Dave Winer last Thursday had a post called “It’s definitely a bubble.”  OK, so it was more of a rant than a post but I share the sentiment of his title.  The biggest issue that I see in the venture market right now is the assumption by both entrepreneurs and investors that winner-take-all economics apply in pretty much every market and for pretty much every company.  With several billion people on the Internet and much of commerce shifting online that assumption will let you justify ridiculous future (and hence current) valuations.

The problem with this assumption is that very few businesses actually have the kind of strong network effects which can result in a winner-takes-(nearly)-all outcome.  As a reminder, the definition of a network effect is where a service becomes more valuable to everyone already using as more people (or companies, or both) use it. Network effects are obvious and strong in social networks and in marketplaces.  

But many more businesses these days claim network effects on what I consider a considerably weaker basis: data.  The argument goes something like this: as we get more users we will have more data on (what they like, how they behave, etc) which will let us improve the service for all users.  We can observe this type of network effect in search where the choices made by other users based on a particular query can be used to improve that query for other users. And in long-tail searches this effect can be quite pronounced, which has been part of Google’s continued success.

For many businesses though, the data effect as I will call it unlikely to result in winner-take-all-economics.  The reason: other considerations will far outweigh it. For instance, in e-commerce factors such as price, convenience and trust will be much more important.  Yes, product recommendations on Amazon are good and are an example of a data effect, but wouldn’t matter if Amazon had high prices or unreliable shipping.  Just to be clear with it’s marketplace Amazon has strong network effects, I am only talking about the strict e-commerce portion.

So I am quite skeptical of the claim by many businesses that they will dominate their market because their early start will give them more information than others who enter later.  The net result is that in many markets we will see more than one company build significant scale and the competition between these will result in valuations far below those from a winner-take-all outcome.

Addendum: After thinking about this more today here is another formulation:  For some businesses (Facebook, Twitter), the network effect is the first oder of importance and everything else comes afterwards.  For most businesses the other stuff is the first order of importance and data effects come afterwards.

PS. It doesn’t help that we don’t (yet) understand how long-term sustainable network effects truly are much as we love them. That will be the topic of an upcoming post. 

Dave Winer last Thursday had a post called “It’s definitely a bubble.”  OK, so it was more of a rant than a post but I share the sentiment of his title.  The biggest issue that I see in the venture market right now is the assumption by both entrepreneurs and investors that winner-take-all economics apply in pretty much every market and for pretty much every company.  With several billion people on the Internet and much of commerce shifting online that assumption will let you justify ridiculous future (and hence current) valuations.

The problem with this assumption is that very few businesses actually have the kind of strong network effects which can result in a winner-takes-(nearly)-all outcome.  As a reminder, the definition of a network effect is where a service becomes more valuable to everyone already using as more people (or companies, or both) use it. Network effects are obvious and strong in social networks and in marketplaces.  

But many more businesses these days claim network effects on what I consider a considerably weaker basis: data.  The argument goes something like this: as we get more users we will have more data on (what they like, how they behave, etc) which will let us improve the service for all users.  We can observe this type of network effect in search where the choices made by other users based on a particular query can be used to improve that query for other users. And in long-tail searches this effect can be quite pronounced, which has been part of Google’s continued success.

For many businesses though, the data effect as I will call it unlikely to result in winner-take-all-economics.  The reason: other considerations will far outweigh it. For instance, in e-commerce factors such as price, convenience and trust will be much more important.  Yes, product recommendations on Amazon are good and are an example of a data effect, but wouldn’t matter if Amazon had high prices or unreliable shipping.  Just to be clear with it’s marketplace Amazon has strong network effects, I am only talking about the strict e-commerce portion.

So I am quite skeptical of the claim by many businesses that they will dominate their market because their early start will give them more information than others who enter later.  The net result is that in many markets we will see more than one company build significant scale and the competition between these will result in valuations far below those from a winner-take-all outcome.

Addendum: After thinking about this more today here is another formulation:  For some businesses (Facebook, Twitter), the network effect is the first oder of importance and everything else comes afterwards.  For most businesses the other stuff is the first order of importance and data effects come afterwards.

PS. It doesn’t help that we don’t (yet) understand how long-term sustainable network effects truly are much as we love them. That will be the topic of an upcoming post.