Unit Economics, Network Effects, Loss Leaders, and Vertical SaaS: Some thoughts on scaling marketplaces


Image result for unit economics

#MOOD? (Credit HackerNoon)

Unit Economics are of utmost importance when starting and scaling a business, especially a marketplace.  I came across a great article by Toby Clarence-Smith, a Toptal finance expert, entrepreneur, and investor, about what Unit Economics are and why they matter.  I want to provide some context given my experience working with hundreds of VC-backed companies and numerous consumer and marketplace startups.

In his post, Toby brings up some great points on scaling a business and how to think in-depth about fixed and variable costs and contribution margin. He also highlights Food as a key industry that has attempted to become an on-demand haven but struggled mightily.  All points are well made and it is a great primer for any transactional or marketplace-based founder to read.

When you factor what needs to go right for even positive unit economics businesses, it is no surprise that purely transactional marketplaces in industries like Food are extremely hard to scale on their own successfully. They require massive investments in both supply-side and demand-side user acquisition and support all for take rates that can be as low as 5-10% based on the price elasticity of a product/service (more on this in another post).  While network effects and winner take all moats can be extremely lucrative, the difficulty in executing and actually succeeding is extremely high.

So what can be done and why are these companies still getting funded at such valuations? Sure some of this may be market froth and a bit of FOMTN (Fear of Missing the Next) but there are some key actions a Company can take to better position themselves for success.

In his article, Toby makes some great points on how companies can get by with negative/minimal unit economics temporarily to generate economies of scale, increase customer loyalty, and drive ROI on an LTV/CAC basis.

I want to highlight his last point on driving ROI around LTV/CAC or the ability to generate minimal margin on first orders to drive profitable longer term customer value.  This business strategy when used effectively can be extremely lucrative but is fraught with danger and bubble-isms of the dotcom era when done wrong.

In my opinion, one of the best at this strategy was Microsoft who used this strategy when driving its Xbox and Xbox live platform to use the gaming console as a loss leader sold at cost or below cost to enable the sale of higher margin games and online subscriptions. Amazon prime has also been a great example of this more recently to drive not only a subscription component but higher GMV.

Image result for xbox 2005

One of the OG Xboxes of my youth

This use of a transactional marketplace as the “loss leading product” can be effective when combined with other revenue streams atop the marketplace. We have seen this of recent in the VC community with Vertical-Specific marketplaces adopting SaaS models in addition to the transactional piece.  This is not specific to loss-leading as many companies can straddle profitable marketplaces and vertical-specific software but I think it is important to illustrate the potential.

Roadster, an online car buying platform, has done this with their express storefront for consumers and selling the backend software to dealerships to not only drive SaaS margins but greatly improve the online buying experience for consumers.

Squire, an online barbershop marketplace with corresponding barbershop software provider is another example.

By allowing for marketplace transactions to be at minimal margin or at cost, it enables the company to not only drive the demand side of the equation to attract consumers with fair pricing but it also enables them to implement software (at much higher margins) on the supply side to allow business owners to better reach this audience within the marketplace.  This SaaS revenue at best drives major growth for the business and at minimum can offset some of the costs for supply and demand-side acquisition and support that is so critical (and expensive) to really get the network effects and marketplace flywheel going.

There are other ways to augment the purely transactional marketplace via premium offerings, promoted posts, and other subscription types and it really depends on what the best use case is for each company and market the founders are going after.

There are lots of ways to build a great business and I am always amazed to see just what the startup community can do around business model innovation to drive change across industries!