Oh, The Marketplaces You’ll Go!

This week, one of the top venture capital firms in the world — Greylock Partners — announced their commitment to funding online marketplaces and added a new partner to their ranks to spearhead this effort. This isn’t just any partner, it’s the guy  (Simon Rothman) who created eBay Motors and is one of the Valley’s experts on all things marketplaces. Even though 99% of technology investors would by definition be interested in marketplaces, as they are a form of a “network effect” business (which scale nicely and are deeply defensible), when a firm like Greylock explicitly communicates its interest in the space and commits a decent percentage of its fund to it, I take notice. Perhaps only a small handful of firms have, in the last 5-7 years, been inside the center of the vortex of so many large network effect businesses.

There are many definitions of what constitutes a “network effect” product. I don’t want to debate that here, but instead, share with you the clearest, most simple articulation of network effects I’ve come across, courtesy of an investor at Venrock named Brian Ascher, who writes: “Network Effects are special because they: (1) Provide  logarithmic growth and value creation potential; (2) erect barriers to entry to thwart would-be competitors; and (3) can create “Winner Take All” market opportunities.” Ascher goes on to list four types of network effect models: (1) classic networks, such as messaging; (2) marketplaces, such as eBay; (3) big data loops, such as Google; and (4) platforms, such as Facebook.

With respect to marketplaces, Ascher writes:

“[Marketplaces are] aggregations of buyers and sellers attract each other. Lots of sellers means variety, competition, and price pressure, which all serve to attract more customers. And because the customers flock, more sellers are enticed to participate in the marketplace. eBay, stock exchanges, and advertising networks are all examples. One nuance of marketplaces, however, is they differ in terms of the scale required for acceptable liquidity. For example, ad networks can achieve sufficient reach and liquidity at relatively low levels which is why you see thousands of online ad networks, where they each exhibit network effects but not in a winner take all fashion. Stock exchanges and payment networks require far greater scale for network effects to operate, which is why you see much greater concentration in these industries.”

As someone who geeks out over eBay auctions and took too many economics classes, marketplaces are perhaps one of my personal favorite types of online (web or mobile) plays. There’s something poetically elegant about using the web and phones to find market inefficiencies to squeeze out and to find new point of equilibriums in shifting markets. I’m trying to classify the “types” of marketplaces I see, and while I realize this may be a crude exercise (please tell me what you think below), I believe there are two types:

  1. Marketplaces which connect buyers and sellers in the exchange of goods, assets, or information. The king example here is eBay, which connects people to buy and sell goods and handles the transaction, but leaves it to the market participants to complete the transaction and adhere to community norms.
  2. Marketplaces which connect buyers and sellers in the exchange of services or labor. A great example here would be Uber, which finds equilibrium in a market for transportation by matching demand with supply and also handles the transaction. These are typically hard networks to run because there is a significant offline service component that is, in part, out of the control of the marketplace commissioner.

So, I would argue that whenever you come across a new business lauded as a “marketplace,” it will have to fit into one of these two categories, and depending on the classification, will have different issues around market liquidity, participant ratings and rules, payment channels and gateways, and in the case of #2, closing the loop on the transaction as there is a significant offline component.

The issue here, of course, is that while everyone knows it’s very hard to build up a marketplace in either category (especially getting to liquidity), there are early-warning signs that emerge that could give a clue into what the unit economics could mutate into once scale is achieved. It is here where early-stage founders and investors can identify big and/or niche but lucrative opportunities to exploit based on the “platform rake” of the marketplace. One of the best posts on this subject is by Benchmark’s Bill Gurley, part of the firm which invested early in eBay, who writes:

Many Internet marketplaces also have a rake. The percentage rake is the amount that the marketplace charges as a percentage of GMS (gross merchandise sales), which typically represents net revenues for the marketplace. As an example, eBay’s 2011 marketplace revenues were approximately $6.6B against GMS of approximately $68.6B for a rake percentage of just under 10%. It may seem tautological that a higher rake is always better – that charging more would be better than charging less. But in fact, the opposite may often be true.”

Therefore, in assessing the potential of a nascent marketplace, one would not only want to consider the GMS, but also the approximate rake the house can clear on each transaction. As an example, in a niche marketplace which doesn’t have high transaction volume but where the average clearing price of a transaction is very high, even a tiny rake percentage could yield high-quality revenue. (As an aside, this is why, in part, folks in the Valley are so tirelessly frustrated with Craigslist, which isn’t a marketplace, per se, but is rather a free listings service. While it makes lots of money selling listings into a handful of categories, if it were to transform into a platform and marketplace, it would generate billions of dollars but also require the landlord to create and enforce a range of community norms so as to not upset its quest to extract rents.)

My belief is that there are a host of small, seemingly niche online marketplaces out there today that could have the unit economics to mature into not only fantastic cash generators with growth, but also to disrupt industries in decay or industries which use old methods of command and control to restrict access and thereby artificially protect their rents. This is but one reason among many why Uber has built such a strong, global, consumer brand — customers and drivers are re-energized by the new life this marketplace allows for.

From the micro-perspective of niche marketplace opportunities, I will end with a higher-level macroeconomic view about why not only is everyone is so interested in the power of marketplaces but why the next few decades could be ripe for all sorts of economic reordering:

  1. First, consider the structural changes at play in the United States economy, with wealth continuing to concentrate in specific geographies and a slew of jobs that simply will never come back. The economy is fundamentally restructured as a result of these forces.
  2. Second, consider how these structural changes will alter the demand-side equation, and when demand increases regardless of price, supply will rush in to fill it — this creates new economic opportunities.
  3. And, three, make sure to read this excellent book review of Taleb’s book “Antifragile,” written by Union Square Ventures’ Albert Wenger, where he makes the case for antifragile approaches to technology investing given that the past is not a good predictor of future outlier events and given that in the face of immutable forces, assets which exhibit strong antifragile properties will not only persist, but potentially gain strength over time. In such a long-term scenario, the elegance and resilience of marketplace economics combined with the efficiency and dispassion of the Internet (web or mobile) provide the necessary ingredients for the landlords to change and for renters to be better off in the future.

Haywire is written by Semil Shah, and is published under a Creative Commons BY-NC-SA license. Copyright © 2014 Semil Shah.

“I write this not for the many, but for you; each of us is enough of an audience for the other.”— Epicurus