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The decline of brands like Myspace, AOL, Geocities and Bebo is usually explained in terms of lagging indicators such as technological disruption and changing tastes, but inverse network effect is what causes users to run away rather than walk.

And it could happen to Facebook (NASDAQ:FB).

Network Effect

Network effects are usually the result of a first-mover advantage. This is the reason for the disconnect in thinking between many young, acquisition hungry Silicon Valley CEOs who want to get there first, and their long suffering investors who'd like a higher ROE and the least amount of debt possible.

PayPal (NASDAQ:EBAY) actually got very lucky: It didn't have a first-mover advantage, but due to a mistake by eBay's management, it was rewarded with network effect by default. eBay purchased Billpoint in May 1999, before PayPal even existed. eBay made Billpoint its official payment system, rebranding it "eBay Payments", but limited the functionality of Billpoint by confining it to only payments made for eBay items, which led to PayPal's explosion in every other payment space, which caused more and more sellers to include PayPal as an option on their auctions. By February 2000, PayPal was used to pay for over 200,000 auctions a day, while eBay Payments was used to pay on only 4,000 auctions per day. eBay finally called it quits and purchased Paypal two years later for $1.5 billion.

Merchants accept PayPal because consumers have a Paypal accounts. Consumers open PayPal accounts because merchants use it, which forces more merchants to accept PayPal. The more consumers use PayPal, the more merchants take it, and the more merchants take it, the more consumers use it. This self-perpetuating circle of causes leading to effects which amplify the causes what's known in engineering as a positive feedback loop; but the term that can be somewhat misleading. The word "positive", after all, is usually suggests something is going right. In fact, a positive feedback loop is often the worst thing that can happen to you.

Investors think about positive loops constantly, they just don't call them that. Investors break positive feedback loops into two categories: virtuous circles and a vicious cycles. Virtuous circles are what make your portfolio. Vicious cycles break the bank. When a virtuous circle results from adding a new network "node" -when a website signs up a new member- it's known as network effect.

Fig 1. Virtuous Circle (Network Effect)

(click to enlarge)

Fig 2. Vicious Cycle (Inverse Network Effect)

Positive feedback loops are the simplest form of feedback because they requires the fewest variables to become self-sustaining. The loop begins to feed on itself, and the trend becomes parabolic. Compare Facebook's and Pinterest's hyper-growth in the following charts below.

Fig 3. Facebook's Growth

Fig 4. Pinterest's Growth

(click to enlarge)

The charts look like twins because the same network effect is driving growth in both of them. Pinterest is just growing much, much faster. This miracle growth has counterintuitive implications for the health of the company. If left unchecked, any positive feedback loop will ultimately destroy the underlying network.

Diminishing Returns

Social networking is a network model with a diminishing returns problem. Socialization depends upon trust. With the PayPal model, trust is baked into the security features of the site and guaranteed by PayPal; but no one can make you trust people you barely know. If you use Linkdin (NYSE:LNKD), you don't benefit every time a new person joins. Most of your contacts are already members. Real world social motivation is limited to a) increasing your visibility so you can increase your number of trusted friends and b) communicating more with the people you know and trust already.

But communication and trust take time, of which users only have a limited amount. The more new contacts you gain, the less time you have to get to know them or interact with them and your old contacts at the same time. When's the last time you went on Facebook to meet someone new?

When there are more friends communicating than you have time to communicate with, the social experience evaporates into a broadcasting experience. No one else has time to communicate on a personal level with anyone else either. The result is a user base more and more inclined to talk at one another, rather than to them. Over time, the network becomes less about social connection, which users have a limited appetite for, and more and more about entertainment, for which users' appetite is often limitless.

Fight For Control and Ad Bombing

The increasing user load forces the network's management to increase control over the network, while decreasing user participation results in an increase in the number of third-party advertisements the website has to place in order to provide earnings growth.

Myspace's 3.0 update de-personalized the experience for a core audience that had stayed loyal to the network because it allowed for more individual expression than Facebook. At the same time, it decreased user's personal content space by 1/3rd to make room for more advertising. This provided a short term increase in revenues but ultimately accelerated the vicious cycle.

Fig 5. Advertising Revenues Peak

A Virtuous Cycle Turns Vicious

The ironic thing about vicious cycles is how they make use of the same infrastructure as the virtuous cycle. A network's users are plugged into one another by definition, which means that if a tipping point is reached in the number of dissatisfied users, it will infect the whole network using the network's own communication lines.

From voices.yahoo -

I could tell Myspace was dying out as a social site. I no longer enjoyed daily interaction with my Myspace friends as most had left. Most had made the switch to Facebook mainly because Myspace had become to much of a hassle to use and Facebook offered a much simpler and easy to use format.

Fig. 6: Users Flee To Virtuous Network

Conclusion

Social networks have one product, and it's a product that tends to result in diminishing returns unless the network finds a way to re-invent the user experience. Again, Facebook is being oversold right now, but that doesn't make it a buy. The stock showed some support at $20, as I thought it would. In terms of a bottom, I expect Facebook to fall to about the $8-$10 range, at which point I may initiate a long position in the stock.

Source: Will Facebook Go The Way Of MySpace And Geocities?