Four Questions Every Marketplace Startup Should Be Able to Answer

The six years I spent building products at Airbnb, scaling the marketplace over 100X, transformed how I understand the work of starting a marketplace platform. No startup is immune to hiccups and setbacks, and sometimes it can feel like you're in combat. But if my time as a product manager at Dropbox felt like operating a stealth bomber, the Airbnb experience felt like trench warfare. Marketplace businesses can be messy, and every gain is hard earned. After all, you're dealing with an ecosystem of participants — buyers and sellers — that's constantly in flux, their needs and desires changing over time. Unfolding in both online transactions and offline interactions, marketplaces are organic and dynamic.

That dynamism can be a tremendous advantage to marketplaces. Their inherent network effects, done right, create a unique virtuous cycle: as liquidity increases, participants become more engaged. Still, not every marketplace succeeds. For every Airbnb there's a house-swapping marketplace that didn't get to liquidity; for every Uber there's an on-demand marketplace that couldn't get the economics to work. Those success stories have overcome many obstacles, largely because they leveraged key elements within the marketplace to create "lightning in a bottle."

Marketplace leaders need to be experts in the dynamics of their platforms. Identify those dynamics in the early days, and you can position yourself to build an enduring and deeply liquid market that creates competitive moats. In my role as director of product at Airbnb, and as a student of the field around us, I identified four key factors that shape every marketplace: network effects, type of supply, incentives, and size and frequency of interaction. Understanding those factors — and structuring your platform accordingly — can make the difference between a wildly successful marketplace and one that never gets off the ground.

Defining a Marketplace

First, though, a quick look at what makes marketplaces different from other businesses. Simplistically, a marketplace is a place where buyers and sellers meet to conduct commerce. In the online setting, that definition still holds true — online marketplaces give buyers a choice in what they would like to buy and sellers a variety of people to sell to. I classify Airbnb as a search marketplace, where the guest selects where they will stay, choosing what to "purchase" in the marketplace.

In recent years, the definition of a marketplace has stretched to include on-demand models that are considered marketplaces because of the independent contractor relationship on the seller side. I classify Uber as a matching marketplace, where the passenger does not pick the specific driver but is matched through an algorithm based on wait time and the routes of other passengers.

Marketplaces have inherent benefits that are unlike those of most other types of businesses:

  • They involve low capital costs, as inventory is brought to the market from the suppliers.
  • The market can self-correct by offering more of the good or service as buyers demand it more, making each marketplace function like a mini economy.

But they also have inherent disadvantages:

  • Because marketplaces need a certain amount of supply from day one, they are super hard to start.
  • It is hard to control the quality of inventory.

Think about why a marketplace would make sense for the problem you are trying to address. If bridging the gap between buyers and sellers is so compelling that both sides will be drawn to your product, producing deep liquidity, then a marketplace model might work. Just be aware of the pros and cons: Marketplaces are challenging in the early days. You may be able to solve that same problem, and build a great business, by controlling supply instead of providing a platform where supply is self-managed. On the other hand, while controlling supply might be easier at the outset, costs often prove more challenging at scale. Marketplaces are a double-edged sword — they can produce impressive outcomes but are hard to get off the ground.

There are four essential factors that shape any marketplace, and with them, four questions that every founder needs to be able to answer before embarking on the messy, rewarding adventure of building a new marketplace.

1. Type of Network Effects: How will your marketplace grow?

All marketplaces exhibit a form of network effects, where each additional user on either the demand side or the supply side enhances the utility of the network for all users. This network dynamic is articulated well in the blog post "All Marketplace Are Not Created Equal" by Bill Gurley.

What is special about Airbnb is that it exhibits global network effects. I mean this literally. Every new listing, wherever it is located, benefits any guest, because travel is global. On the other side, every new guest that joins the platform benefits every host, as guests can come from all over the world. Many businesses achieve network effects, but very few achieve truly global network effects.

Other types of marketplaces might have root density network effects. What I mean by this is that each market grows independently of another. Consider an example like TaskRabbit (services) or DoorDash (food delivery). As supply and demand increases in a specific market, like San Francisco or New York, the experience improves for both sides. But those networks do not meaningfully facilitate new markets. Supply gains little value from demand growth in another market, and demand gains little from supply developing in another market. These businesses grew from being the first mover in each market, then aggressively building supply, city by city.

Uber is another interesting example — it's a little bit of both. At its core, it's a root density network effects business; most customers use the app in their home market. But Uber also touches travel, a unique category that is global by nature. When you fly into a new city, you commonly need transportation, and Uber's supply in that market can fulfill your needs immediately. Uber exhibits global network effects in a minority of its use cases, travel, enabling it to build liquidity faster than businesses that benefit solely from root density network effects.

The way to grow supply for global network effects and root density network effects differs. Global network effects businesses tend to grow more organically. At Airbnb, we started to see listings pop up in remote parts of the world that we previously couldn't find on a map. All travelers could see those listings, too. We decided to make our platform as broad as possible from the get-go and allow anyone to list their place while we raced to internationalize the product over several years. Meanwhile, to accelerate this growth and jump-start liquidity, we focused efforts in specific key markets.

Root density network effects businesses tend to grow supply in more concentrated ways. For Uber, if just one driver operated in a market, passengers would become immediately frustrated and not use the product. In these cases, it is best if the product is restricted in each market — a specific geography or vertical — until there is enough supply to create a compelling user experience. Both types of network effects can lead to enormous success, but it's crucial to understand these dynamics as you build supply.

2. Homogeneous vs. Heterogeneous Supply: Is your startup a search marketplace or a matching marketplace?

Another factor that dictates the dynamics of the marketplace tremendously is the uniqueness of your supply.

Airbnb offers heterogeneous supply, meaning that each listing is unique. This creates a competitive moat — it is hard to replicate that supply — and an inherent advantage to Airbnb.

On the other hand, this heterogeneity increases cognitive load on the demand side. Heterogeneous marketplaces are search marketplaces, where guests are responsible for finding their desired listing. Searching for the right supply becomes the biggest barrier to a transaction, which can create a huge drop-off in conversion. Reducing that cognitive load, then, becomes a key challenge for heterogeneous marketplaces.

There are a few ways to do that, including:

  • Decreasing the number of choices for the demand side by artificially constraining the number of options
  • Providing filters to curate available options
  • Developing taste profiles of users to adjust search to reveal the most desirable listings up front

Once you have unique supply, it is up to the product team to build a compelling demand-side product experience that simplifies search, creating as much of a one-click purchasing experience as possible.

Many other marketplaces offer homogeneous supply, meaning that one supplier's goods are roughly indistinguishable from another's. Unfortunately, that makes it easier to replicate the business, as the supply is not unique and can be quickly copied. But a huge benefit is that it decreases the cognitive load on the demand side, creating a simpler transactional experience. Consider, for example, using Uber. The purchase experience is not a search problem anymore — it becomes a matching problem that the marketplace solves through algorithms. Homogeneous marketplaces are matching marketplaces, where demand doesn't care which supply they receive as long as it is above the standard that the marketplace sets.

Without the competitive moat that unique supply affords, homogeneous marketplaces compete on other aspects of the product offering, like price. This type of competition can compresses margins, though. The best way to compete is to create additional value for your platform's users, thereby fostering greater loyalty — for example, by focusing on the supply side and treating them like partners instead of a commodity. Another competitive dynamic — one that seems to be playing out between Uber and Lyft — is focusing on brand distinction, or what values the marketplace ultimately stands for.

3.. Two-Sided Incentives: How will you keep both buyers and sellers in the marketplace?

For a marketplace to function — and keep functioning — both sides need to desire to conduct commerce within the marketplace and not outside of it. If either side leaves and brings the other along with them, then the platform is cut out of the equation and a transactional revenue model breaks down. This is called market breakage.

There are two broad incentives to keep transactions on the platform: trust and convenience. A buyer has to have faith that any inventory in the marketplace is going to be qualified, and has to be satisfied that there's no easier way to conduct the transaction than through your platform. The key, though, which is often ignored, is that both trust and convenience need to be established over multiple interactions. Buyers and sellers conduct commerce with new participants all the time requiring the platform to establish these incentives with each transaction.

Trust is a critical theme for Airbnb. We needed to help hosts over the high hurdle of letting someone into their homes and convince guests that our platform could deliver an amazing trip. Through technology, Airbnb enabled a behavioral shift in travel and accommodations that is still playing out today. Technology can bridge trust by offering:

  • Identity Verification — Who is this person and do I trust them?
  • Reviews — Have others stayed here and do they like it? What do other hosts have to say about this guest?
  • Assurance — If something happens, can I call on someone during my travels? If my home is a mess, will I be covered for my loss?

Once both sides have had several trusted point-to-point interactions, they begin to ascribe trust to the platform at large, enabling them to be more promiscuous in their interactions. That's how the platform strengthens its value. If parties always conducted commerce with the same participants, then the platform would provide no additional trust and those transactions would eventually be taken offline.

The convenience of interacting on a new marketplace platform should be several orders of magnitude better than the alternative. Before Airbnb, prospective travelers would search a variety of websites hoping that they were not scams — if they could find an accommodation at all. Technology can offer greater convenience by facilitating:

  • Payments — As a host, will I get the money for the stay? If I send money, can I be sure the listing exists and isn't a fraud?
  • Messaging — Can I easily communicate and reach out to the other party?
  • Transactions — Did I buy the good or service? Did it reduce the burden of going back and forth multiple times?

All marketplaces build trust and streamline friction between the buyer and the seller to lower the barrier to commerce, creating liquidity. These incentives may not be enough, though, as some marketplaces continue to have market breakage. The core use case has to be strong enough to withstand anyone deviating from the platform.

For Airbnb, a traveler's destination is typically different each time they travel. If there were repeat interactions, then trust could be built outside the platform, opening up the possibility of taking the transaction off of Airbnb. This rarely happens, though, because of the variety of destinations and the complexity of trying to take an international transaction off-platform. Airbnb provides trust and convenience between new parties all the time, keeping both sides on the platform.

For Lyft and Uber, it is easy to assume that trust is quickly developed between both sides and that a passenger could just call up a favorite driver and pay them in cash. They don't, though, because calling a driver directly would inevitably take longer than allowing an app to select any driver for you. Uber and Lyft keep people on the platform by offering the convenience of shorter wait times and therefore a better experience.

A cleaning service model, on the other hand, is more challenged due to the repeat nature of the interaction between the same party. Once trust is established through the platform, it is just as convenient to call the same cleaner directly the next time. After the marketplace creates an initial match, there is little reason for either side to stay on the platform. For that reason, these types of services work much better using a lead-gen model, where revenue is based on leads and not transactional.

Trust and convenience are key to the vitality of a marketplace. Each platform must find its own way to create these incentives, and to keep creating them with every interaction. It's well worth the time to identify how a new platform will do that from its earliest days. Get it right, and you'll unlock enormous opportunity as you scale.

4. Size and Frequency of Interaction: What are the unit economics of your marketplace?

The size and frequency of interaction in a marketplace are paramount to its health. Frequency of interaction determines how much liquidity there is on the platform. It is always better to have a higher frequency of interaction, which begins to change users' behavior and make the product stickier. Ideally, it becomes part of users' lives, staying top of mind when it needs to be. (Make sure those frequent interactions aren't always between the same parties, though, or you're headed for market breakage as we discussed above!)

On the other side of the equation is the size of each transaction. Larger-dollar transactions are better for the platform because they generate more economic activity. Normally, the larger the transaction the lower the take rate (i.e., the platform's percentage fee) should be, to disincentivize participants from taking the transaction offline.

The ideal marketplace would generate high-dollar, high-frequency transactions. If this case existed, it would create tremendous value for participants and therefore for the marketplace itself. Flush with cash, the business would also be able to spend significant amounts of money to acquire new users.

Some businesses are high dollar but low frequency. Airbnb fits squarely in this category. It is disadvantaged because guests only travel a few times a year. But when they do travel, they spend a considerable amount of money. That makes the unit economics of Airbnb's business model work. Moreover, the nature of travel exposed Airbnb to a large national and international audience, allowing it to thrive even though the number of transactions per user is low.

For other marketplaces, like Uber and Lyft, transaction size is small. But because the frequency of usage is high, creating a ton of liquidity, the unit economics work here, too. This is the exact opposite of a model like Airbnb's.

Tread carefully with marketplaces that deal in low-dollar, low-frequency transactions. With little money coming in, it becomes increasingly difficult to acquire users, and revenue per transaction is commonly too little to even cover credit card processing costs. The only way to make this model work is to have enormous user numbers. It's challenging to get these marketplaces off the ground, though, let alone to build that kind of liquidity.

Every marketplace should strive to drive higher-frequency usage, particularly in the early days. Sometimes the way to do that is to actually aid the supply side in lowering their transaction size so that the product becomes more compelling for the demand side. Liquidity is key. Making sure that transaction volume is thriving is more important to a new marketplace than getting the largest revenue per transaction.

Closing Thoughts

Each marketplace faces its own unique challenges, as every platform is different.. Being the Airbnb for X or the Uber for Y does not mean that it will work. Exploring all the nuances of the marketplace model is critical to understanding if there is an enduring business to be built.

Marketplaces aren't going anywhere; entrepreneurs will continue to build compelling consumer- and business-facing platforms that transform society. Just as online marketplaces began by selling goods, like eBay, then evolved to sell services, like Airbnb or Uber, we're now entering a new era. The eBays, Airbnbs, and Ubers of the world had to solve many technical marketplace challenges themselves, but those solutions are now being productized. Technologies like Stripe for payments, Checkr for background checks, and Lob for address verification will only make it easier to create new marketplaces.

But no new technology, no matter how good, can replace an understanding of the basic principles of marketplaces. If founders aren't intimately familiar with concepts like network effects and two-sided incentives, their marketplaces will flounder. Not every problem or vertical should be solved with a marketplace.. But if these four factors align, then with hard execution you can build the liquidity needed to maintain a thriving platform. I can't wait to see what's next!



SHARE THIS
Previous Post
Next Post