The MarketPlace Creation Story

At its best, a marketplace has something self-sustaining and life-like to it, with buyers and sellers coming together and re-generating themselves.  In another great essay by Paul Graham, he explains that even those marketplaces that are most life-like today had a creation story that involved a manual breath of life to overcome a highly fragile situation at birth.

Manual:

One of the most common types of advice we give at Y Combinator is to do things that don’t scale. A lot of would-be founders believe that startups either take off or don’t. You build something, make it available, and if you’ve made a better mousetrap, people beat a path to your door as promised. Or they don’t, in which case the market must not exist.

Actually startups take off because the founders make them take off. There may be a handful that just grew by themselves, but usually it takes some sort of push to get them going. A good metaphor would be the cranks that car engines had before they got electric starters. Once the engine was going, it would keep going, but there was a separate and laborious process to get it going.The most common unscalable thing founders have to do at the start is to recruit users manually. Nearly all startups have to. You can’t wait for users to come to you. You have to go out and get them.You’ll be doing different things when you’re acquiring users a thousand at a time, and growth has to slow down eventually. But if the market exists you can usually start by recruiting users manually and then gradually switch to less manual methods.Airbnb is a classic example of this technique. Marketplaces are so hard to get rolling that you should expect to take heroic measures at first…

Fragile:

That initial fragility was not a unique feature of Airbnb. Almost all startups are fragile initially. And that’s one of the biggest things inexperienced founders and investors (and reporters and know-it-alls on forums) get wrong about them. They unconsciously judge larval startups by the standards of established ones. They’re like someone looking at a newborn baby and concluding “there’s no way this tiny creature could ever accomplish anything.”

It’s harmless if reporters and know-it-alls dismiss your startup. They always get things wrong. It’s even ok if investors dismiss your startup; they’ll change their minds when they see growth. The big danger is that you’ll dismiss your startup yourself. I’ve seen it happen. I often have to encourage founders who don’t see the full potential of what they’re building. Even Bill Gates made that mistake. He returned to Harvard for the fall semester after starting Microsoft. He didn’t stay long, but he wouldn’t have returned at all if he’d realized Microsoft was going to be even a fraction of the size it turned out to be.

Freelance Tagging

Netflix has a team of 40 freelancers who tag incoming TV shows and movies, so it’s a manual process but variable cost.  From the Wired article re: Netflix:

We have more than 40 people hand-tagging TV shows and movies for us. These are typically freelancers who do this to supplement their income. All of our analysts are TV and film buffs, and many have some experience working in the entertainment industry. They obviously have personal tastes, but their job as an analyst is to be objective, and we train them to work that way.

What You Are Really Watching

Sometimes the customer is right and sometimes she isn’t.

In designing search algorithms, it is important to determine when a stated preference is real or just aspirational.  Take Netflix’s experience, revealed in an interview with their algorithm gurus:

Why do I see so many three- or even two-star movies in my recommendations?

Gomez-Uribe: People rate movies like Schindler’s List high, as opposed to one of the silly comedies I watch, like Hot Tub Time Machine. If you give users recommendations that are all four- or five-star videos, that doesn’t mean they’ll actually want to watch that video on a Wednesday night after a long day at work. Viewing behavior is the most important data we have.

Amatriain: We know that many of the ratings are aspirational rather than reflecting your daily activity.

Gomez-Uribe: A lot of people tell us they often watch foreign movies or documentaries. But in practice, that doesn’t happen very much.

It’s important in getting a stated preference to know whether someone is telling you what they want or what they think they are expected to want.

Addressable Markets

One of the central topics that interests this blog is what factors create opportunities for disruptive marketplaces.  This blog post from a few months ago by David Haber of Spark Capital is a nice contribution to that thinking in listing some of these factors.  I quote:

As I look at this list as well as all marketplace companies that we get pitched at Spark, I keep coming back to a few salient points which I believe dictate the potential value of these companies:

• Size of the Market  – Don’t be fooled by the incumbent market, think about the one that may be created or unlocked. While the initial focus might be small, what does the potentially broader market look like for this company (i.e. from couchsurfing to travel lodging industry in its entirety)?

• Excess Capacity– Some call it an asymptotic market, but it’s simply the fact that a good portion of a given industry is sitting idle or under-monetized.  Why is that? Can it be changed by a new business?

• Friction / Opacity– Are there middlemen in this market that shouldn’t exist?  The larger or more considered the transaction, the more likely there are intermediaries (i.e. buying a bike vs. buying a company).  Intermediaries benefit from (and often perpetuate) opaque markets.  They withhold information in order to make margin.  Value is created when these intermediaries can be dis-intermediated.

• Fragmentation – Is this market highly fragmented, or are there a few dominant players?  There isn’t much opportunity in a market where there is concentration on one side or the other.

• Customer Experience – Whether you become the transaction processor that eliminates an awkward in-person cash transaction or simply provide a more compelling user interface to a staid business (i.e. like Uber has done with the livery business), a better customer experience can be the differentiating factor for your success (and one that keeps transactions within your platform).

The Governance Layer

From Perry Chen as interviewed by Walter Isaacson in Aspen.

“I think governance is key for every user-generated website…Sites like Wikipedia found a way to have this kind of body of core members, most other sites have their internal teams but it’s potentially becoming the most important layer of the web.  It’s not like new chips anymore, it’s not about the speed now, it’s about identity, about the personality of the company, about how your regulate and govern your community.”

A FICCing Pain In The Ass

Another example of complexity driving better margins are the debt markets as compared to the equity markets. The debt markets have higher margins because there is more complexity in the variety of products, and because that complexity has been amplified as those markets have resisted the move to electronic marketmaking.  See the discussion below from the Economist:

Margins on the debt side of investment banking have generally held up much better than they have on the equities side mainly because debt markets are vastly more complicated. Large companies will typically issue a single class of shares, and any subsequent issues will usually be completely fungible with the ones already outstanding. Yet companies will often issue tens if not hundreds of different sorts of bonds, and even the simplest issue will differ from the previous one because interest rates will have changed and it will have a different maturity. This provides rich pickings for bond traders as buyers will often have to hunt around to find exactly the bond they want. Gaël de Boissard, the head of fixed income and Europe, Middle East and Africa at Credit Suisse, points out that there are 38,000 different corporate-debt securities in America alone, only a few of which trade every day of the year. But pressures for simplification are rising. Investors and issuers want it in order to lower costs and improve liquidity, and regulators want to make sure they can clean up quickly if a large bank fails.

Innovations that have transformed equity markets, such as ETFs and electronic trading, are also making their way into debt markets. Goldman Sachs, UBS, Morgan Stanley, BlackRock and Bloomberg, a financial-data and news firm, are all experimenting with electronic bond-trading networks that try to match buyers and sellers.

Lessons on Bigger Takes From Equity Markets

From the equity markets, the variation in spreads (“takes” in Bill Gurley’s phraseology) turns on the degree of complicated and bespoke big block transactions that a platform can facilitate.  As this clipping from the Economist explains, the ability to make those markets turns on capital deployed (i.e., willingness to be stuck with a transaction), greater intelligence to figure out for what transactions buyers and sellers can be matched (i.e., how risky it is), and technology (i.e, speed of making transaction happen).

BlackRock, a huge asset manager, frets that much of it is “phantom liquidity” that quickly evaporates when investors try to buy or sell significant numbers of shares, usually known as “blocks”. Being able to trade big blocks is important for asset managers because they may want to raise or lower their stake in a company without affecting prices in the market or tipping off their competitors. In a recent report BlackRock said that trading in blocks consisting of 10,000 or more shares in a single company now makes up less than 7% of the total trading volume of S&P 500 companies, down from nearly 50% in the early 1990s.

Yet part of the reduction is because most banks are allocating less capital to equity trading and are less willing to take on the risk of trying to move these big blocks. That reduces their opportunity to earn juicy spreads rather than modest commissions for carrying out the basic paperwork or trading. “Banks and brokers are our partners,” says Richard Prager, global head of trading at BlackRock. “We need their liquidity, their intellectual capital and their products, but if we have to take the execution risk, then the market tips to an agency model where we pay a commission and not a spread.”

The greater a bank’s market share, the better it is able to sense shifts in the mood of the market.

The challenge for investment banks, then, is to be able to take on execution risk from clients but without having to dedicate too much capital to it. Here again it helps to have a large share of the market. The greater a bank’s market share, whether it is trading bonds or currencies, the better it is able to sense shifts in the mood of the market and the more easily it can match buyers and sellers. That gives it an advantage in working out how risky a bespoke transaction might be, for instance, if a fund manager asked it to sell or accumulate a large block of shares without tipping off the rest of the market. And the more trading a bank does, the more it is able to invest in better and faster systems. The share of equity trading controlled by the five leading banks (Goldman Sachs, Morgan Stanley, Credit Suisse, JPMorgan and Bank of America) has increased by about one percentage point each year for the past few years, reckons Matt Spick, an analyst at Deutsche Bank. Estimates of the total for the five vary somewhat: Mr Spick thinks it is at around 44% but Brad Hintz, an analyst at Bernstein Research in New York, puts it at about 49%.

Frictionless Pricing

Bill Gurley follows up on his marketplace post with one on marketplace pricing.  He used the term “rake” which is the commission or the amount skimmed off by the platform.  The key, is:

If your objective is to build a winner-take-all marketplace over a very long term, you want to build a platform that has the least amount of friction (both product and pricing). High rakes are a form of friction precisely because your rake becomes part of the landed price for the consumer…

High margins also make it easy for your competitors to come in and disrupt or prevent your network effect by drawing others to competing platforms:

High volume combined with a modest rake is the perfect formula for a true organic marketplace and a sustainable competitive advantage. A sustainable platform or marketplace is one where the value of being in the network clearly outshines the transactional costs charged for being in the network. This way, suppliers will feel obliged to stay on the platform, and consumers will not see prices that are overly burdened by the network provider. Everyone wins in this scenario, but particularly the platform provider. A high rake will allow you to achieve larger revenues faster, but it will eventually represent a strategic red flag – a pricing umbrella that can be exploited by others in the ecosystem, perhaps by someone with a more disruptive business model. As Jeff Bezos is fond of saying, “your margin is my opportunity…”

Booking.com took a much more aggressive approach (perhaps because it was the only one available) . They started with a 10% “agency model,” which not only represented a lower rake, but also provided better cash flow terms to the supplier. As such, they were able to signup nearly every small hotel in Europe…

Gurley points out a nice twist, where you can get the supply side of the marketplace themselves to bid up the “rake” if they see value in doing so.  This perhaps kicks in after the network has won in some sense.  The archtypal example is Google Adwords.  The only limitation to this, it has to be done in a way that does not turn off or cast doubt to the other side of the market, suppliers bidding for placement cannot destroy customer confidence in the recommendations that the platform is delivering.  I suspect that in many markets, “pay to play” would undermine the platform itself.

It turns out that the average rake at Priceline Group  is even higher today, as they allow merchants to voluntarily bid up their rake for better placement in the network (you can see this in the table above). This is one of my favorite marketplace business model “tweaks.” You start with a low rake to get broad-based supplier adoption, and you add in a market-driven pricing dynamic that allows those suppliers who want more volume or exposure to pay more on an opt-in basis. This way no one leaves the network due to excessive fees, yet you end up with a higher average rake over time due to the competitive dynamic. And when prices go up due to bidding and competition, the suppliers blame their competition not the platform (part of the genius of the Google AdWords business model). This also allows you to extract more dollars from those suppliers who desire to spend more to promote themselves (without raising the tax on those that don’t).

The Complex, Yet Simple Alchemy of Network Markets

I missed this incredible post from Bill Gurley where he breaks down the online marketplace built on networks, with the expertise of Chris Collinsworth breaking down a pistol offense.  So many things stick out that I excerpt freely below.  There are so many great themes, but perhaps the biggest that — like any good dealmaker knows — to have repeated success, both sides of the market have to walk away from a transaction thinking that they have gained so they return again and again.

• Great marketplaces do not simply aggregate a market; they enhance it. They leverage the connective tissue to offer the consumer a user experience that simply was not possible before the arrival of this new intermediary.
• When this experience delta is great enough, it creates “wow” moments for new users. “Wow” moments lead to word-of-mouth viral growth…”
• Another interesting example of this bi-directional advantage is AirBNB. For the property owner, the income is “found money” that simply didn’t exist prior to the marketplace. And in many cases the consumer receives a better price as well. If you can positively change the economics of an industry, you will find the participants on both sides rooting for your success. This gives you a huge head start when it comes to tipping the marketplace.
• In many marketplaces, the technology offering greatly enhances the user experience…as well as increasing switching costs.
• High buyer and supplier fragmentation is a huge positive for an online marketplace. Likewise, a concentrated supplier (or purchaser) base greatly diminishes the likelihood of a successful online marketplace. A highly concentrated supplier base will be reluctant to allow a new intermediary in their market, and as a result will likely fight rather than support your arrival. They will also be very reluctant to share in the economics of the industry…
• In some markets signing up suppliers is relative easy. In others, it can be a painfully slow process that requires lots of touch and local presence. At companies such as Yelp, Uber, and GrubHub, new city launches are relatively quick after a process model had been established for how to launch those cities.
• Remember, however, that supplier aggregation is the easy part. Aggregating demand is much harder and more critical.
• Another potential error that can be made while analyzing TAM is to fail to understand that the features and enhancements of the new marketplace may actual expand the market opportunity for the whole industry. This may sound like a brazen claim, but certain marketplaces do indeed expand the market — by exploring new price points or enhancing convenience or usability…Uber’s ease of use and simplicity have led many of its users to greatly increase the number of times they use an alternative car service. Some customers now use it as a second car alternative. As such, the company is meaningfully expands the market for black car services, which is in turn a huge boon to the suppliers that share in the economic expansion.
• All things being equal, a higher frequency is obviously better. Yelp, GrubHub, OpenTable, 1stdibs (for the designer) and Uber are all high frequency use cases, where the consumers can rely on the marketplace as a utility. Many failed marketplaces attack purchasing cycles that are simply way too infrequent, which makes it much more difficult to build brand awareness and word-of-mouth customer growth.
• Payment Flow. All things being equal, being part of the payment flow is superior to not being a part of the payment flow. This is due to the fact that it is much easier to extract reasonable economics when you are in the flow of payment. The supplier not only looks to you as a provider of revenue, but they receive that revenue “net of the fee.” Contrast this with a marketplace where you add value first, and then send a bill to the supplier at later date for services rendered. In this latter case the marketplace appears as an expense, and it’s easier for the supplier to view it is a “tax” versus a distribution relationship.
• Network effects are tricky and hard to describe but fundamentally turn on the following question: Can the marketplace provide a better experience to customer “n+1000” than it did to customer “n” directly as a function of adding 1000 more participants to the market? You can pose this question to either side of the network – demand or supply. If you have something like this in place it is magic, as you will get stronger over time not weaker.

Trust and Reputation Via The Social Graph

The Facebook or Linkedin Graph may have a psychologically lubricating effort into encouraging transactions on peer-to-peer talent marketplaces, taking a lesson from the room rental and ride-sharing sites, according to the Economist:

In addition, some peer-rental services (including Airbnb, RelayRides and Lyft) integrate with Facebook to let owners and renters check to see whether they have friends (or friends of friends) in common.

“We couldn’t have existed ten years ago, before Facebook, because people weren’t really into sharing,” says of the sharing economy does not” Nate Blecharczyk, one of Airbnb’s founders. Airbnb doesn’t require its users to connect their accounts to Facebook, but when people find they have friends in common with another user it sets their minds at ease. Thanks to social media, says David Lee, founder and managing partner of SV Angels, an early investor in Airbnb, “people are generally more comfortable meeting new people using technology.” Providing a secure platform for financial transactions is vital, he says, but creating a trusting community is just as important when it comes to attracting users.