What Is The Value Of The 'Network Effect'?

Includes: AMZN, FB, GOOG, LNKD
by: Mike Arnold

Last weekend, I attended Start Up Weekend which is designed to bring people together to pitch ideas, organize teams comprised of people with relevant and complementary skill sets (software developers are known as hackers; design folks, hipsters; and non-technical business development types, hustlers), then teams set out to build a "minimum viable product," acquire customer validation, develop a viable business plan, and pitch the business to judges at the end of the weekend.

Interestingly, but maybe not so surprising, was the fact that many of the pitches were related to mobile applications or web services allowing people to "connect" and for "shared experiences." Those ideas build on the idea of collaborative consumption, and connecting people who might not have been connected before, which is the value proposition of social media.

For example, LivFly, the winner of Start Up Weekend Portland, is a mobile app allowing people to find a running partner. GiveDaka, is an online gift giving service, allowing groups of people to pool resources for gifts. DreamPath, is a web service which aggregates data to help people find their dream job. Interested in these services? Go sign up!

The common theme running through most of the business ideas last weekend revolved around accessing user data from established social media platforms like Facebook (NASDAQ:FB), LinkedIn (NYSE:LNKD), and Google + (NASDAQ:GOOG), then using the data for more targeted, specific purposes.

So, that begs the question. How exactly can one value Facebook or LinkedIn based solely off their current operations? In my mind, the economic power of these social media platforms has not been fully established yet, and as more users sign up to each platform, they become more valuable to other businesses wanting to use the data to solve other consumer pain points. Of course, accessing the social media platform's data will come with some sort of license fee based on traffic, number of users, etc.

Therefore, I can envision these platforms extending their revenue base from solely advertising revenue. LinkedIn, by the way, is already doing that, by offering a premium subscription and tiered service.

Alternatively, with so much innovation occurring in the social media industry, it could be possible that a new platform disrupts the established players. For example, look at Pinterest, which is now the fastest growing and third largest social media platform, behind Facebook and Twitter. In my view, the barriers to enter the social media space are very low, so it's hard to determine which platform will be the dominant social network 10 years from now. Not to mention, tech giants (with more diversified businesses and ecosystems) such as Google can and do enter the market. Google + is now reported to have upwards of 350 million users.

Surely, Facebook with its 1 billion + monthly active users is the giant in the room, but reports indicate they may be losing monthly active users, indicating it may be in a precarious position as old and new entrants compete for user share. If users get more utility out of a competing platform, it's easy to defect. For me personally, Facebook has become less attractive because it feels a little stale. It's also not as powerful to promote start up businesses, as say Twitter or LinkedIn, in my view.

The power of the network effect, though, is unquestioned, and I can envision other ways Facebook and LinkedIn might monetize the value of the user information they hold. But it's terribly difficult to get a good gauge on future subscriber counts, and the level of activity on each site, considering the number of social media platforms being created, and the fickle nature of the user.

When I can't bring a unique angle to a business's operating model, or can't fully understand the competitive landscape in which they operate (currently and prospectively), that is an indicator in my mind to avoid an investment, as tempting as it is to invest in services I understand and have used dutifully in the past, and continue to do so.

The other unique insight I developed over the course of Start Up Weekend is that every tech-based startup is interested in the cloud. The public cloud, that is. And, in particular, Amazon Web Services (NASDAQ:AMZN), to host their back end systems because AWS is seen as the service and cost leader, allowing startups to reduce time and cost to market.

It is reasonable to assume then that once a public cloud vendor captures a startup, they potentially have their business for the life of the enterprise, a more stable recurring revenue stream. The model is different from a social network: cloud service providers are running business functions, not managing social media users and ad platforms. The public cloud vendor customer model is perhaps more similar to how Gillette [owned by Procter & Gamble (NYSE:PG)] sends a free razor to young men when they turn 18; they want to instill a sense of brand and value awareness, and loyalty for the rest of the consumer's life.

I think the public cloud vendors (i.e., Amazon) will become more valuable down the road once the successful startups they host turn into enterprise level customers, and rely on cloud services more heavily.


Always be on the lookout for unique investment insights. Start Up Weekend reinforced to me that the social networks are extremely powerful tools, with many potential ways to monetize the user data retained within the network. However, figuring out which social network will be the dominant platform 1, 3, or 10 years from now is a difficult task. Therefore, Facebook and LinkedIn are 'avoids' in my book because their current valuations are priced for significant future growth.

Not all the social platforms will grow at the pace expected by Wall Street, I just can't figure out who will.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.