Why I Love Marketplaces

For my first post why not talk about Marketplaces! – the business and economic model I find most exciting. If you can build a marketplace, truly — both supply and demand sides — you’ll have captured lightning in a bottle.

Marketplaces are the real world affirmation of economist Adam Smith’s “invisible hand” idea. It’s serendipitous really, buyers and sellers readily find one another and make an exchange of value for goods and services. Not only do both sides benefit, but you as the enabler of said marketplace benefit, too. Marketplace participants are so delighted by the convenience afforded them that they are happy to cut you in on the action. Further, the financial profile of a marketplace is better than that of a retailer, as the marketplace holds no inventory and recognizes high margin revenue related to its cut of the transaction, while a retailer must recognize inventory costs at the detriment to profit margins.

The Flywheel… or Virtuous Cycle

The true genius behind marketplace models and why I like them is the fact that their success breeds more success. Imagine if you will, a flywheel in an engine. It’s a mechanical wheel that is designed to capture, store and maintain rotational energy. In simplest terms the engine spins a rod and the flywheel is connected to that rod. Just like a bike wheel, even if you stop pedaling that wheel keeps going. The best flywheels can go for hours and use ceramic ball bearings and other technology to create low friction spin, thereby preserving energy. The other benefit is that once you get a flywheel up to speed it wants to maintain that speed, so it actually becomes easier to keep it in motion than when you first started it up from no speed.

Good marketplaces may take time to get up to speed, but once they have momentum they are almost impossible to stop and competitors are left in their dust as participants gravitate to the one leader.

Take Airbnb for example. The home sharing startup began with a few people listing available rooms for rent, and a few other people renting those rooms. Travelers enjoyed the experience, told their friends, listed their own properties, made some money along the way. As that cycle continued the network has expanded, and resulted in Airbnb becoming the go-to leader in travel rentals. Of course if you ask Airbnb founder and CEO, Brian Chesky, he’d let you know it’s not easy. There are plenty of challenges to creating a marketplace.

I like the flywheel analogy best, others call it a virtuous cycle, network effect, etc., but that flywheel really evokes the imagery of an unstoppable force in my mind.

Every good marketplace has the flywheel. They also have a huge problem, “The Chicken and the Egg”.

The Chicken and the Egg

Would-be marketplaces have to jumpstart the flywheel by bringing buyers and sellers to the market. How did PEZ dispensers become the first thing to sell on eBay? What  caused the first person to make a reservation on OpenTable and how did a restaurant know to list it’s availability on the service? How did Uber convince the first driver to come on board when there were likely no riders? How did a regular guy named Craig create a list that ended up being so popular it became the (one time) dominant web-based marketplace we know as craigslist?

The chicken and the egg problem highlights the fact that creating liquidity in a marketplace is incredibly challenging and more like capturing lighting in a bottle than one would think. I’ve worked with a few marketplaces and read and studied a few more and in my mind, there are two ways to create liquidity: 1) hack it or 2) buy it. Hacking it is rooted in the community and ideals of a marketplace: start small, build momentum in one geography at a time, incentivize the first few people, really create value for participants, and then encourage them to spread the word. This is by far the best way to build a marketplace with good sense of community. But it takes a lot of time, effort, and continuous cultivation of the network. Buying liquidity is the act of dumping money at the problem. Spend marketing dollars on Facebook and Google to buy advertising for your customers. Buy Instagram followers, pay influencers to spread the word, pay people to be on the platform. Letgo and OfferUp, two startups seeking to replace craigslist, are currently waging a war to buy liquidity for their mobile-first horizontal classifieds businesses. Estimates are that these companies are spending tens of millions of dollars each month on advertising to attract users to their platforms. Despite all their efforts, they still don’t seem to have as much inventory as craigslist. Within a few seconds of scrolling through OfferUp’s infinite scroll-style feed I see a repeat item, a sign that liquidity is still below craigslist. Despite all of its faults, craigslist is still the leader in its space. The other problem associated with buying the traffic is that you  are buying people on the margin, those that are not high volume users, not highly engaged  so you have to keep paying for those people to come back. The theory is that over time in the mix of people a few gems are found that stick to the platform and carry the momentum of the flywheel.

Additional Challenges Facing Marketplace Models

Monetization is the next greatest challenge for marketplace businesses  how much do you charge, who do you charge, and when do you have enough scale to begin charging? If you monetize too soon growth will suffer. The key here is patience and testing. Several methods can work, and the most common are listing fees, promotional/advertising fees for premium placement and visibility in the marketplace, fees for data and analytics about what is going best in the marketplace, shipping/logistics fees, and then add-on fees (think about the $3 that TicketMaster charges you for the privilege of printing your own tickets on your own paper at home). Most often the seller of products and services pays the tax to the marketplace operator. Look at Etsy, who takes about 5% as their cut, or eBay, who takes a varying percentage depending on the type of item — these fees are called take rates. Once the marketplace can bear fees, then the game becomes one of finding stasis, that is, to increase the take rate further and further without users abandoning the market. One way around this is to give more value to sellers in the marketplace and charge them for those “seller services”.  Etsy is a great example of that and has introduced several seller services over the years, from shipping software and label making to website creation.

Another challenge that has arisen in the sharing economy is that of creating momentum in three-sided marketplaces. Door dash is a 3-sided marketplace that has been incredibly successful despite challenges here in the U.S. The first two sides are buyers of items (food, Apple Store products, etc.) and sellers (e.g., restaurants, the Apple Store). Adding that third leg of an on-demand delivery workforce is an incredible feat. Doordash has an incredible challenge to deploy its marketplace model, but does so on a strategic city by city basis, focusing on creating liquidity at the great expense of a marketing budget and lots of sales force – think individual conversations with restaurants – and even more recruiting labor – people and billboards to find delivery help. But as Doordash expands city by city the company learns unique lessons for that particular geography, which are often transferable to the next. It’s safe to assume that Doordash’s marketplace team is now full of experienced flywheel ninjas. The lesson here is to be calculated and go small, finding a niche (food for doordash) before expanding, and focusing on one geography before going nationwide, thereby creating liquidity on a small basis.

Building trust and safety is another key challenge. It just takes one bad deal for someone to leave the platform, and others will hear and follow. The answer to how best to provide trust and safety problem is more straightforward, though solutions for achieving it vary. People simply like doing business with people they know and trust. eBay provides all its buyers and sellers with a rating, all based on number of deals and peer reviews. The more positive rated deals someone has done, the more likely you will trust them and do business with them. Ratings work to a large degree but they don’t guarantee. So marketplaces often promise that if you work within their rules, transact within the platform, the marketplace will make you whole of something bad happens. The eBay seller guarantee, for instance, does just that. On Airbnb the platform provides tools and insurance that will make users whole in the event of a stay gone wrong. And even better for the marketplace operator, some of these services are offered at a price. Marketplaces often thrive on the basis of trust and safety, because both sides of a transaction apprecite a mediator watching over the deal, facilitating authenticity and often payment. Fraud is also rampant on these platforms, so larger global marketplaces end up spending millions of dollars to develop software and teams to combat fraud. I learned this lesson the hard way by selling a phone on eBay, then shipping it to the address the seller requested, in Africa, and not the U.S. address they listed officially with eBay. They then claimed never to have received the phone and I lost the battle with eBay because I didn’t use their shipping label.

Leakage, or transacting off platform, is often detrimental to the success of a marketplace’s financial model, even though it’s probably a positive sign that the marketplace works. Constituents are just finding more efficient ways to transact. Craigslist is an example of a market where every transaction occurs outside the view of Craig and his list. They only see the initial post and nothing else until the seller removes the listing or allows it to expire. eBay on the other hand manages the payment process and sees almost every dollar that transacts on the platform. They still can’t stop a buyer and seller from ultimately thwarting the process and meeting up in person to make a trade, thereby avoiding the eBay fees associated with selling an item.

But When They Work…

But when marketplaces work, when trust and safety prevail, when buyers and sellers find one another with ease, when both sides benefit, it’s a beautiful thing! No other model of business and commerce is more appealing, has more measurable moats that continually reinforce themselves, and works so seamlessly as a marketplace. Leaders can garner 60%+ profit margins, making them one of the most profitable models as well.

Some of my favorite marketplaces are: craigslist, Uber, Zillow, Artsy, ezCater, Etsy, Amazon (yes they also have a subtle, high margin marketplace functioning within their e-commerce offering), Rent the Runway, Poshmark, Doordash, Farfetch, OpenTable.

If I didn’t have a day job I’d like to try my hand at creating a marketplace. I like all things two-wheeled, so why not a marketplace for bikes, scooters and motorcycles. Hack some liquidity by dropping fliers in all the morotcycles I see, posting in the cycling forums, and making partnerships with local bike shops and used/new motorcycle dealers. Buy some liquidity by advertising to my fellow millennials on Snapchat and Instagram, because apparently that’s a good place for advertising to us. This may only work in San Francisco, where people ride all year, and where two wheels can meaningfully reduce your commute thanks to legal lane splitting, but why not start smaller rather than go nationwide.