Ep 10: Network Effects In Gaming (NFX Masterclass)

SPEAKER_1 (0:00)

You're listening to episode 10 on Network Effects In Gaming from the Network Effects Masterclass here on the NFX Podcast. We're in the first wave of Web3 Games, and a lot of people believe that game companies don't have network effects. But in this episode, NFX partner Gigi Levy-Weiss takes you on a deep dive into the world of defensibility within the gaming industry, sharing the four layers of network effects and an even closer look into Steam, a case study on the leading platform for video game development. So let's jump in.

Gigi Levy-Weiss (0:27)

We were looking to build the best venture fund out there that's going to serve Silicon Valley and Israel. And we were trying to think, what is it we want to focus on? And James started talking about the studies he's been doing with network effects and how we figured out that network effects companies are the best ones that are coming out of Silicon Valley. What I immediately shared is that also observing Israel, we could see that the best companies coming out of Israel were also network effects companies. And so we looked at each other and we said, why don't we try to create a venture fund that's going to focus on these businesses? That led us to complete a study that I think James started before we started NFX of actually trying to understand what percent of the value in tech comes from network effects versus what percent of the value in tech comes from non-network effects businesses. And what we could see is that while only around 20% to 30% of companies had network effects in them, like of all the business plans we were getting, all the DAX we were getting, only 20% to 30% had network effects in them. When you look at the successes, more than 70% of the value created in tech, after the beginning of the internet era, came from network effects companies. And so if it's 20% of the companies and it's 70% of the value, it's probably a better business to focus on network effect, which is why we decided not just to focus on it, but also call our fund NFX.

One of the things that people often mistake is thinking that game companies don't have network effects. What people think is that a game is a game, and you play it, and that's about it, and it's really not about network effects, and it couldn't be farther from truth. And so what I thought I'll do today is start by telling you about the actual network effects in games, and there's quite a few of them. The first thing is the direct multiplayer network effect, which is basically a normal typical network effect, which means that the more users that are participating in the game, the more value all the users that are already part of the game is getting, and of course the more value the new user that's coming in is getting from the entire community that's already playing there. This is pretty common, and it's pretty true for most games, but it's very true for multiplayer games. And multiplayer games can be everything from a poker game all the way to Fortnite or Call of Duty or any other major game. And so when we want to play these games, we want to play against other. We want to be matched. We often call these things liquidity. And so if we don't have enough players that we can actually play with, then the game loses its value. But even if we have, let's say, that we're 50 people and we have 50 people that want to play, if these 50 people are all going to be different levels, it's really not going to be fun for everybody. And so we now need to match 50 people that are around the same quality of play, which means that for us to be able to do that and do it on the right geography, so there's no latency between the different people that are far one from the other. And if we want to do it even in the same language sometimes, we require more and more and more and more games. And so the more people that are actually participating in the game, the better the game can be. That's the very first and basic network effects of games, liquidity. However, that's not enough. The next layer basically is being able to play against people that you actually know. And so in this particular case, if you want to play Fortnite now and you want to play in a squad with your friends, then the fact that you can play with actual people that you know creates an even stronger network effect. Joining forces with people or playing against people that you really know creates even stronger defensibility for the game. Which is why many games are trying to get more users to be able to play with each other rather than just play with strangers. But even that's not enough when it comes to the network element of the game's network effect. Because in many of these games, there's something called clans. And what these clans do is that they take groups of people, sometimes people that know each other, but often people that actually don't know each other, and you put them in this organization called the clan. And what the clan does is it basically gets you tasks that you need to do on behalf of the clan. It gives you benefit for participating in the clan. It gives you mission that you need to do not as an individual gamer, but as the clan. And then because of that, participating in the clan actually creates a much stronger feeling of belonging, a much stronger network effect, which gets people to stay much longer in the game. Generally speaking, in games, users that become part of the clan retain dramatically longer and spend more money than those that don't become part of the clan because the belonging, because the network element is much stronger for them. And so the first thing is the actual network that's being built in the game. At the high level, liquidity, and then personal network with the people that you know, or personal network with the people that you partner with in the clan. That's the first layer. Once you have that clan, or the friends that you actually play with, there is what's called the personal utility network effect, because now you need to coordinate with these people. You need to coordinate when you're going to play, you need to coordinate when you're going to strike, you need to coordinate what you're going to do. And so suddenly, we have now a messenger inside the game. We have now tools to actually communicate with each other over voice, over video, over text. These coordination elements are personal utility network. They're very similar to a Facebook messenger or a WhatsApp that are personal utility. And basically, the more you use the personal utility, the stronger and more defensible the game becomes, because you're now dependent on the game for that communication. And so layer number one is the network. Layer number two is the personal utility. But even that's not enough. The next thing we have in games, we have a marketplace. And marketplaces are basically two different layers. The first and basic layer, which we're going to talk about a bit later, is the actual App Store Network Effect, which is the place where you find games, where you discover games. And that exists on the iOS platform, that exists on Google. It's called Google Play and Android. It's called Steam, and we're going to talk about Steam a bit later. And this is the first layer of marketplace in games. But the second layer is a marketplace that's dedicated for every game. In this marketplace, what's generally happening is that people can actually exchange things, like their virtual goods or skins or anything that they acquired or won in the game. That element of trading and marketplace basically makes the game much better for them, and of course, increases the defensibility of the game. It's very interesting to say that basically what we've saw in Web3 gaming over the last couple of years is an enhancement of that marketplace element as what the NFTs do. They allow people to actually trade their virtual goods of the game not just within the game, but anywhere they want. And so basically creating a more global marketplace that enhances the value that you can get out of your game goods. The last network effect of games is the bandwagon effect, that we all see when we ask kids what game they want to play. And so like any other bandwagon network effect, what's happening is that as people start playing a game, beyond all the core network effect that we discussed, the next thing that happens is that people start talking about playing the game. And so you hear from your friend that this is the game they play, you hear from your friend that this is the coolest thing that's happening right now, you hear from your friend that this is better than other games, and then you jump in. And so the combination of the network, network effect, especially when it comes, becomes personal, especially when it becomes with other people that collaborate with in a clan, coupled with the personal utility of the tools the game gives you to actually communicate with the people that you collaborate with, and then the marketplace on top of it, and the bandwagon network effects make the top games super defensible. And I think that what people generally miss is that many of these top games have not been around for a month or two, or even half a year. We're talking about games that are at the top charts for 10, 12, 15 years. And the reason that's the case is because of the network effect. It's not that there aren't other good games out there. It's that the network effect of these top games makes them so defensible that they actually stay on the top charts for many, many, many years. And that's why we truly believe that when we find the best game companies, they can create not just amazing businesses that grow very fast, but also super defensible business thanks to network effects.