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The two sides of a marketplace are buyers and sellers. Successful 2-Sided Marketplaces like Craigslist are very difficult to disrupt. To break them apart you must have a better value proposition for both parties simultaneously, or else nobody moves. Customers are there for the vendors, and vendors are there for the customers. One won’t leave without the other. With a 2-Sided Marketplace, the network is what provides the majority of the value, not the app or website itself — which explains why marketplaces products like eBay and Craigslist can afford to look essentially unchanged after 16 years.Marketplaces come in more shapes than we might think. Media companies, for example, are essentially 2-Sided Marketplaces. Audiences (supply) come to the marketplace and sell their attention for content experiences. Advertisers (demand) on the other side buy the attention of the audiences. The greater the audience of a media company, the more likely advertisers will be to spend any money on that media company at all, and then the more money they will be willing to pay the company when they do. “Sellers” i.e. readers/viewers have a direct positive network effect for “buyers”, i.e. advertisers. And vice versa, because (in theory) more advertising revenue gives a media company the resources to produce better content. 1 . 2 - S I D E D M A R K E T P L A C E Marketplace participants don’t always fall neatly into two categories. Often there are multiple participants on one or the other side of the marketplace that perform different functions. For example, in a food delivery marketplace, you have one side that is clearly the supply (restaurants), one that is clearly the demand (customers). But what about the drivers? They help fulfill the supply, but they have different incentives and monetization than the restaurants.True n-sided marketplaces, however, tend to be market networks. They help coordinate many suppliers/vendors around a complex, multi- step process (such as wedding planning) using a SaaS workflow tool. For example, HoneyBook allows a florist, venue, caterer, photographer, and event planner to coordinate to supply the wedding. In a market network, transactions happen in a 360-degree pattern like in a network, but with a transaction in mind. 2 . N - S I D E D M A R K E T P L A C E Not all marketplace network effects function the same way.There are broadly three different types of marketplace nfx. They differ in how marginal supply-side users on the network impact the value of the marketplace to demand-side users.For a typical marketplace like eBay, there is a direct correlation between the amount of supply/ inventory on a marketplace and the value of that marketplace for demand-side users. Each new eBay seller adds value to all the eBay shoppers. 3 . M A R K E T P L A C E N E T W O R K E F F E C T T Y P E S By contrast, delayed marketplaces like OpenTable take a long time to get to a critical mass of supply before the marketplace is very useful for demand side users at all. If only 1 out of every 100 restaurants in your city is on OpenTable as a restaurant-goer, the value of OpenTable does not increase by 100% if that increases to 2 out of 100 restaurants. It’s still negligible and makes no real difference to you. But when OpenTable approaches a critical mass of restaurants in your area, it becomes exponentially more valuable. Asymptotic marketplaces are the inverse of delayed marketplaces. Uber and Lyft are prime examples of asymptotic marketplaces, where the threshold for a critical mass of supply is easily reached, but the added value of marginal supply after that point quickly reaches diminishing returns. Disintermediation is a vulnerability that mostly applies to marketplaces and market networks. It happens when, after initially connecting through a marketplace or market network product, users take future transactions off the product and transact directly. This is a significant problem because retention leading to repeat purchase is the name of the game in most transactional networks. To help prevent disintermediation, you can provide tools, reputation, insurance, compliance, leads and other incentives. There is an extensive playbook about the many things you can try if your marketplace is challenged with this problem. Some never overcome it. 4 . D I S I N T E R M E D I A T I O N Multi-tenanting is when demand or supply-side users use multiple competing marketplaces to sell or buy products. It usually happens when there are low switching costs to listing products or buying them across different marketplaces. This is fairly common; many people on both sides of the marketplace often use both Uber and Lyft, both eBay and Craigslist, both Etsy and Amazon Marketplace. Multi-tenanting can harm the defensibility of a network and mitigate network effects, but only up to a point. Ultimately, the bigger network will win out because it will have a higher profile for potential new customers and will be more likely to retain existing customers, even if those customers occasionally multi-tenant. Because the network is bigger, the number of options will be greater and people will only turn to competing networks in moments of dissatisfaction or as a supplement for the value provided by the larger network. For example, people who use Snap stories may use Instagram stories to reach a different audience. Usage of one service may serve to reinforce and increase usage of the other service as people become more habituated to using both and see greater value from the broad category of “stories” shared on both. Customers of eBay or Amazon might look to Etsy specifically for vintage products, and although this is a case of multi-tenanting, usage of one reinforces the other because the greater the variety of goods consumers buy online, the more likely they are to shop online. 5 . M U L T I - T E N A N T I N G The “chicken or egg” problem refers to the problem of getting enough critical mass to trigger a positive feedback loop. If the people on a network produce the majority of value for other users, how do you get the first users to join? This is an especially big problem with 2-Sided Marketplaces (and to a lesser extent with 2-Sided Platforms) because there are two types of users — buyers and sellers (or developers and users) — and one needs to be in place before the other one will have an incentive to join. Kickstarting 2- sided networks requires giving some sort of initial value to the users on one side or another, which is independent of the complementary value that results from the other side of the network being there. There are at least 19 specific tactics we know of that can help solve this problem. Several of them involve creating a single-player mode product that provides value to one side of the marketplace even without a network in place. Others involve attracting one side of the marketplace with compensation, such as cash or leads. 6 . T H E C H I C K E N O R E G G P R O B L E M ( C O L D S T A R T P R O B L E M ) A supply-side marketplace is simply a marketplace where it’s harder to attract the supply side. Many marketplaces are like this — it is very difficult to attract the initial supply without any demand, but once a critical mass of supply is reached, demand comes on its own. Often with supply-side marketplaces, companies will spend the majority of their paid user acquisition budget on the supply-side. 7 . S U P P L Y - S I D E M A R K E T P L A C E A demand-side marketplace is the inverse of a supply-side marketplace. Owning the distribution is what matters for a demand-side marketplace because if you have enough demand, the suppliers will join on their own. Most marketplaces are not “balanced.” One side is much harder than the other. Which side is harder might change over time, but even that is rare. Fintech-enabled marketplaces are marketplaces with tech-enabled financial services built directly into the platform. Recently, we’re seeing marketplaces begin to offer services like: - Insurance: In-house insurance products made possible by better underwriting models - Financing: Non-traditional financing options such as rent-to-own or income-sharing - Banking: Novel and customer-specific solutions to manage transactions, deposits and payments. AI and data advances are enabling all three of these buckets, because models for underwriting debt, insurance, and loans are becoming increasingly powerful thanks to AI and increased data exhaust. A number of B2B companies have also been popping up which leverage the growing amount of data available to be sourced or scraped from public sources and package it together to underwrite risk for their customers. 8 . D E M A N D - S I D E M A R K E T P L A C E 9 . F I N T E C H - E N A B L E D M A R K E T P L A C E Leveraging new data sources and AI reduces the cost of underwriting via automation and improves loss ratios relative to more traditional underwriting or credit models. As a consequence, insurance and alternative financing options are becoming cheaper and more broadly applicable, expanding accessibility and giving rise to new use cases for debt and insurance that marketplaces can tailor to their specific needs. In any particular market or vertical, the number of players and the amount of market share owned by the players can differ widely. In winner- take-most markets, the few biggest incumbents have the majority of market share and are often highly consolidated. In more commoditized markets, either the supply or demand might be fragmented into many different players, each with their own small piece of the pie. For new marketplaces, fragmentation in a market vertical usually signals opportunity. One of the reasons why 2-Sided Marketplaces are so defensible is because of the “lock-in” created by cross-side network effects. If you’re a supplier, you can get locked into a marketplace because there is too much demand to leave, and vice versa. Neither side can move, once the marketplace nfx get going, without sacrificing access to the other side. 1 0 . F R A G M E N T A T I O N V S . C O N S O L I D A T I O N / C O N C E N T R A T I O N 1 1 . L O C K - I N The critical mass of a network refers to the point at which the value produced by the network exceeds the value of the product itself and of competing products. This can happen at different times depending on the type of a network. For example, physical direct networks such as telephones gain critical mass quite early on. As the chairman of AT&T pointed out back in 1908, “a telephone — without a connection at the other end of the line — is not even a toy or a scientific instrument. It is one of the most useless things in the world.” Since one telephone without any connections is utterly worthless, a telephone network with even two users has sufficient value to exceed the inherent value of a single product on its own. Contrast that with a platform network like Windows or iOS. The value of the Windows operating system, even without any programs or applications, is quite high on its own. Only after the network of users and developers has grown quite large does the value of all the third-party programs, plus the value of the interoperability with other users, exceed the value (for users) of the Microsoft programs by themselves. Most products with network effects must ultimately reach critical mass in order to fully take advantage of the defensibility provided by their network effects. Before the size of the network reaches critical mass, the product remains quite vulnerable and may not have much value to users. For such products, the challenge is often to build enough initial value to incentivize early adopters to start using the product even before the network effects value has kicked in. 1 2 . C R I T I C A L M A S S Same-side network effects are direct network effects that occur on the same side of a multi-sided (2-sided or N-sided network). Same-side network effects refer to the change in value that occurs for users on the same side with the addition of users on that side. For example, Uber actually has negative same-side network effects or a congestion effect. That’s because at any given time, a greater number of riders means a higher price point or a higher wait time per ride. The same is true for drivers — more Uber drivers mean more competition for other drivers. Same-side network effects can also be positive, however. This is the case for Windows users, who benefit from the addition of new Windows users because of file compatibility. Two Windows users can easily share files amongst themselves, and the number of people you can share files with grows with the number of people using the same platform. 1 3 . S A M E - S I D E N E T W O R K E F F E C T S Cross-side network effects refers specifically to the direct increase in value to users on one side of a network by the addition of users to another side. Cross-side network effects are direct network effects that arise from complementary goods or services in a network with more than one side. So to take the example of Uber yet again, there are large positive cross-side network effects because each additional driver adds direct value to all the users on the passenger side (up to a point) and vice versa. 1 4 . C R O S S - S I D E N E T W O R K E F F E C T S Marketplaces usually monetize by taking a percentage of each transaction that occurs on the marketplace, known as the take rate or rake. This can eat into the margins of suppliers on a consumer marketplace or on both sides of a B2B marketplace, which can be an incentive to disintermediate the marketplace. Pricing strategy is therefore a key part of the formula in getting marketplace nfx going. Switching costs refer to the costs in time, effort, or money that arise when you switch from using one product to another incompatible product. When switching costs are high, it tends to create customer lock-in because the customer has more of an incentive to stick with the same supplier throughout their life cycle. Network effects heighten switching costs. Not only is it costly from a compatibility perspective to switch products, but when the product has network effects, switching costs are heightened on a group as well as an individual level. For example, on a 2-Sided Marketplace like Craigslist, there are high switching costs for apartment renters as a group, because unless apartment seekers all move to a new marketplace at the same time as the renters, it’ll be too prohibitively costly for the owners to leave. Therefore the two sides of the marketplace lock each other into place. 1 5 . R AKE / TAKE RATE 1 6 . SW ITCH ING COSTS NFX is an early stage venture firm based in San Francisco that is transforming how true innovators are funded. As founders ourselves, we built ten network effect companies with more than $10 Billion in exits across multiple industries and geographies.
