A thriving two-sided marketplace is one of the better businesses to run. Operational costs are relatively low (especially when compared with traditional eCommerce), the marketplace itself is highly scalable, and the network effect of a large marketplace inherently discourages competition. The real challenge for entrepreneurs, however, is striking a balance between supply and demand, particularly during the initial stages of the marketplace’s growth. Fundamentally, this is a chicken-egg problem – limited demand discourages quality suppliers, while a lack of quality suppliers impedes demand generation.

Building a defensible two-sided marketplace, thus, means striking a balance between finding enough buyers to keep sellers interested, and attracting just the right type of suppliers to give your marketplace some legitimacy.

Balancing Demand and Supply

Building up supply is arguably more difficult than generating demand in the initial stages of a marketplace’s growth (the situation gets reversed once the marketplace matures). This is particularly true for broad, mature markets (say, taxis) served by traditional marketplaces. The only way to attract quality suppliers in the initial stages is to ensure that your value proposition is strong enough to offset the opportunity cost of investing time and energy into your marketplace. It is not unusual for founders to kickstart the supply in the initial stages themselves. Uber founders Travis Kalanick, Garrett Camp and Oscar Salazar, for instance, were the first three ‘drivers’ who tested out demand for the service. Similarly, Reddit founders created the initial ‘seed’ content for the company by posing as fake users.

Demand generation is comparatively easier (emphasis on comparatively) in the short term with a cache of early, quality suppliers in place, but it is by no means trivial and only gets harder at scale. The initial demand is crucial to keep suppliers invested in the marketplace long enough for the network effect to kick in, but ultimately the  challenge is to generate enough demand in the long term to ensure happy suppliers. This is best done with some sort of key differentiators, whether it be brand loyalty or a proprietary technology.

Below, we’ll take a look at some actionable strategies and differentiators a marketplace can adopt in its initial and growth stages:

1. Have a niche focus: Marketplaces like Etsy have been phenomenally successful by focusing on a niche market (handmade products) underserved by existing marketplaces.

2. Offer a new take on an existing model: Lyft and Uber have been successful by offering both drivers and passengers a new take on an existing model. For both these marketplaces, the opportunity costs for drivers is offset by the flexible work hours and increased demand for their capacity. Passengers, meanwhile, are attracted primarily by the convenience and lower costs as compared to traditional cabs.

3. Tackle one market at a time: Uber launched in San Francisco before expanding to other regions. Founder Travis Kalanick already had a strong social network within San Francisco, which provided initial demand. It also didn’t hurt that a number of tech publications and bloggers are located in San Francisco, which summarily helped generate word of mouth (and pent-up demand) for Uber before the company expanded to other markets.

4. Offer a better solution to underserved customers: Airbnb found its initial buyers and suppliers in the vacation rentals classifieds of Craigslist. They were clever in their approach in doing so, as well, since Craigslist didn’t offer an API. Airbnb’s service was both more convenient and safer for both sides of the marketplace that had traditionally been underserved by existing services.

Building a Defensible Marketplace

Although two-sided marketplaces are highly defensible due to their very nature, they are, by no means impenetrable. This is particularly true today due to the low costs of building marketplaces and attracting audiences. To this effect, some strategies startups can adopt to retain their market position are:

1. Leverage technology: Technology can be a significant factor in creating a defensible marketplace, especially when it cannot be easily replicated without sufficient data. Uber’s vast collection of data, for instance, gives it a significant competitive advantage over new-entrants, who cannot compete with its superior matching algorithm sans data.

2. Build Loyalty: Lyft has been particularly successful in resisting competition by building a strong culture centered on its drivers. The company regularly holds community rallies to drum up support, which pays off in the form of better brand loyalty. It also operates a private Facebook group where it encourages drivers to interact with each other.

3. Foster a Community: Pinterest founder Ben Silbermann individually emailed the first 5,000 users (it took nearly a year for Pinterest to find its first 10,000 users) and regularly held meet-ups with them. This helped foster a strong sense of community and loyalty which allowed the startup to reach scale.

Building a two-sided marketplace is tough, but by no means is it impossible. Plenty of startups have done it before, and plenty will continue to do it again despite the overwhelming odds.

–Arteen and TX

Last week, we posted what qualitative characteristics we look for when evaluating eCommerce companies. This week, we thought we’d get to the real fun and talk about the quantitative stuff.

The Quantity:

When looking at financial projections, the earlier the deal, the more likely the projections will be wrong. Thus, we put most weight in you understanding your financial model, not just your projections. Within that, you should know what your key performance indicators (KPIs) are and which are most critical to the success of your business.

Key metrics to track as an eCommerce company: 

1.  Cost of customer acquisition (CAC)

How much do you have to spend to get one new customer?  You should take into account anything you spend to bring in new clients, including share partnerships, paid marketing and cost of direct sales.

2.  Conversion rate (CR)

Of your site traffic, how many are actually buying? Depending on source, this varies from ~0.75% from social media to ~2% from search and ~3% from email. Desktop and tablets get double or triple the CRs than smartphones.

3.  Shopping card abandonment

How many potential customers put products in their shopping cart but didn’t place the order? The average is 67 percent of shopping carts are abandoned.

4.  Average Order Value (AOV)

What’s the average size of a single transaction? Of course, this is variable, but we see averages between $80-$120.

5.  Life time value (LTV)

How much profit will a single customer generate over the entire span that they are a user? Use this formula:

(# of months they will be a customer x average order value/month) – customer acquisition cost

6.  Churn

What is the rate at which you are losing customers? If you have 100 customers in April but only 80 in May, that means 20 percent of them have churned. Churn rates below 5-8 percent are ideal, but the lower the better. By dividing 100 by your churn rate, you can also estimate expected number of months as a user. For instance, a churn rate of 20 percent indicates your customer will only stick around for five months (100/20), which is not very long.

Rules of thumb we use when evaluating metrics:

1.  Gross margins near 50 percent

Because eCommerce businesses are so capital intensive, we want to make sure you still have at least half of your revenue remaining for operating expenses, selling, general and administrative expenses (SG&A), etc. after taking out the cost of goods.

2.  Lifetime value of at least three times the cost of customer acquisition

In another words, the amount of revenue a single customer will generate for your business over the entire span of them being your customer should be at least three times greater than how much you have to spend to get that customer.

3.  Size of your raise that lasts at least 12 months, if not 18

For example, if your net burn (revenue minus total expenditures) is $50,000 per month, you would need to raise $600,000 for a 12-month runway.

 4.  Reasonable conversion rates

You should have reasonable expectations for conversion down each step of the purchasing funnel. If they’re much different, you should have solid reasoning to justify why they’re different. Reasonable rates for email marketing are as follows, partially from Monetate reporting.

• 15% email open rates
• 20% click through on those opens
• 8-10% add to cart rates
• 67% cart abandonment (meaning 33% follow through with purchases)
• Following that entire funnel through = ~1% traffic to sale conversion

 

 5.  Realistic revenue expectations

Unrealistic expectations are a red flag for us. Anything greater than 20 percent month over month top line revenue growth is often unrealistic, with the exception of the occasional extreme outlier.