Investing in Online Marketplaces

From eBay to OpenTable to Airbnb, understanding the marketplace business model

Last week I sat on a panel to discuss the “state of the marketplace economy.” The discussion was geared to provide a better understanding of the general framework of online marketplaces and how they function, the dynamics on how they get started, grow and come to scale, and the defining characteristics that allow some to become immensely successful (while others do not).

Here at Scale Venture Partners, I have been spending quite a bit of time focused on online marketplaces, which is a space that has received plenty of interest from the investor community over the last decade. According to Pitchbook, in the last three years alone, investors have poured > $100B across 2,000 marketplace businesses. Reflecting on the event, I thought it would be useful to share some of my thoughts and research on the space in the context of some of the questions that surfaced during the panel.

How do you define an online marketplace?

We typically define online marketplaces as businesses that intermediate the exchange of items online while taking no (or only temporary) ownership of the items being transferred. While there are many variations of marketplaces, most tend to follow a fairly standard structure whereby the buyer or seller (sometimes both) are taxed for facilitating the exchange within the platform.

What are the key attributes of a successful online marketplace?

There is no universal set of characteristics that engender all successful online marketplaces but there are a few attributes that do tend to appear with some regularity among the most extraordinary marketplace businesses. First, and likely most important, is whether the marketplace creates a much better purchasing experience for the participants involved than the status quo. Put simply, if a marketplace can’t create a significantly better experience for those involved, neither side is going to be willing to pay for it. OpenTable is a classic example of a marketplace that dramatically enhanced the existing user experience of reserving restaurant tables. By contrast, Homejoy is an example of a marketplace that ultimately failed principally because the product it delivered was not considerably better than what was already available in the home cleaning services market.

Another characteristic of successful marketplaces is having a large enough base of potential participants (quick gut check might be whether there are enough consumers willing to keep the app on their phone or use it frequently enough) to make the business stand up.

Lastly, is the existing market fragmented enough to justify creating a marketplace? Remember, at least one side of the marketplace is usually taxed for participating. Understanding the additional benefits for paying that tax (e.g. can the marketplace validate trust, become part of the payments flow, expand on the existing supply, etc?) will be important.

Can you define TAM and explain how important it is to look at in the earliest stages of a marketplace?

TAM is defined as “total addressable market,” but in this case, more specifically, it refers to the number of existing businesses and consumers that are willing to come online to make that transaction. If you have a quorum of participants that purchase goods or services in a large (and broken) market today, an entrepreneur is likely to have found a strong beachhead opportunity for building a marketplace business even, if only initially, a specific subset of the market is willing to come online. The best examples of online marketplaces often start by addressing a specific need, do so very well, and then expand into other adjacent verticals (eBay, Amazon, and Uber have all successfully done so). To summarize, asking the following questions: 1) what percentage of the initial market is willing to come online and 2) what are the adjacent markets (and are they big enough) that the business can move into? - will be important points of discovery.

Why can marketplaces have such staying power once they break away from competition? Does this justify the large amount of up front capital that many require?

The simple answer is that a truly successful marketplace will become the easiest way to purchase goods and services once it reaches scale. That creates staying power. Stated differently, if a marketplace makes the purchasing experience that much better, it will become the default venue for buyers and sellers to transact, and that is something very difficult to unseat.

On that point, it is not uncommon for marketplaces to require several rounds of financing to reach scale. Uber and Airbnb, for example, have raised $11.5B and $4.3B of private capital, respectively, and though these may be somewhat extreme examples, they illustrate the point. These volumes of funding may happen for several reasons. First, it is typically expensive for marketplaces to acquire and retain an adequate base of buyers and sellers (and to pull users away from the methods they are accustomed to doing business). Second, marketplaces often experience a high degree of turnover among their customer base, as users will transact once and then disappear. Third, marketplaces tend to be lower margin businesses because they only retain a relatively small percentage of the transaction volume that they support. And finally, and perhaps most importantly, most marketplaces operate in very competitive environments (take food delivery as one example, which has dozens of entrants including Blue Apron, Grubhub, Doordash, and Sun Basket - just to name a few - and very low switching costs). As such, these companies often have to incentivize consumers to test drive the product, and this can become very expensive as time goes on. This wasn’t always the case. Opentable raised less than $50M in private funding prior to its IPO, and one of the most successful marketplace examples of all time, eBay, raised just $6.7M prior to going public. In the end, however, if the marketplace becomes the default method of exchange, it’s likely that the business has become quite large and produced a successful outcome for those involved.

What are the key questions that investors look at when they evaluate investing in marketplace opportunities?

Ultimately, investors are interested in whether opportunities can be big, so this ties back to the first question around attributes of successful marketplaces. Back in 2012, Bill Gurley famously outlined 10 factors to consider when analyzing marketplace opportunities and it still holds true. Key questions I’d want to think about include the following:

  • How much does the marketplace improve the purchasing experience vs. the status quo?
  • Is the addressable market large enough (and more specifically, are enough buyers and sellers willing to come online to transact)? Does existing market fragmentation support (or work against) this trend?
  • Do the fundamental unit economics of the business make sense or will customer acquisition costs ultimately crush the company?
  • What are the opportunities for continued value add that the marketplace can furnish? For example:
    • Can the marketplace facilitate trust (or manage dispute) between two parties?
    • Can the marketplace incorporate payments, or manage shipments and / or returns?
    • Can the marketplace expand (or reinvent) the existing supply?

 

How does valuation tend to differ between traditional SaaS businesses and marketplaces?

This question is somewhat nuanced and could merit a lengthy explanation. But for simplicity’s sake, although there are a number of variables that I’d want to pay attention to here, there are three in particular that stand out:

  • Growth rate
  • Non-recurring revenue vs. subscription revenue
  • Gross margins (and the effect of a take rate or “rake”)

Early stage investors ultimately invest behind growth, so perhaps above all else, the question is whether the business is growing its GMV base (and more importantly, net revenue base) at a healthy clip. This of course varies widely depending on the stage of the business, but for where we tend to evaluate companies at ScaleVP, it’s not uncommon to see growth in the triple digits on a year-over-year basis. This is the metric that sets the tone.

In 2015 my colleague, Alex Niehenke, asserted that the valuation of public SaaS companies has averaged out around 5x current revenue looking across the last decade. For some comparison, eBay, which is probably one of the most well-known marketplaces at scale, was valued at 4.1x current revenue (market cap / current quarter revenue annualized) at the time of its last earnings call. Alibaba traded around 12.1x, Etsy at 4.3x, and Lending Club at 1.9x. There is some considerable variability here, but in intrinsic to each is the rate at which the company is growing its revenue base. Lending Club, which carried the lowest valuation relative to its revenue was growing at just 3% YoY. Alibaba, which was trading at close to 3x the valuation of its peers above, was growing revenue at 50% YoY.

Related to, but not dependent on, growth rate is whether the company recognizes revenue on a recurring basis. Most SaaS businesses bill their customers on a recurring (or subscription) basis. Most marketplaces do not. There is a big distinction here because, by definition, the go-to-market leaders of non-recurring businesses start year two at zero dollars in revenue and need to go out and find an entirely new book of business after the first year. In most cases, of course, a share of the company’s revenue in the second year is going to come from its original customer base via retention, but depending on the type of business, it may not. In this vein, it is not uncommon to see 70% + of original customer revenue churn after the first year. This, coupled with how much value the company is able to extract from its customers leads us to a third point, take rate.

A marketplace derives its true value from the percentage of GMV it retains (some refer to this as a take rate or “rake”), when which multiplied by GMV, translates into the company’s net revenue. Take rates tend to vary from marketplace to marketplace, but usually fall in the ballpark of 10 - 30% of GMV and are loosely associated with the perceived value that the marketplace brings to its customer base. Stated differently, consumers are inherently willing to pay a higher rate for goods and services that are more challenging to render independently (without the help of an intermediary online). This has a direct influence on valuation, because, assuming a 20% take rate, a marketplace is only retaining $0.20 of net revenue for every $1.00 it processes, and as such, will run significantly lower gross margins than its SaaS counterpart (where it is not uncommon to see margins > 75%) and is left with less cash to reinvest back into the business.

Tying this all together, marketplaces have the ability to trade at similar revenue multiples to their SaaS counterparts, but I would argue that they face different structural challenges and have to “work harder” to get there. But once at scale, they can be that much harder to unseat.

In Summary:

Over the last two decades, there have been a number of extraordinarily successful marketplace businesses. These companies have typically created step functionally better experiences for their participants than the status quo and have brought multi-billion dollar markets online. Some of these companies have also faced some inherent challenges that have made scaling expensive and difficult, but those that have come to market effectively have made it very difficult for challengers to compete - and from an investor’s perspective, have been able to achieve valuations similar to (if not greater than, in some cases) their SaaS counterparts.