Competitive advantages come from switching costs, network effects, proprietary data, brand, scale and distribution. Network effects are especially powerful, and especially often claimed without evidence.
11 min read · Level 1
I think the phrase network effect should be treated as a hypothesis until a company can show its product getting measurably better or stickier as it grows. It is the most valuable moat in technology and also the most casually claimed, and the difference between the two is usually visible in the retention data.
A moat is a durable advantage that makes it hard for competitors to take customers or profits.
Source What it means Example Switching costs leaving is costly or disruptive accounting software holding years of records Network effects the product gets better as more people use it a marketplace with more buyers and sellers Proprietary data information competitors cannot obtain medical imaging data Brand customers prefer and trust it a trusted consumer name Economies of scale unit costs fall with volume a large logistics network Distribution privileged access to customers bundled with an existing product
Network effects. In a direct network effect, each new user adds value for existing users. The number of possible connections grows much faster than the number of users:
Users Possible connections (n x (n - 1) / 2) 10 45 100 4,950 1,000 499,500
In practice most products do not benefit this strongly, and many network effects are local - a food delivery marketplace in one city does not become better because another city grows.
Because a business without a moat can succeed and still have its profits competed away. Investors pay for future profits, and future profits depend on how defensible the business is.
It also matters because moats are frequently overstated. Almost every pitch claims a network effect; far fewer can show the product genuinely improving as it grows.
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Two marketplaces claiming network effects.
Marketplace A (home services, one city): more providers improve choice for local customers, but growth in another city adds nothing. Customers often hire the same provider directly after the first job. Marketplace B (a professional community): each new member increases the value of the network for existing members across locations, and leaving means losing connections and reputation.
A has a weak, local network effect undermined by disintermediation. B has a stronger effect with switching costs. Both use the same phrase in their pitch.
Accepting a claimed network effect or moat without evidence that the product genuinely becomes harder to compete with as it grows.
Identify which source of advantage applies, rather than accepting a general claim.
Ask whether retention, engagement or margins improve as the company grows.
Determine whether growth in one area helps users elsewhere.
For marketplaces, ask whether users can transact directly after meeting.
When evaluating a company's long-term defensibility.
Do not expect strong moats from very early companies; judge whether a credible source could develop.
Operators of service marketplaces - for freelancers, home services and tutoring - have widely described users meeting on the platform and then transacting directly, undermining the platform's claimed network effect and pushing companies to add payments, insurance or tools to keep transactions on the platform.
A network effect that users can easily step outside of is weaker than it looks in a pitch.
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