Akin to tech companies, tech investors must continually reinvent themselves. An investing thesis that worked five years ago is now likely to be a bust. We made several freemium/premium model investments in the early days of HPVP – FarmLogs and NoRedInk. They are turning out well with significant market share and paid conversion traction. But does freemium/premium work in agtech and edtech now? I don’t think so. Customers have come up the learning curve, seen (and paid for) the value software provides and may already have an installed favorite. These are markets more ripe for monetization with better product, less so “free”-driven land grabs. As I’ve discussed before, investment theses follow an arc of unproven bet to reality. SaaS is doing the same.

HPVP has been a committed SaaS investor from the beginning, and we will remain so. However, our conviction and commitment in SaaS is not without a realization that SaaS has become increasingly competitive. Many horizontal SaaS markets such as CRM, ERP, MarTech, Sales Enablement have broadly become hyper-competitive where only the best of the best executors can win. There is no margin for error, yet we all know there is so oft error in starting up. In these horizontal markets we see pockets of opportunity – sub-theses where there is not yet consensus and where returns favor experimentation and speed, in addition to execution. Such is the case with our Terminus investment, the early leader in the Account Base Marketing “sub-thesis” of Martech. We see much more consistent SaaS opportunity in the much-lauded vertical SaaS area and remain excited about agtech, logistics tech, digital manufacturing and supply chain, all industries with extreme Midwest advantage and affiliation.

We are also looking outside of SaaS to marketplaces. Chicago has had storied success in marketplaces. There is good DNA here including Grubhub (food) and Groupon (deals). More recently, we are home to Raise (gift cards), Parkwhiz (parking) and Spothero (parking). We are already investors in G2CrowdParkwhiz, Dolly, Partyslate, Truss, Tock, Pearachute and every day we are looking at more marketplaces.

Marketplaces can be harder than SaaS. They are often two business models in one (as if one wasn’t hard enough) and tend towards winner-take-all. However, they are also very large opportunities given the scale of consumer and B2B product and service markets, and they are increasingly favored by evolving tech trends and consumer behaviors. Seamless payment technologies, digital imaging (think matterport) and internet everywhere reduce transaction costs to enable marketplaces. Consumer acceptance of reviews as a trust standard, increasing preference for digital communication (text/email) and the gig/on-demand economy all favor consumer and business adoption of marketplaces as well.

For entrepreneurs considering a marketplace model, Bill Gurley’s seminal 10 Factor post is a great place to start. Bill’s is a terrific framework to sanity check marketplace ideas, but basic economic theory provides an even quicker test. In simplest form, the requisite conditions for a marketplace are trust, product standardization and potential for liquidity.

Trust:  People and businesses won’t transact on a marketplace without trust. In advanced marketplace exchanges (like Nasdaq or NYSE) the trust issue is solved by the exchange taking the counter-party performance risk. In most digital marketplaces (Ebay, Expedia, AirBNB, Amazon Marketplace, Uber, Etsy), user reviews are employed to mediate trust. Historically, this was a supplier side phenomenon. Users have long been creating and referencing supplier reviews on Ebay and Expedia to make buying decision. On-demand economy opportunities, however, place suppliers at much greater risk; having someone sleep in your home via AirBnB or be a passenger in your car via Uber is much riskier than mailing baseball cards via Ebay. These are shared experiences with valuable assets at stake, not simple product transactions. Enter the buyer review to solve this: AirBnB and Uber buyers are rated, and AirBnB has a $1M guarantee for sellers. Trust is also big issue in business-to-business marketplaces given the large dollars and reputations at risk as well as complexity of B2B transactions. Our portfolio company, G2Crowd, is leading the way in bringing trust and transparency to the B2B software market using reviews, both on its own platform and soon beyond.

Product Standardization: There are search goods and experience goods in economics. Search goods are products or services whose features, quality and value can be easily assessed before purchase. Experience goods can only be assessed during use or consumption. In general, digital marketplaces lend themselves well to a subset of search goods, standardized products – known physical skus, commodities, or other products with which the buyer has prior experience or can see outside the marketplace before being certain of buying the same product online (think visiting BestBuy to see a phone and then buying on Amazon… don’t hate me, BestBuy). So then what of all of the growing service and experience marketplaces like Uber and AirBnB? Uber jumps through hoops to standardize their service with expectations for drivers on type of cars, age of car, politeness and driving behavior. Travel marketplaces like Expedia and Kayak do the same by bucketing the multitudes of branded hotel rooms into simple 1,2,3,4,5 hotel star brackets. AirBnB is an outlier, actually turning standardization on its head by using non-standardization as a differentiator. However, it shoe horns “experience products” into “searchability” through extreme information sharing from hosts (pictures, commentary, maps) and prior visitor reviews.

Potential for liquidity: Even with trust and standardization, there must be many buyers and sellers – what I think of as many “match pairs” – for liquidity to be possible. For liquidity, there must also be a propensity or willingness for match pairs to change and stay on-platform instead of going off-market together for the next transaction. Match pairs on travel sites rotate, for example, because consumers want new experiences and the best price. On Uber they rotate because consumer want the closest car. On AirBnB, Grubhub, Etsy, (and Ashley Madison!), match pairs rotate because consumers want diverse experiences and goods. These are all examples where ongoing “coordination” costs and loyalty of relationships are low, something airlines and hotel brands have been trying to fight for years.

But where do I start?

Let’s say your idea checks out on Gurley’s key questions and the basic economics above. How do you actually get it started? I am regularly asked by seed stage marketplace entrepreneurs, “which side of the market should I build out first?” The flip answer is “both”… most marketplaces are built via correlated growth on both sides. However, in the earliest, earliest days, you need to focus your attention somewhere first. Where? To answer, I like to explore these three questions:

Which side of the transaction is more desperate? In any two-sided marketplace, there is usually one side(the buyer or seller) who is more desperate to transact. While there are exceptions, it is usually the seller – the restaurant, hotel, airline or maker that needs customers to survive and wants to explore new channels.

Which side of the market is more patient? There is a risk, however, of focusing too narrowly and too long on building seller inventory. How long will they wait for demand? The answer depends on the effort that is required of sellers to onboard and remain “active”. We have seen restaurants remain on marketplaces for many months without much action because their effort is limited. The menu is uploaded then stays the same; if an order comes through, terrific. The patience of sellers with changing inventory and prices that must be continually updated is much shorter. We have seen this with various B2B wholesaling marketplaces that failed – by the time entrepreneurs got to driving demand, inventory was stale.

Which side can be short-circuited? There are also cases where one side can be “short-circuited”. By this I mean inventory or demand is quickly onboarded through an aggregator or unique wholesale acquisition strategy to solve for one side of the marketplace. Then the other side can be quickly tested. Aggregators, for example, exist in the travel and the consumer deal industries. If you have a new twist on a travel or deal marketplace (bless your soul), building initial inventory to test demand is pretty doable. If demand materializes, you can later onboard direct supply to score a larger piece of the economics. Usually the seller side is easiest to short-circuit, especially if it is the “B” side of a B2B2C marketplace. Businesses are easier to aggregate and short-circuit than consumers.

Each marketplace fits  differently in this framework, but if the clear answer to at least two of the questions is the same side of the market, you have a strong indication of where to begin. Oh, and if you’re building a marketplace, let’s chat!

2 thoughts on “Investing and building marketplaces

  1. Great take on marketplaces and excited to see which you all end up investing in.

    One thing I’d add to the section on transaction desperation- it’s not enough to just know which side is desperate right now. A founder needs to understand the ebb and flow of the dynamic, especially on the supply side. Those SMBs ignoring you today may be beating down the door if the market turns against them

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