I Love Network Effects

I love network effects; in fact, the world loves network effects. It's what drives the tremendous growth of websites like MySpace, Flickr, and of course, eBay (Nasdaq: EBAY  ) . More importantly, it can be a highly profitable business model.

The network effect goes back to Robert Metcalfe, the founder of 3Com (Nasdaq: COMS  ) and the co-inventor of Ethernet technology (which is for computer networks). He also created Metcalfe's Law, which is: "The value of a network increases exponentially with the number of nodes."

Huh? Basically, a network becomes increasingly more valuable as more users are connected. For example, email is useless if there is only one person. But if a million people use it, the overall value surges.

When you apply this to marketplaces, the same magic occurs. More buyers attract more sellers and, in turn, more sellers attract more buyers. It's a virtuous cycle.

Moreover, the network effect establishes a barrier to entry. In other words, why would a user go to another network if the No. 1 network provides more opportunities? Another problem is that in moving to another network, the user has to learn a new approach, which is an added cost known as "vendor lock-in."

In fact, Google's (Nasdaq: GOOG  ) platform is an example of the network effect. This is according to Mark Sigal, the CEO of vSocial, an online video site. He said: "Google first leveraged its popularity of its search engine to build a contextual ad targeting network primarily focused on search. Then they leveraged this position to extend their reach to search partners that they had distribution deals with. Then they leveraged this footprint to go after content publishers."

Foolish takeaway
So, what are the investment opportunities? Interestingly enough, a variety of IPOs -- such as LoopNet (Nasdaq: LOOP  ) and Liquidity Services (Nasdaq: LQDT  ) -- have models that benefit from network effects.

In the case of LoopNet, it has developed an extensive marketplace of buyers and sellers in the commercial real estate business. For the past year, revenues rose 56% to $48.4 million.

As for Liquidity Services, it's an online auction marketplace for wholesale, surplus, and salvage assets. In its fiscal first quarter, revenues were up 40% year over year to $45.2 million; net income was $2.3 million.

Essentially, these companies have low-cost models, as well as big market opportunities and growing brand recognition. This is the kind of stuff that any investor loves.

For further Foolishness:

What's sending Fools' hearts aflutter? Go back to our intro page to see what else we have a crush on.

Fool contributor Tom Taulli does not own shares mentioned in this article. eBay is a Stock Advisor recommendation and LoopNet is a Rule Breakers pick. The Motley Fool has a disclosure policy.

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