My inaugural blog post on our website is an essay I wrote almost two years ago and published on medium.com. It is a piece I believe will stand the test of time.
In 2018, I spent most of my spare time studying startups. The best startup idea I came up with was a multisided marketplace in a large retail sector which had not yet been disrupted by digital technology. It will be soon, I know how it will happen :) a startup will build the technology that I envisaged back in 2018 within the next five years. I no longer want to build that startup, I do not want to create the tech, and I no longer dream of using it as the key enabler for a unicorn multisided marketplace... but I do remain a great admirer of MSMPs.
You may be unfamiliar with the term “multi-sided marketplace”, but I can assure you: you use them all the time. iTunes, AppStore, Uber, check-a-trade, etc. Most often, they do not sell their own products or services. They are marketplaces and their business is to create demand and connect it with supply. They use ingenious and often intricate business models to monetise suppliers, advertisers as well as customers on their platforms.
The 7 Wonders of Multisided Marketplaces and ‘Networked’ Economics
Dec 2, 2018·6 min read
Platforms, multi-sided marketplaces are fascinating businesses. They pose difficult challenges. Growth is hard to ignite, it requires understanding, management and monetisation of multiple customer bases (buyers, sellers, developers, advertisers, etc.). On the other hand, platforms can be monetised in innovative and disruptive ways, and those that achieve ‘critical mass’, often end up with ‘power law distribution’. Which is just the smart way of saying: “the winner takes it all” and sweeps all chips for a large segment, entire market or for a bunch of connected markets. Scale is the ‘name of the game’ in the platform business and these are the 7 challenges and wonders of building large multisided marketplaces (Note: I will use the terms ‘marketplace’ and ‘platform’ interchangeably hereunder).
(1) Multisided = ‘Double’ Burn
This problem often referred to as the ‘chicken and egg’ conundrum. Users, viewers, buyers, costumers are not incentivised to join before sufficient mass of content is available on the platform. Without users and demand, contributors, app developers, service providers, manufacturers, designers, etc. will not provide content or discontinue providing their services, and supply will build very slowly or will not build at all. Most often, some ‘supply’ (e.g. content), is created initially, but in order to resolve the ‘chicken and egg’ conundrum, resources must be poured into building both sides from an early stage.
Cost of Building Solutions For Multiple ‘Sides’
The start-up has to ‘burn both ends of the candle’ at a stage when growth is slow, revenue is low and resources are limited. Most platforms never pass this stage, they never become ‘liquid’ and fade into oblivion.
(2) Product-Market Fit = ‘Liquidity’
Achieving product-market fit is extra difficult for multisided marketplaces. Conventional start-ups invest in mass customer acquisition AFTER reaching product-market fit. Platforms need to acquire a large or fast growing ‘customer’ and ‘supplier’ base IN ORDER TO reach product-market fit. Their value proposition is THE marketplace they create. Without demand or without supply there is no market. Without market there is no ‘marketplace’ and no value generated on the platform.
Platforms must create sufficient ‘liquidity’ by acquiring large number of suppliers (content liquidity) and users (demand liquidity). They must solve the ‘chicken and egg’ conundrum to create value for each side: product-market fit is created by liquidity and liquidity gets the marketplace going.
(3) Liquidity = ‘Tornado Effect’
Successful platforms grow like tornados do, i.e.: formed from two components and gaining momentum at an exponential rate.
Tornados formed from the swirl and rise of warm moist air meeting large quantity of dry cold wind. The rising swirl creates low pressure below and keeps sucking in continuous and growing supply of warm and cold air. Energy of the whirl keeps multiplying and the tornado expands up and out.
The Platform Tornado — Tom Rigo, 2018
Continuous flow (liquidity) of supply and demand is the life-blood of platforms. It is the energy that elevates websites from small ‘whirl winds’ into large platform ‘tornados’:
Each new user ads further ‘network nods’ by pulling peers, friends, colleagues, business partners, etc. This drives exponentially increased number of interactions and transactions on the marketplace. This attracts growing network of contributors (content and service providers, developers, etc.). Abundance of applications, relevant content and services generate cash liquidity. Interactions and transactions continue growing at an exponential rate, further lifting and extending the platform ‘tornado’.
(4) Tornado x Pre-Monetisation = Burn Rate on Steroids
Exponential network growth creates its own problems. A particularly difficult one occurs when the number of users and transactions sky rocket before the business model becomes sustainable. Why? Because scaling the platform changes its economics.
Cost of Exponential User Growth With Negative Margin
Prior to scaling, the number of transactions is low and ‘burn rate’ is largely driven by fixed costs and overheads (e.g. salaries, office rent, investment in equipment). At scale, burn rate is driven by the margins achieved on transactions. If the margins are negative, the amount of money burnt becomes function of the number of transactions. Each transaction generates loss and losses follow the same exponential trajectory as that of the number of transactions. Fast growing platforms cannot afford to stuck in a negative spiral where Customer Acquisition and Retention Costs exceed Customer Lifetime Value:
LTV < CAC + CRC
PayPal and YouTube both went through periods when the more customers they gained, the more cash they burnt. They avoided bankruptcy by adjusting customer acquisition and monetisation mechanics and thank to the deep pockets of their parent companies, eBay and Google respectively.
(5) Tornado x Cash Positive Monetisation = Margins on Steroids
Implicit to the dynamics explained at no.4: Cash positive monetisation of transactions puts gross margin (GM) on steroids, because GM is function of the number of transactions.
Exponential growth translates into similar trajectory of gross margin. Meanwhile, fixed costs can be spread on a growing network of users and this leads to reduced cost per user and lower total cost per transaction.
(6) Data = The New Gold = Profits on Steroids
90% of all data ever generated by humanity was created in the last two years. The vast amount of user data, transactional and contextual data of platforms transforms return on investment of user acquisition and retention activities. Targeting of customers with new services and re-selling becomes highly efficient, data driven and automated.
Vast amount of data combined with technology guarantees to hit the target in the bullseye. As a result of better targeting, marketing costs will reduce and LTV will become multiple of acquisition and retention costs on the platform:
LTV > CAC + CRC
So, exponential growth in data leads to growth in cash positive transactions as well as reduction in cost per transaction. Upselling via automated and sharply targeted offers puts profit of large platforms on steroids. They say, ‘time is money’. In networked economics: data is gold.
(7) Platforms = Higher ‘Value Multiplier’
Future cash-flow expectations of platforms are based on their ability to grow and monetise their user base. The more opportunity created to monetise relationships and the more profitable are those relationships, the higher the future value of the platform becomes. ‘Opportunity’ is a function of the amount of interactions and as described under no.6 above, interactions are driven by data.
‘Profitable relationship’ is function of LTV. Combination of the LTV and the amount of user engagement with average user can provide a good proxy for the future value generation prospects of platform businesses:
The above equation is not scientific, but it is pretty intuitive. Value of the platform is predominantly driven by A) the propensity of user engagement and B) cash balance generated through the interactions.
(+1) Bonus Wonder
The ‘bonus wonder’ of platform businesses is their very nature of being ‘multisided’. ‘Single sided’ businesses derive their income from selling or brokering products and services to customers. Multisided businesses can monetise their relationship with suppliers, make money from buyers and often receive income from advertisers and generate revenue from their own software or consultancy services on the marketplace. Once at critical mass, their business model choices multiply and platform ‘tornados’ become force to recon with. Multiple revenue flows allow them to cross-finance losses. E.g. Free services and low prices given to customers can be cross financed from revenues generated from suppliers. Investment into attracting more suppliers can be paid from advertising revenues.
I hope you agree: digital platforms are true wonders of the start-up world. Why would anyone want to build a traditional business? Traditional companies rarely benefit from ‘tornado effects’, they are ‘treadmill’ businesses. Customer acquisition and growth is slow, the business requires significant effort just to stay in the same position. Their valuation is based on single to low double-digit multiples of profits they generate (e.g. 10x). Think big, aspire to build a multisided ‘tornado’ instead.
Thanks, and I would love to hear from you,