands of merchants is really really hard and that the daily deals market, like e-commerce, has low barriers to entry but high barriers to scale. Groupon is still huge and growing fast, and so is the second-comer LivingSocial, but well-funded well-staffed followers like BuyWithMe are nowhere. First prize is a Cadillac, second prize is a set of steak knives, third prize is you’re fired. It’s no coincidence that Groupon came out of Chicago and not Silicon Valley, where the belief in network effects is the strongest.
Gilt Groupe, which should do $500 million in revenue this year, also doesn’t have network effects, and that doesn’t seem to stop them.
The three startups we’ve mentioned have not network effects but all of them have economies of scale. Again, the point here isn’t to say that there is no such thing as network effects or that they’re not great. There is, and they are. But they may be overhyped, specially in the travel industry, where execution is key, due to the complexity of the business and the very reduced margins, and economies of scale will be fundamental to be globally competitive.
Sean Parker says: «Companies that harness the power of networks will dominate the future of the internet.» That may be true, but I firmly believe that this alone will not be enough.
