Business

Network Effect and valuing Free Customers


Came across a pretty interesting paper in the HBS working knowledge site yesterday. The paper talked about how a "free" customer can be valued. This can be particularly useful while valuing new age business like ebay and the various job sites because these sites generally have two types of customers: job seekers (or "buyers" as the paper calls them) and companies (or "sellers"). the companies pay the sites for putting up their jobs and every person recruited thru them while the job seekers are normally free (at least for the basic services). Now a seller can be directly valued by finding out the revenues that the site gets from him but how do u value a free customer?

The concept of valuing a free customer comes from Metcalfe’s law which basically says that the value of a network (like YouTube, Ebay, Monster etc.) increases with the number of users connected to it coz every user attracts other user to the site and also the greater the number of users the greater the number of sellers who will be attracted to the site or the network. This law is generally accepted to be the explanation behind the rapid growth of the internet and a recent article in Strategy+Business also blames the oversimplistic implementation of this law as one of the major causes of the sky high valuations during the dot.com boom.

Coming back to the paper, the authors, with the help of a whole lot of mathematical mumbo jumbo, analyze the value of a typical job site (they have not given the name due to reasons of anonymity) and come up with the result that the network effects of buyers on seller are nearly six times the effect of seller on buyers. so more buyers attract more sellers but more sellers don’t attract buyers to the same degree. So, in effect the value of a buyer is more than the value of a seller, even though there are more buyers than sellers.

Also, the marketing efforts of such a company should be more concentrated more in the start of the business to build the initial critical mass of buyers, after which the marketing efforts can be cut down.

The only catch here is that the model created in this study can only be applied in two sided markets. i.e. with buyers and sellers. So orkut and you tube cannot be valued by this model. Wonder how Google valued Youtube?

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