Network Effects

The startup opened its virtual doors to customers on July 4, 1996. The date was a great choice in terms of corporate symbolism, but a terrible one for creating buzz. Most media outlets operate with skeleton crews over Independence Day, so the launch generated almost no press coverage. And there was no ad campaign to pick up the slack. Of the $300,000 in seed capital that the company had received, less than $50,000 was targeted for promotion. "There wasn't even a marketing budget," remembers Steve Jurvetson, a managing director of Draper Fisher Jurvetson (DFJ), the venture-capital firm that provided the seed money.

So much for a virtual "shot heard 'round the world." The launch of the world's first free Web-based email service had more the effect of a wet firecracker. Then a funny thing happened: Customers began signing up. John Fisher, another DFJ managing director, was at a trade show with one of the startup's founders the week of the launch. "His beeper would go off every 30 minutes," Fisher says, "and there would be reports of several thousand more sign-ups. It became immediately clear to us that we had a tiger by the tail."

The first markets to light up were universities -- places with ".edu" domains. A user would sign up at, say, Cornell. A day later there'd be a half-dozen users at Cornell. The next day, there'd be 100. By the end of the first week, there'd be 1,000. The service would spread to another university, and the process would repeat itself. Then word of the service began spreading around the world. Within three weeks of the first user from India signing up, 100,000 additional users from that country came on board. "It was like a miracle was unfolding before our eyes," says Jurvetson, a boyish 32-year-old whose voice still conveys the excitement of those early days. "At one board meeting, we'd see, maybe, Sweden show up for the first time. At the next month's meeting, there'd be a huge number of users from that country."

By Christmas 1996, less than six months after the launch, the new company had 1 million registered users. In the entire history of subscriber-based media, nothing had grown so large, so fast. The company's performance was unprecedented. That it happened with a marketing budget of less than $50,000 was simply unbelievable.

The startup, of course, was Hotmail, a company that has become a legend among Silicon Valley entrepreneurs for its fast-forward approach to attracting customers and creating value. By Christmas 1997 (less than 18 months after its launch), Hotmail had signed up 12 million subscribers. A few days later, on December 29, founders Sabeer Bhatia and Jack Smith sold the company to Microsoft for $400 million in Microsoft stock. Today, with 50 million registered users, Hotmail is the largest Web-based email service on the planet.

Not surprisingly, the investment in Hotmail touched off an inferno at DFJ, which has done 57 Internet deals -- more than any other independent VC outfit. "We want to invest in companies where we can light a match and start a fire," says Jurvetson. And apparently word did spread like wildfire. When DFJ recently set out to raise a new pool of money, investors offered to provide three times as much as it was looking for. It decided to limit the size of the new fund to $180 million. (Its third fund, a $50 million pool established in 1995, is now reportedly worth $760 million.)

It's easy to grow weary of Web hype. Pick an industry, and you're almost guaranteed to encounter a pack of twentysomethings with a few Macs and an Internet connection who are vowing to start a revolution. You'll also encounter more buzzwords than the mind can process. Still, there's no denying that the Internet economy works by a different set of rules than the old economy. When, in business history, have so many companies generated so much value so quickly? Hotmail is one eye-opening case among many. Yahoo!, a company that's still barely five years old, has 65 million registered users and a market value of $35 billion. EBay, which went public in September 1998, now has 3.8 million registered users -- and a market value of $17 billion. And don't forget RealNetworks, priceline.com, and E*Trade -- three young Web companies with a combined market value of $31 billion.

The stories behind these companies involve different missions, different markets, different business models. But they all illustrate the power of network effects. In a sea of new-economy buzzwords, network effects is the one new idea by which more and more companies will chart their course. Part economics, part strategy, part ideology, network effects may be the defining business mind flip of the 21st century.

Scott Reamer thinks so. An athletic 28-year-old analyst with SG Cowen, Reamer (whose official title is director of Internet research) is a new breed of Wall Street power player -- a financial wizard whose job is not just to evaluate stocks, but also to explain the logic of value creation itself. What Reamer calls his "Internet first principles." There are four of them, and they are at work in every company he tracks.