Network Effects

To Reamer, what matters most is the presence of network effects. That's why he loves America Online, a company that he's followed since 1996 -- and that's now worth a stunning $125 billion. "The real beauty of AOL's service is that, like any network, its value grows to the nth power of the number of people who use it. A telephone network is meaningless with 1 phone on it. With 2 phones, it begins to be useful. With 1,000 phones it's important. With 100 million, it's incredibly important. AOL works the same way. The value of its service increases with every single person that joins."

If you understand how the partners at DFJ decide on which companies to fund, and you understand how Scott Reamer determines the value of the companies that make it to Wall Street, then you'll begin to understand the mind-bending logic of network effects.

You've Got Hotmail

In Web circles, the Hotmail story is almost as well-known as the service itself. But, like so many Internet takeoffs, Hotmail almost didn't get off the ground. Founders Bhatia and Smith had been turned down by something like 21 VC companies before they met Steve Jurvetson. Even he wasn't all that impressed by the startup team's big idea for a company called JavaSoft. But one feature of their plan -- free Web-based email -- did catch his eye. The talks heated up, and JavaSoft became Hotmail.

Then came a meeting with Tim Draper, 41, DFJ's founding partner. It was the first time that Draper had met with Bhatia and Smith. Draper was enthusiastic about the company, but he was adamant about one small detail: He wanted to put a hot link at the bottom of every email with a message, "P.S. I love you. Get your free Web-based email at Hotmail." Clicking on the link would bring the message recipient to Hotmail's site, and let that person sign up for the service immediately. That idea almost blew the deal apart. "The founders thought that it was like Spam," recalls Jurvetson. "And it's true: Until Hotmail tried it, the contents of email were always considered completely private."

Which is why Bhatia and Smith not only hated Draper's idea but felt it was contrary to the spirit of the Internet. "They fought me for quite a while," Draper says, remembering that initial meeting. "Then, finally, they came back and said, 'Okay, we'll do it. But no 'P.S. I love you.' " Draper's bemused smile turns into an oversized grin. "Then Hotmail just started to spread."

And it spread unlike anything DFJ had ever seen. "We had to keep asking ourselves, 'Is this a fluke, or is it something important to think about?' " Jurvetson recalls. "After the Microsoft buyout, the magnitude of the value Hotmail had created hit us in the face. We actually thought that the founders should have held out and not sold. But in the end, they really wanted to sell."

Around the time of the Hotmail sale, Netscape, another pretty successful Web startup, asked Jurvetson to contribute to its internal newsletter, "The M-Files." The assignment was twofold: First, to write about new companies in the DFJ portfolio that were using Netscape technology. Second, to examine what those companies were doing that was unique and to draw out some lessons. "That was the first time that I thought to myself, 'How can I describe why Hotmail is special?' " Jurvetson wrote something and passed it to his partners for comments. In a meeting with Draper, the two financiers began trying to coin a phrase that would describe the phenomenon that they had helped create. They tried terms like "pyramid marketing," "geometric marketing," and "tornado marketing."

Then they came up with a term that stuck -- "viral marketing." The email service had spread around the world with the ferocity of an epidemic. By passing along emails with a clear (but inoffensive) marketing message, current users were infecting potential users. And the rate of infection increased rather than decreased as time went on. Forget diminishing returns; Hotmail was enjoying increasing returns.

Jurvetson went home to his wife, Karla, a psychiatrist, and began poring over her medical books. "I read that a sneeze releases 2 million particles," he says, "and I really started thinking about the idea of infection for the first time. A sneeze is only dangerous when there's a crowd around. A sneeze on the Internet, however, can infect millions of people scattered across the planet. It's as if Zeus sneezed: How many people would catch a cold?"

Suddenly, the principle behind viral marketing seemed so easy to understand. In this new world, companies don't sell to their customers. Current customers sell to future customers. In exchange for a free service, customers agree to proselytize the service. Because recipients of Hotmail messages are almost always friends, relatives, or business acquaintances of the sender, the marketing message is that much more powerful. Each email carries an implied endorsement by someone who the recipient knows. (See "Four Laws of Viral Marketing," page 216.)