You're listening to episode 10 on network effects and gaming from the network effects master class Pete on the NFX podcast. We're in the 1st wave of web 3 James, and a lot of people believe that game companies don't have network effects. But in this episode, NFX partner, Gigi Levy-Weiss James you on a deep dive into the world of defensibility within the gaming industry.
Sharing the 4 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. We were looking to build, the best venture fund out there that's gonna serve Silicon Valley and Israel. We're trying to think what is it that we want to focus on?
And James started talking about the studies he's been doing with network effect 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 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, eventually trying to understand what percent of the value in tech comes from network effects versus what percent of value and tech comes from non network effects businesses. And what we could see is that while only around 20 to 30 percent of companies had network effects in them, like, of all the business plans we were getting, all the decks we were getting, only 20 to 30% had network effects in them.
When you look at the successes, Morgan 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 is 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 and effects. 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 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 James, 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 James, but it's very true for multiplayer games.
And multiplayer games could 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 this thing 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 fifty people, and we have fifty people that wanna play.
If these fifty people are all gonna be different levels, it's really not gonna be fun for everybody. And so we now need to match fifty 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'd wanna 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 wanna play Fortnite now and you wanna play in the 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 create 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 there's many of these James. There's something called Klands. And what these Klands do is that they take groups of Pete. 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 Klan.
And what the Klan does is it basically gets you tasks that you need to do on behalf of the Klan, it gives you benefit for participating in the Flint. It gives you mission that you need to do not as an visual gamer, but as the clan. And then the 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 they're 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 a personal network with the people that you partner with in a 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 gonna play. You need to coordinate when you're gonna strike. You need to coordinate what you're gonna do. 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 1 is the network.
Layer number 2 is the personal utility, but even that's not enough. The next thing we have in games, we have a marketplace. Marketplaces are basically at 2 different layers. The first and basic layer, which we're gonna talk about a bit later, is the actual App Store network effect. Which is the place where you find game where you discover games. And that is that exists on the iOS platform that exists on Google. It's called Google Play and Android.
It's called Steam, and we're gonna talk about Steamabit 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 Morgan 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 so in web 3 gaming over the last couple of years is the 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 wanna 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 there 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 to 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 2 or even half a year. We're talking about the James that are 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 for network effects.
I wanted to talk about specific examples of network effects and games. And while not specifically a game, the what would want to talk about is team, which is a platform for game distribution over PC. So if you think about it in history, when you wanted to buy a game, you literally had to go to store games where packaged goods that you went to a store and bought and then put them in your computer and started playing them.
And over the years, as the Internet emerged, game developers initially wanted to start updating their games. It was not even about sending them at the beginning. It was about updating the games once you bought it. And a company called Devolve started this app that was called Steam that was supposed to allow them to update their games after you acquired them. Over time, they started selling games over this platform rather than just update games.
And today, it is the number one platform for distributing games or Pete with over a 120,000,000 users every year and revenues north of $30,000,000,000. So this is literally the number one game distribution channel for games over PC.
Steam is actually the equivalent of the App Store on iPhone devices or Google Play on Android devices with maybe one big difference, which makes it a lot Morgan, impressive, which is clearly does not come bundled with Pete, meaning that to get to these 120,000,000 users, Volve the creator of steam had to be in a position that people actually wanted to download and install steam on a 120,000,000 computers, which is super impressive.
So let's try to analyze the network effects of steam at what makes it so successful now for more than 15 years. So the first thing that steam is used for is essentially a marketplace. Right? This is a marketplace between game developers that are putting their games on this marketplace that users can find them and users who wanna play games and use team as a discovery channel for games. This has been the first use case of Steam and where Steam started growing.
Steam basically allows for discovery of all the PC games, all the major PC games, for all the PC gamers in the world, and that's the beginning of its strength. But that's not enough because what seemed made to become more defensible was to create 2 additional layers of marketplace on top of the initial developer to players marketplace. That are making it so defensible. The first layer is the UGC layer, user generated content. So what's team said is the following thing.
If we're only gonna allow developers to sell games to users, we're gonna have maybe a lot of supply, but it's still gonna be limited supply. Is it gonna be limited? Because there's a limited number of developers that can actually launch games and sell them on steam. What if we then allowed users to start creating versions of the game called mods or items for the James? In a special place called the Steam workshop, and then we allow these users to distribute what they've built to all the players.
So now on the demand side, we still have all the all the players. But in the supply side, we don't have just game developers We also have all the very engaged users that wanna create content for the games they love. That makes the marketplace a lot stronger. And if you think about it, if tomorrow a new platform emerges.
And now all the developers wanna sell their game also on the other platform, If that other platform doesn't get all these unique features that the users generated, it will never be as exciting. It will never be as rewarding. As getting the game on Steam. And so by adding that second layer of a marketplace, on top of the first marketplace layer, Steam became a lot more defensible. But even that's not enough.
Because what's team did later is add also a 3rd layer of marketplace, which is between the users themselves for the virtual goods in the game. So what Tim did is that they said if you own a virtual good in one of the games, the ownership of that virtual goods is gonna be stored on the steam servers so that now if you wanna sell that virtual good to somebody else, you can do it using Steam, then actually get real money for the virtual good that you won or that you bought in the past.
Again, if you think about what's gonna happen when a new marketplace emerges, maybe, to sell the same games, if you now can't move your virtual goods that are stored on the steam servers, into that other marketplace, why would you ever want to use the game consume the game on that other marketplace?
And so basically by adding 2 additional layers, user generated content layer, and a marketplace layer for virtual goods, steam took advantage of the strongest marketplace network affects the feasibility they could get to make sure that even when a new marketplace emerges, is not gonna be really beneficial for the users to get their game in another marketplace, but that's not enough. Because one of the thing that SCIM gave the game developers is the entire layer of identity.
So rather than you having to create your identity in every game you play from scratch, You have your steam identity. And your steam identity basically allows you to log in into these games and play them very fast. Which, of course, is great, but that's not the strength of it. The reason the strength of it is that you can take now your social graph, your network from one game to another.
So when you have a friend on Steam, maybe a friend that you knew Morgan, and maybe a friend that you got to know in one of the James. When you go to play the next game, you're gonna be able to find that friend also in the other game or invite that friend to the other game. And so now we're taking the network effect of actually having a personal network over laying it over the marketplace and creating a v even much, much stronger network effect that makes steam so powerful.
If you add on top of it, the fact that steam by design also has the bandwagon network effect, because it basically shows you which games are played by most so that you can see which games are the most popular. You can see which games your friends are playing. So that it can direct everybody to play the same games and get that bandwagon effect that makes it even stronger.
The combination of these network effects basically makes teams so strong that it can command a 30% rake on all transactions that are happening on the platform. And when you think about it, for a $30,000,000,000 business with 30% rate, you could assume that there's gonna be lots of other competitors. Well, the reality is that there are very little.
The reason that they're so little is because the strength and defensibility of Steam's network effect using the marketplace 3 layers, the personal network that we mentioned, and the band rigor effect make it so hard to compete with that there have been very little attempts to go against it. Flint literally in the last few years, we've seen Epic The publisher of Fortnite tried to come up with their own store. They now have more than 50,000,000 users, thanks to Fortnite.
But what they're starting to discover is that it's gonna be super difficult to move additional developers to their own store simply because of the additional layers of network effect this team added over the years. For epic to succeed, they will need to be able to replicate these network effects and make their own marketplace as strong and powered by the same network the team have created over the years.
This is a great example how a very simple business that started just as a normal marketplace between developers and players can become such a defensible, long lasting, huge, strong business. Thanks to very smart implementations of additional layers of network effect making it more and more and more defensible. Stay tuned to the NFX podcast as we'll post 1 episode per week until we complete the course.
You can also watch this entire master class online atnfx.com/masterclass, where you can log in, track your progress, and watch full videos, retranscripts, and find other related Materials. Thanks for listening to the NFX podcast.