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Buying something on eBay (EBAY) required a leap of faith during its early years.
Users mailed a check or money order to a stranger, and the seller didn’t ship anything until the payment cleared, which could take days or even weeks. If something went wrong, users had no recourse.
Photo from Unsplash
The system worked until it didn’t… and that’s when a handful of engineers and entrepreneurs saw an opening for digital payments.
Most of the early attempts failed. Products like DigiCash and CyberCash promised futuristic systems built on heavy encryption and experimental currencies
But as much as users wanted speed and reliability without changing their habits, they weren’t willing to give up the credit cards and bank accounts they already trusted.
So while the rest of corporate America tried to reinvent the wheel, one startup found a better way.
A Better Way of Moving Money
PayPal (PYPL), founded in 1998, let users send money to anyone with an account. All that was needed was an email address. The money could come from a bank account or credit card.
It also paid people to try it. New users received $10 for signing up and linking a bank account, and another $10 went to anyone who referred a friend.
The campaign spread fast. By March 2000, this startup was handing out $10 million a month just to bring people in.
It was a genius marketing play. But the company didn’t stop there.
While competitors struggled to find users, PayPal benefitted from eBay. Many eBay sellers were part-timers and weekend entrepreneurs who loved the idea of getting paid instantly, and they steered their buyers toward PayPal.
Every successful auction became a mini sales pitch. Sellers encouraged buyers to pay through PayPal, buyers signed up to get their purchases faster, and each new user brought in more.
Between January and March 2000, PayPal’s user base exploded. Growth hit 7% to 10% daily.
Less than a year earlier, eBay bought Billpoint to serve as its own payment processor. But users weren’t interested in eBay’s in-house payment system.
PayPal had the scale and customer trust, and once people started using it, they had little incentive to leave.
PayPal went public in February 2002 and churned out profits within months. Meanwhile, in summer of that year, eBay acquired PayPal in an all-stock deal worth $1.5 billion.
(eBay became an independent and publicly traded company in 2015.)
By reshaping how online payments worked, PayPal became the trusted layer for Internet transactions. In essence, it built a “network effect” that enabled it to grow as more and more people used it, making it even harder for users to stop using it.
This network effect has led to the creation of some of today’s biggest companies.
Same Pattern, Different Company
The network effect PayPal used to dominate the payments space is being used in different industries today:
Social Media – Meta (META) is a classic example. The more popular its social media platforms are—Facebook, Instagram, and WhatsApp—the more users want to join them.
Payments Processing – Credit-card network operators Visa (V) and Mastercard (MA) process a huge volume of the world’s payments because nearly every merchant accepts their cards. The same logic applies:
The more places those cards can be used, the more people want to use their cards… and the more attractive it is for merchants to accept them.
Tech – Even chip-designing giant and AI darling Nvidia (NVDA) benefits from the “network effect.” Its proprietary CUDA software has become the industry standard for building AI models.
As more developers build on CUDA, its library of tools grows richer, which draws in still more developers and enterprise customers. Because CUDA only runs on Nvidia chips, every new CUDA user also means more chip demand.
The Lessons for Financial Advisors
Businesses with sustainable network effects tend to remain competitive long-term… and their shares tend to reflect their respective networks’ popularity.
As a professional doing due diligence on behalf of clients, a network effect is one of the more valuable moats to look for. A business in the early stages of developing a network effect has a high chance of beating the market.
Best regards,
Joel Litman & Rob Spivey
Chief Investment Officer &
Director of Research
at Valens Research
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