When is a Marketplace No Longer a Marketplace?
The network effect between supply and demand is the defining feature of a marketplace — sacrificing this in the pursuit of better customer experience can create unexpected trade-offs
The wave of unicorns we have seen over the past decade has been partially populated by what VCs and founders call “managed marketplaces”. This term has been used to describe a dizzying range of business models including consignments, verified matchmakers, iBuyers, asset rental services, etc. So, much like the term “platform”, the term “managed marketplace” has been used so broadly that it has lost all meaning. Let’s take a deeper look at what managed marketplaces really are and what happens when they can no longer be categorized in that bucket.
Before diving into managed marketplaces, we first need to understand what a marketplace is and why they have network effects. As I have previously explained, a marketplace connects two or more distinct types of participants to enable transactions, i.e. buy and sell products or services. The addition of each seller increases the value of the marketplace for all buyers and vice versa — this network effect is a critical facet that fuels the scalability and defensibility of marketplaces. While the strength of these network effects can vary, their existence is the defining feature of a marketplace.
What is a Managed Marketplace?
Managed (or full-stack) marketplace is a loose term for a marketplace that attempts to improve its customer experience by being more involved in the execution of transactions. This definition is not remotely close to being exhaustive, but it will do for now.
The food delivery space is a simple example of the transition to a “managed” model. The first wave of food delivery marketplaces was led by Just Eat, Grubhub, and Takeaway.com. These companies simply connected restaurants to consumers, leaving restaurants to handle deliveries themselves. Deliveroo, DoorDash, and Uber Eats were able to displace them by offering a superior experience to both restaurants and consumers. These challengers owned last-mile delivery in addition to connecting demand and supply. This made delivery times more predictable and also allowed consumers to track progress in real-time. Logistics (or fulfillment) is just one way that managed marketplaces can get involved in transactions. Other managed marketplaces may own background checks, verification, customer service, etc. depending on the product or service in question.
Clearly, superior customer experience is a strong argument for taking more direct involvement in the transaction. This is especially true when the transaction involves high value, sensitive or regulated products and services — including luxury products, childcare, etc. But how far can this involvement go? This question captures the essence of confusion around managed marketplaces. Based on their level of involvement, there are two types of companies that founders and investors have called “managed marketplaces”:
- True “Managed” Marketplaces
- Marketplaces in Name Only (MINO)
True “Managed” Marketplaces
Companies in this category are marketplaces first and “managed” second. In other words, the additional services provided by the marketplace are meant to enhance interactions between buyers and sellers. These services are primarily aimed at removing points of friction, e.g. increasing trust, streamlining fulfillment, etc. As a result, this additional involvement does not disturb the network effect between buyers and sellers. Instead, it enables or enhances the network effect.
Take Vestiaire Collective as an example — a second-hand marketplace for luxury fashion. Luxury products are high-value items. Buying them online, sight unseen, from an unknown third-party seller obviously introduces a trust deficit. Potential buyers may be enticed by the lower price of a second-hand luxury product, but they still want it to be authentic. This is where Vestiaire Collective steps in. Sellers first ship their product to Vestiaire Collective for authentication, before it is shipped to the buyer. Vestiaire Collective’s involvement helps establish trust with buyers and makes the fulfillment process easier for sellers. But the goal of this involvement is to make it easier for buyers and sellers to transact with each other.
Vestiaire Collective is just one example. Other true “managed” marketplaces in the luxury and specialty product space include Farfetch, Poshmark, TheRealReal, Rebelle, Watchmaster, and GOAT. In each of these cases, the marketplace steps in to establish the authenticity of products before shipping them to buyers. True “managed” marketplaces are also common in regulated services. For example, childcare marketplaces like Bubble, Kalendit, Koru Kids and Trusted need to ensure that all service providers are background checked and qualified before accepting them into their marketplace. This reduces concerns from the demand-side and makes it easier for them to test the service. Here, again, increased marketplace involvement enhances the network effect and does not interfere with it.
True “managed” marketplaces are often able to charge higher take rates because of the additional services they offer. However, they still have lower gross margins than unmanaged marketplaces because of their higher cost base. Because of this, true “managed” marketplaces are sometimes (unfairly) associated with poor unit economics. They do have lower gross margins, but that does not always lead to poor unit economics. Instead, poor unit economics are normally the result of marketplace structure, i.e. commoditized supply (causing intense competition) and/or hyperlocal structure (increasing costs to scale). This has nothing to do with how “managed” they are, as long as they remain true “managed” marketplaces.
Marketplaces in Name Only (MINO)
In some cases, companies get so involved in the transaction that buyers and sellers no longer interact with each other. Instead, the company takes on the role of the supply side itself to control the customer experience. When this happens, buyers are attracted to the inventory, assets, or resources owned by these companies — not very different from a retailer like Tesco or asset rental company like Hertz, albeit enabled by technology. Since the demand and supply sides do not interact, network effects no longer exist. In other words, they no longer exhibit the defining feature of a marketplace. The term “managed marketplace” is a misnomer when applied to these businesses. They are better described as marketplaces in name only (MINOs).
Take Opendoor for example. Home sellers don’t list their properties on Opendoor. Instead, they sell their homes to Opendoor (after an assessment). Opendoor then refurbishes them and lists its inventory of homes to prospective buyers. Buyers and sellers don’t transact with each other and instead transact with Opendoor, in turn. This certainly improves the experience for both buyers and sellers as it gives them more control over close dates. This allowed Opendoor to challenge an established incumbent with strong network effects — Zillow. However, this comes at the cost of losing all network effects — buyers are attracted to Opendoor’s inventory of homes and not the number or variety of active sellers.
What are the consequences of losing network effects? For one, capital requirements go up dramatically. For example, Opendoor bought 11,000 homes and sold 7,000 homes in 2018, i.e. their inventory of unsold homes increased by 4,000 during the year. Based on the median sale price in the US, that amounts to more than $1.2B in added inventory — as a frame of reference, Opendoor has raised a total of $1.5B in funding to date. Scaling is also a function of capital because expansion depends on acquiring inventory in new regions. And, of course, this is in addition to marketing investments. In contrast, true marketplaces can leverage supply to attract demand organically and vice versa — this reduces customer acquisition costs over time leading to exponential returns on marketing investments.
The absence of network effects also weakens defensibility — competitors like Offerpad, Knock, Zillow Instant Offers, and Redfin Now don’t need to match the diversity or volume of Opendoor’s seller base. Instead, they simply need enough capital to acquire a “good enough” level of inventory in one geography. This doesn’t mean that MINOs have no defensibility. They do have economies of scale — for example, the per-unit cost of refurbishing a home decreases as inventory increases. This is most effective if competitors do not have access to the same level of capital and inventory. But in a world where capital (and competition) is abundant, this cost advantage is balanced out by higher (and sustained) customer acquisition costs — often resulting in weak unit economics.
High capital requirements and complex transactions made real estate (or proptech) a perfect breeding ground for MINOs — other examples include WeWork (office space), Compass (estate agents), and Nested. However, proptech is by no means the only place to find them. MINOs are also common in the used car space — Vroom, Carvana, Fair.com, Cazoo, Beepi, etc. Scooter rental startups like Lime also fall squarely into this category. As do fashion startups like Rebag. Many of these companies have struggled with unit economics because their spending and growth projections were incorrectly based on the inherent defensibility and scalability associated with network effects.
To summarize, network effects are the defining feature of marketplaces — a fact that is often lost in the discussion of how “managed” they are. True “managed” marketplaces aim to ease interactions between buyers and sellers, enhancing their network effects. In contrast, marketplaces in name only (MINOs) take on the role of the supply side themselves, removing all network effects.
This does not mean that MINOs are bad businesses. In fact, the lack of network effects is often the result of offering a superior customer experience — this is one of the only ways to disrupt an incumbent built on strong network effects (e.g. Opendoor vs. Zillow). I will dive deeper into this in a future post. But at scale, MINOs tend to be more capital hungry, have weaker moats, and are more expensive to grow than true marketplaces (“managed” or not). These companies need to find other avenues to create defensibility beyond capital — layering network effects on top of this model is one such avenue.