In this post, I’m going to review the concepts of starting an online marketplace. More appropriately, how to create an online platform that serves a market. We won’t cover the actual building of a marketplace. Rather, we’ll cover the business model – the design for the successful operation of the business, identifying products and services, customers, sources of revenue, etc.
Let’s dig into the two-sided marketplace business model.
A marketplace is a two-sided network that connects two distinct groups of people – groups that provide each other with benefits. A marketplace can be offline or online.
An example of an offline marketplace would be a credit card – a physical card that links merchants to consumers. An operating system would be another example – it connects application developers to computer users.
Examples of online marketplaces are eBay and our startup Menyu. eBay connects online sellers and buyers of physical goods, while Menyu links restaurants to people searching for their menus.
Marketplaces are unique business models that stand outside the traditional value stream. Additionally, they experience a unique growth pattern called network effects. Let’s briefly discuss the value stream and the network effects.
Unlike traditional business models, where value flows from left to right, i.e. cost on the left and revenue on the right, marketplaces have both costs and revenues on left and right. There are costs involved to serve each distinct user group and likewise revenues to be generated from each side.
Traditional Value Stream
Marketplace Value Stream
In traditional business models, growth beyond some point typically leads to diminishing returns. This makes it harder to acquire new customers as less and less people find the value proposition appealing.
Marketplaces are different. Because each group is attracted to the other and growth on each side increases the benefits to the other side, marketplaces experience what’s called network effects – the value of the business grows as the platform matches demand for each side.
Managing two groups of customers makes marketplace business design much more complex than traditional business design. With any business its vital to understand the customers you aim to serve, but with two-sided marketplaces it’s even more critical. You must create a platform that serves TWO sets of customers WHILE creating the desired network effects. Incorrect design can collapse your network.
You’re reading about starting an online marketplace. At this point, I’m assuming you’ve identified your market and the two groups of people you’ll link with your platform. I’m further assuming you have a platform design in mind. It’s now time to carefully consider which side of the market you will:
- Get your money from, known as the money side
- Subsidize and forgo revenue to fuel growth, know as the subsidized side
Let’s dig into each of these bullets in more detail.
Pricing Your Marketplace
Pricing a two-sided marketplace is a main driver of complexity in the business model. As we mentioned above, you typically want to choose a money side and a subsidized side. Correctly choosing which side is which is critical to the health and sustainability of your online marketplace.
Lets look at the money side first.
The Money Side
The money side is the group you want to generate revenue from. Below are a few ways to help identify which side is likely best to become the money side.
- The group that is less sensitive to price
- The group that is responsible for ensuring your network is of high quality
- The group that gains more value from the other group growing in volume
Let’s further review each of these. We’ll use our startup Menyu to explain.
The Group Less Sensitive to Price
Simply put, the group with the deepest pockets tends to be the least sensitive. This is the restaurants for Menyu. They on average have more money and are less sensitive to price than diners. They generate revenue themselves, so if Menyu can provide a good return on their investment, they’ll spend money.
The Group Responsible for Providing High Quality
This can seem counter-intuitive, but the group that needs to supply high quality (restaurants for Menyu) is the group you typically want to charge. To ensure high quality of your online marketplace, you want to eliminate any low-quality providers. You do this by charging. The low-quality providers will not pay and drop out of your network, thus raising the quality.
The Group That Gains More Value from The Other Group’s Volume
Often, each side’s growth will fuel growth in the other. However, there will be one side that benefits the most from growth in the other side. Menyu offers an interesting case study for this bullet. Restaurants certainly benefit from more diners viewing their profile, but so do diners benefit from being able to view more restaurants in one place.
To decide, the restaurants benefit the more from user growth. Most diners search for and view a specific restaurant. Some will view other restaurants while on the site, but most will view the one and leave. That one restaurant however benefits much more from reaching 100 diners in a day than just the one.
The Subsidized Side
The subsidized side is the group you want to forgo revenue to fuel growth and add more value to both sides, but especially the money side. We can safely assume identifying the subsidized side involves looking for the opposites to the money side’s characteristics.
- The group that is sensitive to price
- The group that consumes quality, not provides it
- The group whose growth provides more value to the other group
After you identify your money and subsidized sides and work through your pricing strategy, including how you generate revenue from the money side, it’s time to understand the competitive forces that will affect your marketplace.
As if complex pricing doesn’t make starting your own online marketplace difficult enough, fierce competition is commonplace. This has much to do with the previously discussed network effects. Although capable of creating enormous profits, network effects introduce some challenges as well.
Let’s review a few.
Winner Take All Dynamics
Because network effects can generate enormous wealth, large amounts of capital are invested in marketplaces, namely your largest competitors. As each side of their network feeds the other, they get bigger and bigger and make more and more money.
Because most users of marketplaces have little incentive to belong to several and because the marketplace that is largest provides the most value to users, the largest marketplaces begin to gobble up the market. This leads to winner-take-all dynamics and forces a race to be the winner, thus creating intense competition.
The Threat of Envelopment
As the winners get bigger, consolidation occurs, and the smaller marketplaces struggle even more to fend off competition. This creates a threat of envelopment – the larger network adding to its features those of the smaller network. This effectively kills the smaller network and further feeds into the network effects and winner-take-all dynamics. There is one strategy that reduces the chance of envelopment.
Find a Big Brother
To minimize or prevent the risk of envelopment, smaller marketplaces can form strategic partnerships with larger marketplaces. The partnership adds valuable features to the larger network while providing protection to the smaller network.
Often these types of strategic relationships transform into successful exits for startups. The larger marketplace realizes the smaller network could grow substantially from more capital, so the bigger one purchases the smaller one. It becomes envelopment, but profitable and rewarding.
We now have a firm grasp on marketplaces, including what they are, how to price them, and what to expect regarding competition. Now let’s discuss building the platform that creates the marketplace and link the two sets of customers. If you want to start your own online marketplace, you must create a platform.
The platform represents the products and services that bring together the users in a two-sided network. It further forms the rules, protocols, and procedures set forth to govern the interaction between the two groups.
Platforms can take many forms. For example, the credit card mentioned above is the platform used to bring merchants and consumers together. Our startup Menyu is the platform that links restaurants to diners.
Design Your Platform
To start designing your platform, I suggest getting a pencil and paper. Proceed to create your wireframes by drawing the screens for your online platform. These allow you to essentially design your website without spending any money. You can draw and erase until you get it right.
Choose the Technology to Build It
As you work on the wireframes, start thinking about the technology you want to use. Are you going to make an iPhone app that must be downloaded from the app store, a website that will work on all devices, or a product specific app like Facebook? These decisions will have big implications, so choose carefully.
For example, when Kevin and I launched Menyu, we chose to launch as an iPhone app. I spent 2 months coding the app in Swift. This including teaching myself as I went. We launched the app and did two publicity shoots for TV news in Youngstown, OH and Cleveland, OH.
We had an initial surge in user downloads that turned into a stream which turned into a trickle. That’s when we realized, without large amounts of capital to market the app and load thousands of restaurants fast, we had zero shot with an app. People weren’t going to download our app without knowing it existed.
Big mistake. I mean BIG mistake. This poor planning and understanding of our marketplace cost us one year and forced us to pivot.
You researched your market, completed your wireframes, and chose your technology. Congratulations, you’re now ready to create your online marketplace. If you’re a developer like me and have time, great, get coding. If you’re not, no worries. Simply do what I do with all the things I’m not good at – delegate and pay for them.
Below are some options for creating your own online marketplace.
- Raise money from family, friends, or seed investors.
- Bootstrap and hire a developer to write your code using money from your day job.
- Find a cofounder who can do the coding. Many sites like cofounderslab exist to help.
- Teach yourself software development and build it yourself.
- Use an existing platform like CS-Cart advertised at the beginning of this article.
- Give up. Just kidding, don’t give up!
Online Marketplace Examples
I’ve created several marketplaces over the years – all bootstrapped and of small scale. To wrap up this article, I will share 3 examples of online marketplaces I created. One I shutdown, one I purchased, redesigned, ran for 15 years, and then shutdown, and one I’m still operating and growing.
The stories are below, enjoy.
West Central Ohio Rentals
Lifespan: 1 year
The Business Model
The Money Side
The property managers were the money side. As the money side often does, this group consisted primarily of business people – people who themselves generate revenue. They can easily justify spending $29.99 on an online ad if it gets them a tenant. Especially since newspaper ads were very expensive and not half as good.
The Subsidized Side
The group looking for a home was the subsidy side. This group was much mores sensitive to price and wouldn’t be able to pay a fee to search properties.
To jump start the marketplace, I cold-called large apartment buildings in the area. I signed up their property managers by offering them free ads for the first year. I signed up several complexes and had about 100 ads on the site. I then started formulating a plan to market to the other side, the side looking for homes.
I never executed that plan. I got my first professional software developer job and put my energy into that, thus abandoning the site. That job launched my IT career, so I’m grateful. But WCOR had tons of potential and I wish I followed it through.
College Campus Connection
Lifespan – 15 years
The Business Model
Very similar to West Central Ohio Rentals except geared toward college students looking for off-campus housing. Landlords could post weekly, monthly, or yearly ads or buy pre-paid credits at a discount. This site originally included a student book exchange as well, but I ended that.
The Money Side
Same as above, the landlords were the money side. Posting ads saved them substantial money from reduced vacancies and eliminating expensive newspaper ads. I sold a yearly ad sold for $40, monthly was $20, and weekly was $10. Most landlords purchased the $40 ad.
The Subsidized Side
The college students were subsidized – although this group has more money than you would think, at least those looking for off campus housing. In the area we operated, you had to be a senior or master’s student to live off campus. These people had money from their student loans or from parents who footed the bill. But as above, they’re not going to pay a fee to find a home, so they were subsidized.
We marketed to this side by acquiring links from colleges’ off campus housing pages. We would convince colleges to use our site as their featured partner for students to find off campus housing. This drove lots of traffic. The downside was colleges and universities are very bureaucratic and persnickety. It can be a very long, frustrating process to get a backlink.
As part of this business, I owned one rental and another eight units with my parents. We operated the rentals and website for almost 15 years. We exited our last rental property in 2018 and we ended the website in the beginning of 2020.
The website made money down to the last day. I didn’t end it because we exited our rental properties. Rather, the site needed totally rewritten as our hosting provider was forcing an upgrade to a newer PHP version. At this point in my life, the return on my time to rewrite it simply wasn’t worth the effort, so I ended it and refunded the remaining customers who had credits or were running ads.
Lifespan – 3 years and counting
Website – theMenyuApp.com
The Business Model
Menyu is a two-sided marketplace that Kevin Sims and I built in 2017. We spent a year as an iPhone app, so the online marketplace launched in 2018. January that year we received our first organic visitor. The site connects restaurants and consumers. Competition is fierce and we’re a late entry to a very mature industry. The threat of envelopment is extremely high.
We believe however that we’ve found a product market fit – a hole in the market that needs served. Menyu is using that hole to enter a very crowded market with hopes of eventually moving up the pyramid and capturing more profitable customers.
The Money Side
We are currently subsidizing both sides of our marketplace to fuel growth. However, as we grow both user groups (restaurants and consumers) and begin to experience network effects, the restaurants will become the money side. They will be able to spend on premium advertising, features, menu integration with their website, and so on. We simply must grow and build a valuable network before we build these features and charge.
The Subsidized Side
The consumer, or potential diner, is the subsidized side. They are price sensitive and won’t pay a fee to view a restaurant’s menu. As this user group grows, it becomes more and more valuable to the money side. This is another reason this side is subsidized – we want this side to grow as fast as possible. Charging this side wad drastically reduce the group’s size, making our network much less valuable to the money side.
Yet, one could argue us advertising on the website turns this side into the money side. They visit our site and click on ads which generates revenue. To keep this article simple, I’ve chosen to ignore advertising. However, the diners are the ones generating our revenue, so one could certainly argue that we are subsidizing the restaurants and charging the consumers.
Menyu is experiencing exciting growth. We grew traffic 570% in 2019 and revenue by 540%. We have fully automated much of the operations. The data entry is handled by virtual assistants paid for by the profits of the business. Kevin and I work weekly on the business, but at the cofounder level – improving the site experience, automating operations, and building our brand via our podcast and this blog.
Menyu competes in a very large, mature, and competitive market. Risk of failing is very high. Additionally, Google has entered the restaurant menu space making the risk of failure even higher. I do believe however that we have product market fit. A chunk of demand that no one else is serving. If we can continue to strengthen the grip on our market, we will continue to grow.
Further Reading on Marketplaces
This article was heavily influenced by the October 2006 Harvard Business Review article titled Strategies for Two-Sided Markets. As of this writing, it can be read here. I highly recommend reading, studying, and using it to design your online marketplace strategy – I did.
Good luck as you start your own online marketplace.