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The Next Era of Spectacular Start-Ups

Nine out of ten startups fail, according to Fortune magazine.1 But a handful of firms, like Uber and Airbnb, have not only beaten those odds, but have grown from zero to billion-dollar businesses in less than a decade.

What do those successful start-ups have in common? They use an online marketplace business model that connects buyers and sellers. And the model is becoming both increasingly popular and increasingly profitable.

In fact, according to the Harvard Business Review, a decade ago there were only two online marketplaces valued at $1 billion or more in the United States: eBay and Craigslist.2 Today, more than a dozen businesses have soared past that milestone, including Airbnb, Etsy, Groupon, GrubHub, Seamless, Lending Club, Lyft, Prosper, Thumbtack, Uber, and Upwork.

That’s just the beginning. By 2020, according to the venture capital firm Greylock Partners, the number of billion-dollar firms based on this business model will double.

What accounts for the growth of online marketplaces? They are perfectly positioned at the intersection of at least three other trends that we’ve explored in previous issues:

1. The escalating momentum of network effects
2. The global cash glut
3. The power of two-sided electronic markets

Let’s discuss how these three trends apply to online marketplaces, starting with network effects. According to Metcalfe’s Law, “The value of a network increases in proportion to the square of the number of people using it.”

As more people join a network, it becomes more useful to everyone who uses it. If only 1,000 people are buying and selling goods on an online auction site like eBay, the network has very little value, because buyers won’t find the variety they want, and sellers won’t get the competition among buyers that drives up prices. When millions of people join a network, everyone derives more value from it.

The same is true of newer networks like Uber. If there are only ten Uber drivers scattered across a major city, the quality of the service will be lower than if 10,000 drivers are available to pick up a passenger anywhere in the city within minutes. Obviously, if there are ten passengers using the app in a city, there won’t be enough business to attract drivers; but if one million passengers use it, the drivers will have more opportunities to make money.

So Uber and the other new network startups have capitalized on network effects by quickly growing both the supply and demand sides of their businesses in order to increase the value to users.

However, growth is expensive. In Uber’s case, the only way to accelerate that growth was to pour money into the business. Essentially, Uber made sure there were enough drivers by paying a higher rate than the free market would dictate. And it boosted the number of passengers by keeping the rate that they pay artificially low compared to the rate that its drivers received.

How could Uber afford to do this? The answer is that the global cash glut has made venture capital easy to obtain for startups like Uber that use an online network model.

According to an article on Observer.com written by Simon Rothman of Greylock Partners, the years from 2010 to 2015 were “the steroid era of startups… when money was cheap and more plentiful, and used as a performance-enhancing drug for company acceleration…. Cash was able to singlehandedly drive scale and growth.3 The zero-interest-rate environment created a generation of investors desperate for returns, and everyone - from angel investors to LPs - ?had money to put to work. The overhang of cash pushed the market pendulum to swing from fear to greed, and with it came unprecedented round sizes, valuations, and total capital raised. This level of venture money hadn’t been seen since the 1999 tech bubble.”

But the VCs learned a painful lesson from the bursting of the tech bubble; now they expect a startup to demonstrate a path to profitability. For networks like Uber and Airbnb, that path involved using cash to achieve liquidity at a faster pace than their competitors. The goal was to reduce the amount of time needed until the lifetime value of a customer became greater than the cost to acquire that customer.

According to Rothman, over a six-year period, Uber raised a staggering $9 billion in equity and $1.6 billion in debt over fifteen rounds of investment. Uber used the money to win the battle with similar competitors Lyft and Sidecar. How did it win? It made the market irresistible to both drivers and passengers. Uber guaranteed drivers rates of $25 an hour, even if there weren’t enough passengers. It also provided passengers with pickups in five minutes, as well as giving away free rides when they referred the service to others.

As the number of drivers increased, faster service was easier to achieve. As the number of passengers exploded, drivers began earning enough money from rides to reduce or eliminate the subsidies. As drivers’ earnings climbed, more drivers joined the network, which made the network more valuable to passengers, and so on, just as Metcalfe’s Law predicted.

Essentially, Uber bought both the supply and the demand until the network grew so large that network effects took over: More supply attracted more demand, and more demand attracted more supply, and so on.

That’s both the challenge and the benefit of two-sided electronic markets. As difficult as it is to build a single company (remember that nine out of ten startups fail), it’s at least twice as hard to create a business that targets two types of customers - such as landlords and renters on Airbnb, lenders and borrowers on Lending Club, or drivers and passengers on Uber. The challenge is that you need a lot of buyers to attract sellers, and you need a lot of sellers to attract buyers.

In the era of cheap cash, however, that challenge was easy to overcome. Once a two-sided electronic market is built, the benefit is that the owner of the market doesn’t have to own or manufacture anything, so its cost structure is extremely low:

- Uber doesn’t own cars or drive passengers.
- eBay doesn’t make Pez dispensers or the countless other items sold on its site.
- Etsy doesn’t create artwork or hand-made jewelry.
- Airbnb doesn’t own hotels.
- Grubhub Seamless doesn’t own restaurants.

These companies don’t need to buy the assets that are sold in its network. Their only role is to provide a smooth connection between a large number of providers and a large number of customers, while collecting a nice profit on every transaction. According to the Harvard Business Review, eBay’s gross margin is 70 percent, while Etsy’s is 60 percent.4

The bigger the network, the more invincible it becomes to competitors. When both sellers and buyers gain value from the network, they become “locked in” through switching costs, making it all but impossible for a rival network to steal share.

Looking ahead, we foresee the following developments emerging from this powerful trend:

First, going forward, online marketplaces will become much more difficult to build.

The era of easy money ended in early 2016. Unlike the entrepreneurs in the first half of this decade, today’s startups can no longer rely on access to cheap capital. While this is bad news for anyone trying to build a business, it’s excellent news for investors. The companies that do get funded will have to pass more rigorous tests. Those that survive will be built on a solid foundation of good ideas, rather than on the quicksand of cheap cash and debt. Companies like Uber won’t be able to buy supply and demand; they’ll need to attract the stakeholders at both ends of a two-sided market by creating a desirable value proposition based on a genuine cost advantage, instead of losing money on every transaction due to subsidies.

Second, entrepreneurs and investors will need to remember that, despite the widely publicized successes of Airbnb, eBay, and Uber, not every online marketplace will succeed.

While many companies will race to monetize marketplaces, only a few will make it to the finish line. Consider what’s happened to once-high-flying companies like Groupon and Living Social, which persuaded thousands of restaurants and other businesses to offer discounts, while signing up millions of customers to pay for deals before they could use them. Unfortunately, there is no barrier to keep other companies from entering this market space, and countless competitors have emerged at both the local and national levels. Switching costs are low enough that both the merchants and the customers have defected to the new sites, diluting the value of the original online marketplaces and unwinding the network effects as the numbers of buyers and sellers shrink. According to an article in the Harvard Business Review, Groupon’s value plunged to less than $2 billion today from $18 billion in 2011, when it launched its initial public offering, while LivingSocial filed for an IPO in 2011 at $10 billion before backing out of the deal and getting bought by Amazon, where its value withered away to less than $250 million by the end of 2014.5

Third, online marketplaces will need to overcome a fundamental challenge in order to thrive.

According to another Harvard Business Review article, companies that use this business model must provide mechanisms to reassure customers that the products and services they purchase will be of high quality and delivered promptly, despite the fact that the network owner isn’t the one providing the goods or services.6 Networks like eBay, Uber, and Airbnb use rating systems based on customer feedback that identifies unreliable sellers, drivers and passengers, and hosts and guests, respectively. Airbnb goes even further by withholding guests’ payments until they have checked in and verified that they are satisfied; it also requires a security deposit that isn’t refunded until after the guest has checked out and the host has verified that the room was left in good condition. If an online marketplace can’t provide such safeguards, it probably makes more sense to switch to a more traditional business model in which it buys and then resells products or services over which it can take responsibility.

References

http://fortune.com/2014/09/25/why-startups-fail-according-to-their-founders/

https://hbr.org/2016/04/network-effects-arent-enough

http://observer.com/2016/05/uber-the-startup-steroid-era-and-the-use-of-capital-as-a-performance-enhancing-drug/

https://hbr.org/2016/04/network-effects-arent-enough

5. iBid.

https://hbr.org/2013/03/do-you-really-want-to-be-an-ebay