Word of mouth without a network effect is not a competitive advantage

In Building Bulletproof Brands, a Loose Threads series about how the internet destroyed traditional moats for physical goods brands but also created new ones, I wrote about how the power of word of mouth is not what many think. As new physical goods startups launch and raise money every week, many are keen to mention a company’s “unparalleled growth via word of mouth” or "IRL virality" as evidence that the company has some special sauce. Many also see word of mouth as a substitution for paid customer acquisition, at least early on.

This sentiment is highly misguided. It conflates a distribution mechanism (word of mouth) with a competitive advantage (a network effect). Companies and investors need to know if a brand is just a brand or if the company has something fundamental that makes it inherently defensible—a competitive advantage. From Building Bulletproof Brands Part II:

Word of mouth is often considered a defensible part of a brand. However, word of mouth is a distribution mechanism, not a moat. It's definitely a good start, but it doesn't guarantee anything. Hoverboards spread by word of mouth but there was nothing defensible about the product or any brand in the space. Word of mouth is simply another (commodified) distribution channel…. Word of mouth itself is inherently agonistic. What a brand does with it makes all of the difference.

Anything good can spread via word of mouth. Most startups that make something people want can grow via word of mouth, especially in the beginning. Early stage startups sell to early adopters, who are more conditioned than general shoppers to spread the word about brands and products that resonate. Early on, these companies have very favorable unit economics and they're able to grow quickly and cheaply.

But once the brand saturates these early adopters, either by selling to most of them or pushing organic marketing to the limit, its acquisition costs often rise significantly, unspooling the entire unit economics of the business. While it was inexpensive to acquire early adopters and empower them to spread the word, word of mouth is fleeting without a reliable mechanism to capture it, such as a network effect. This is especially problematic when a company raises money by convincing investors that it has a special cost structure because of its “inherent virality,” when, in fact, it's just a product company selling to naturally favorable early adopters.

This is when word of mouth quickly turns from an asset to a liability. Nasty Gal, for example, grew via word of mouth early on and raised lots of money at a generous valuation. But it was nothing more than a physical goods company subject to the same economics of every other physical goods company. When the company could no longer grow only via word of mouth, it had to ramp up its acquisition efforts, plowing millions of dollars into advertising to keep growing at the rate it promised investors. This happens when there is nothing inherently sustainable about a company's growth mechanism. Many other physical goods companies followed a similar path.

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Although it's easier to see the shortcomings of word of mouth with companies that failed, the problem is more prevalent for companies who have stopped growing or are slowing down. The cycle repeats itself: a company raises money at a good valuation because of early growth, only to find that it will be impossible to keep growing at the same rate and with the economics if the company doesn't have anything that allows it to regeneratively grow.

Companies with network effects harness word of mouth and virality to grow more sustainably and defensibly than those without it. Network effects are more common with technology companies, since scaling software is faster and less costly than physical goods, but some physical goods brands are experimenting with the same concepts. Supreme, Glossier and Peloton, as discussed in Part II of Building Bulletproof Brands, fall into this category. These brands have the ability to channel word of mouth into something greater. But those that try to only grow via word of mouth without any network effect are in for a rough and confusing ride, as they will watch a once promising business rapidly fall apart at scale.

Both brands and investors need to have a more realistic mindset when it comes to discerning what makes a brand defensible and what doesn’t. There are an endless number of products that spread via word of mouth only to fizzle at a later date because there was nothing working to capture and retain the word of mouth growth. Word of mouth is valuable, but only if it’s understood and harnessed. Growing via word of mouth is a tactic, not a moat. Everything else is a mirage.

Read more about the changing landscape of brand durability in Building Bulletproof Brands.