Google, Microsoft, Facebook, Apple. What do these companies have in common? They print money. Even if these companies failed to innovate anything remarkable in the next 5 years, they would still be huge players, and highly profitable. This isn’t just a prediction, look at the last 5 years of Apple’s product development. Between 2001 and 2010 Apple released three category-defining devices, the iPod, iPhone, and iPad. In the last 5 years? Airpods.
The lifeblood of all these successful companies, the sword they live and die on, is their network effects. A network effect is just the phenomenon that as usage of a particular product or service increases, so does its value. No one would use Google if it couldn’t provide you with the best search data, compiled from its vast user-generated data lake. No one would use Excel if it wasn’t the standardised spreadsheeting tool, and no one would use Instagram if their feed was empty.
In this day and age, it’s pretty much impossible for any company to reach a significant size, or profitability, without leveraging network effects. Network effects facilitate organic adoption of your service, they keep the cost of acquiring customers down. They also act as the magic fairy, that sneaks into your servers every night, injecting value into your platform in the form of user-generated data or content. All while your development shares a few overpriced, gluten-free, carbon neutral ales.
With network effects, every employee at your company can go to sleep at night and wake up to a bigger, better, and more valuable company in the morning. This is true leverage.
My opinion, however, is that network effects as we know them are coming to an end. Certain companies with incredible products (Excel, Netflix, perhaps Google search) may have their tentacles so suffocatingly wrapped around an industry they can rest on their current network effects, but new companies — the disruptors, in the majority of cases will have to leverage new weapons that are sharp enough to slice open the strong grip of incumbents.
These new weapons are all of the same family. Web3.
Network effects in Web3, are just like network effects in Web2, only more so. We’ll now explore some of the fundamental advantages Web3 network effects have over Web2, and why these advantages will be too great for disruptive startups to ignore.
If you’ve ever watched a sports game you’ll notice that whenever there’s a slight lull in the tempo, whenever the producers are unsure how to entertain the viewers, the go-to, fail-safe option is to show an attractive woman, preferably made up in all the team kit and maybe some cute face paint.
Whether you think these kinds of tactics are permissible or backward is beside the point. The market has decided that, in its current stage of ego and cultural development, this is what it wants to see. Inevitably this practice will dissipate as society develops, but I get distracted, I’m not trying to make a point on culture progression here.
The point is, that this attractive woman, brings more value to the sports game, to the TV audience, and therefore to the club, than an average-looking bloke drinking a beer. They both paid the same for a ticket, they both receive the same rewards (nothing except the enjoyment of the spectacle) yet, their contributions were different.
This, albeit rather a strange example, personifies a critical point about networks, not every contributing node on the network is equal, some nodes add far more value than others.
Web2 systems struggle with valuing different contributions from nodes differently. If I use Google religiously if I leave reviews of every restaurant I visit, if I use Waze (Google-owned) to meticulously report every traffic incidence and pothole, my value to the Google ecosystem is far higher than your Grandpa — who uses google once a year to do some Christmas shopping.
Yet, and this is the completely backward thing about Web2 network effects — both your Grandpa and the power-user described both get the same reward from the network, free access to Google products. This is the same reward every node receives, because, from Google’s point of view, every node is equal.
Web3 unlocks the ability to treat nodes individually, this is because DAOs can decide through decentralised, on-chain mechanisms, what behaviour is desirable for a node, and choose to reward the node proportional to the extent of that good behaviour. One way this is achieved is through ownership as a reward.
One of the problems with Web2 companies is that they are quite limited to how they give rewards to different nodes on a network. As an Uber user, I can refer my friends and get £10 in credit, but this isn’t really enough of an incentive for me to promote it over other ride-sharing services. Likewise, I might be incentivised to fill in a feedback form for Amazon, in the hope of having a slim chance of winning a voucher — not that exciting.
What is exciting though, is ownership. Equity is what separates the wealthy from the poor, and we are living in a time where society is waking up to the fact that if you want to gain real financial security, you need to own assets, not liabilities. Earning credit, to be spent on a Web2 product is inherently a liability, credit does not produce wealth, inflation ensures that if I hold onto it, its value will gradually decrease over time, and if I purchase something with it, I’ve got a liability.
If though, rather than receiving £10 in Amazon credit, you could receive £10 of Amazon stock, all of a sudden that’s a value-producing asset you hold. An asset that has the potential to increase in price at a greater rate than inflation, contributing to your financial security.
Web3 companies, through the simple fact they are tokenised, and tradeable on a highly liquid decentralised protocol, allow effective ownership in companies to be distributed as rewards.
It’s no secret that, at least to gain initial traction, many startups lean heavily on referral mechanisms. They are cheap — in Airbnbs case, they can acquire a new host who may bring £0000’s in fees over the course of their lifetime, for just a few hundred pounds. They are also highly effective.
Generally, though, referral mechanisms lose their punch over time. As soon as everyone (or at least the low-hanging fruit) has been onboarded in a local area, there’s just no one left to refer, or the cost to do so increases considerably. This is an issue, as a company moves from the acquisition of new users to trying to extract more value from each user, one of their most effective leavers becomes redundant. As an Uber customer, I’m incentivised to encourage friends to use the service one, but I have no incentive to encourage them to continue using Uber over competitors after this.
One of the innovations of tokenomics is the concept of a staking/rewards pool. This is a pool of tokens that is reserved to reward token holders or those who most contribute to a project. An interesting trend is we are seeing is these reward pools being used to drive new users to a platform, usually, this is in the form of yield farming, where users stake their tokens in order to gain access to tokens in the reward pool, kind of like depositing money in the bank.
There’s no reason these mechanisms couldn’t be used to provide deeper referral structures. If as a referee, I was not only incentivised via tokens to bring new users onto a platform, but also saw an upside on every transaction they completed, you make use of Ponzi-game incentives to motivate users to care about the lifetime value their referees gained from the system. This could encourage greater sharability or virality of services.
For example, imagine you are a customer of a service that delivers beauty treatments to your door. You are partial to a weekly manicure. If this service was a Web2 marketplace, in which you had no real buy-in, you might be inclined to snap a quick picture of your freshly spruced hands on Instagram, perhaps with a pithy line to accompany it. The difference in Web3 is that if you’ve referred a few of your friends to use the service, you can be exposed to the upside of their repeated use, you’d therefore be far more likely to tag the service provider, in the hope to nudge some of your friends to use the service again, rewarding you financially.
My hypothesis is simple. Disruptors trying to compete with incumbents in established industries who have heavy network effects are going to be at a major disadvantage if they don’t utilise Web3.
Unless the product is 100x better than something that exists, or their growth-hacking team is out of this world, it’s just going to be very difficult to displace incumbents, without leveraging Web3.
Web3 is a tool, that by definition, is much harder for incumbents to utilise. The chance of Facebook tokenising their products is minuscule. They have complex cap tables, legal structures, and generally aren’t set up to take advantage of Web3. However, Deso or similar applications can start from a clean sheet, they can bake Web3 capability into their products from the outset, ensuring that early adopters gain ownership of the product, and incentives are set up to reward users who provide value to the system.
In effect, all companies that rely heavily on network effects to scale will need to adopt a Web3 model. It’s the only weapon that’s currently sharp enough to slice through the sticky, powerful network effects of established Web2 companies.
At Lithium Ventures, we are on the lookout for companies who are looking to compete in lucrative industries via a Web3 model. If you want to build the next Uber or Doordash, we’d love to hear from you. If you are looking to build the next Airbnb, maybe think of an easier incumbent to displace…
