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10 Laws of Successful Marketplaces

October 16, 2015

*This article first appeared in TechCrunch.

It has many names: the Sharing Economy, Collaborative Consumption, the On-Demand Economy, and even most recently called by Presidential candidate Hillary Clinton, the Gig Economy. Whatever it’s called, one fact is clear: on-demand marketplaces are big, and they’re mainstream. Venture Capitalists have funneled more than $12 billion into the sharing economy, more than twice what was invested in social networking startups like Facebook and Twitter, according to a 2015 Deloitte report. From transportation to food delivery, car sharing to laundry, the sector is getting immensely crowded and valuations are skyrocketing, leading many to speculate on whether we are in a bubble. Because of this, it’s more important than ever to understand the key factors that go into building an enduring business vs. a flash in the pan that can’t withstand market volatility.

Companies like Uber (a Menlo portfolio company) and Airbnb boast incredible market potential and long-term defensibility that results from network effects. Entrepreneurs entering the space today should follow these 10 laws of marketplaces to optimize for long-lasting success:

1. Go vertical, not horizontal

Marketplaces focused in a particular vertical tend to grow faster and achieve critical mass more quickly. Within a broad horizontal marketplace, it becomes more difficult to achieve sufficient liquidity. eBay, for example, needs to match supply and demand across a variety of “micro” marketplaces, from bicycle sellers to car buyers. For vertical marketplaces such as Uber, UpCounsel or Rover, everyone on the platform is there to find a ride, a lawyer or a dog sitter, and matching friction is reduced.

2. Cater to services rather than goods

While there are numerous examples of successful marketplaces in either category, we believe that service-based businesses have the largest potential markets, as services account for roughly 80% of U.S. private-sector GDP*. In addition, services are more recurring than the transfer of goods. I might clean out my garage once a year by selling on OfferUp, but I’ll use Uber multiple times a week.

3. Think local before international

Buyers on Thumbtack need a local service professional to be around to fix that leaky faucet. But other marketplaces like eBay and Poshmark are global–a provider in California would have no problem transacting with a buyer in New York. Today near-ubiquitous mobile penetration allows marketplaces to penetrate locally first before expanding internationally—a strategy that was never possible in the early days of the Internet. This allows for local marketplaces to drive early growth in a more efficient manner, by using services like Facebook to target and grow geo-specific liquidity.

4. Consider the impact of on-demand

The ability to provide totally homogenous supply on-demand has been a hallmark of Uber’s meteoric rise. By creating totally homogenous supply available instantly, on-demand marketplaces attain pricing and supply power and become less susceptible to disintermediation.

5. Create consumer habits

Successful marketplaces create habits in consumers who find that the purchasing experience is far better than an alternative. Many investors track consumer marketplace retention on a monthly cohort basis. We’ve found that top marketplaces retain about 20% of the initial revenue each month over a long-term period. Marketplaces with high frequency create habits in consumers, which significantly raises the LTV of the platform, and enables companies to be more aggressive on upfront marketing.

6. Understanding curation is instrumental

Marketplaces can meaningfully curate supply for consumers by leveraging data to ensure better quality for both parties. Curated marketplaces ensure that suppliers are setting appropriate prices, and buyers are finding quality sellers. Marketplaces help customers to make better decisions. Instead of calling up a variety of service providers, or relying on word of mouth, homeowners can use to find out exactly who the best contractors are based on peer reviews.

7. Consider the shadow market

The size of the core market is less important than the potential for market expansion with the entrance of a superior service. Investors should think not only what the market is for the competing service, but what the market looks like for adjacencies. For example, the dog-sitting marketplace Rover competes for the $6 billion spent annually for dog boarding. However, this is just a fraction of the potential market as only 1 in 10 dog owners actually uses a kennel. By providing a safe, easy, and affordable alternative to boarding, Rover effectively catered to the 9 out of 10 people who weren’t using kennels.

8. Focus on NPS

Over the long-term, marketplaces have the potential to be immensely profitable businesses. For early-stage marketplaces, customer acquisition cost (CAC) is often low as passionate early adopters are acquired, however, as the service begins to go mainstream, the CAC invariably increases, creating pressure to sustain profitable growth. A service with strong organic growth through word of mouth can continue to acquire efficiently, even as CAC increases. Best-in-class buyer NPS tends to exceed 40%, while seller NPS can be slightly lower, but should still exceed 20%.

9. Don’t neglect your suppliers

In addition to demand, successful marketplaces should be highly focused on the retention characteristics of marketplace supply. Unlike customers who transact sporadically on the platform, suppliers (especially in service-based marketplaces) may use the platform to provide full-time income. For many labor-based marketplaces, suppliers shift their behavior, increasing both hours and income on the platform in the months after signing on. Top labor marketplaces may exceed 150% of initial monthly spend in subsequent months.

10. Seek opportunities to boost rake

As marketplaces begin to achieve scale, they should take advantage of opportunities to boost the rake of the business in addition to top-line growth. For example, when Etsy went public, investors were very excited about the company’s ability to grow gross margin annually by 10% by providing additional services to sellers. These additional income streams not only boost the financial profile of the business, but also increase lock-in with sellers who are able to have a high-end experience. The marketplaces of the future won’t simply be matching platforms, but will offer powerful tools for both sides to increase the value proposition, and potentially bring on offline business.