Online Marketplaces: Key Benefits of This Business Model

Online marketplaces are becoming a hot business model, especially amongst startups. Why are they popular, and why might you want to build your own company on this model?

You love widgets — can’t get enough of them — and thus decide to start a business selling widgets. But, you soon realize there are many different ways to provide people with widgets.

Perhaps you want to manufacture them and sell directly to consumers and businesses. You could be a vendor! But, the notoriously carcinogenic chemicals involved in widget manufacturing have you squeamish.

That’s fine. Perhaps you’re more suited for reselling — buying widgets from manufacturers and selling them for a markup directly to the consumer.

Or, you could use your knowledge of the widget market to set up a platform for individuals with widgets to sell to others who desire widgets. In other words: an online marketplace.

Bryn Huntpalmer recently wrote a thorough, practical guide for building an online marketplace from scratch. I highly recommend reading it.

But why would a founder want to choose an online marketplace over another business model? Here are a few key benefits:

Online Marketplace - No Inventory

No Inventory

Casting off the shackles of inventory is one of the defining upsides of an online marketplace.

Inventory is the stuff on the shelves of your local supermarket, the boxes of faux-rustic knick knacks in the storeroom of Pier 1 Imports, and the Ford Focuses sitting on the lot of a car dealership. It’s the stuff that a business owns but has yet to sell.

And inventory is one fickle mistress.

Too little, and your customers won’t find the specific good that they need. They’ll leave your business to satisfy their needs elsewhere.

Too much, and it will sit on the shelves or in the warehouse untouched. The supply will exceed the demand and you won’t be able to sell all of your product.

If it’s perishable (like food), it will rot and you’ll lose money. Even if your product is not perishable, it will still lose value over time as newer models become available or as trends change.

Unless you’re able to find and stay in that “Goldilocks zone” of perfect balance between supply and demand, inventory problems will cost you money or customers.

In most cases, an online marketplace doesn’t require any inventory because the company is not selling the actual good. Instead, it is connecting people with goods or services to those who want to pay for those goods and services, and then taking a cut of the transaction.

Because there’s no inventory to store or ship, a marketplace also saves on the cost of facilities to store inventory and an operations department to process it.

Consider the massive undertaking required to get a 60-pack of bicycle helmets from a factory to a specific Costco store: drivers to move around the helmets, buildings to store them in for processing, and planners to decide how many bicycle helmet mega-packs ought to go to each store. Then there’s insurance, property taxes, human resources staff to support your bulging work force, and so on.

Or, you can skip all that. Be RelayRides rather than Hertz, Airbnb rather than Motel 8.

Things still might not be easy (being a founder never will be, just ask Nicki Boyd). But, at least you don’t have to worry about all your capital sitting around in boxes.

Online Marketplace - Free Advocacy

Free Advocacy

Of course, the widgets are just the first component of your online marketplace; the other is the user base.

Unlike the widget vendor in the factory, your user base is comprised of sellers and buyers, not just buyers. You’ll need to shape your business to offer a quality service to both parties, which is a delicate balancing act. But if you pull it off, you’ll reap the sweet benefits of having a double advocate base.

If inventory is one of the most expensive disadvantages of a traditional reseller model, another is the cost of marketing. Once a reseller has a bunch of items up for sale on its website or in its store, the company needs to convince people to come and buy them. This includes informing the customer and convincing them to come to your store rather than another.

The antiquated musket that used to be the main weapon of the marketing industry was advertising on print, radio, and/or television. It was (and still is) a prohibitively expensive tool that dramatically favors the established players, like these 36 companies that spent over a billion dollars on ads in 2011. That’s why efficiency-minded startups focus instead on virality and growth hacking tactics.

In an online marketplace, every transaction involves two parties: a buyer and a seller. Assuming everyone involved has a positive experience, both parties will have a reason to spread the word.

More importantly, at least one of these users — the seller — is a stakeholder in the online marketplace, meaning she’ll do better if the marketplace does better. While good will and excitement will turn many users into advocates, nothing works better than a clear financial incentive.

Craigslist sellers will link people to their listings through their own social media, Uber drivers encourage people to use Uber, and TaskRabbit handymen will advise people to employ their services through TaskRabbit.

As your group of sellers grows, so does your guerrilla marketing team — no Don Drapers required.

Online Marketplace - Exponential Growth

Exponential Growth

Thomas Malthus preached in the 18th century about the dangers of population growth. Because population grows exponentially, but food production does not, the whole of humanity ran the risk of plunging into a famine-driven Dark Age rivaling the collapse of Rome.

Wouldn’t it be a disappointment if armageddon were caused by insufficient grain stores rather than the sharkpocolypse or zombie virus that Hollywood keeps promising?

Similarly, exponential growth of demand creates major problems for vendors and resellers. If a worker can produce X widgets in an hour, the only way to respond to rapid growth is to either match it with an exponentially growing workforce or to continuously overhaul manufacturing processes to increase efficiency. Either way, operational costs will increase just as fast as revenues, perhaps faster.

And growth is critical to a successful startup. In ironic contrast to the locavore small-batch coffee roasters that their employees love, tech companies are focused on scaling as quickly as possible.

There are good reasons for this. Tech startups are often harnessing a recently-developed technology or tapping into an emergent market, and one of the biggest risks in the early stages is being overrun by a competitor. Simultaneously, fast growth creates momentum and attracts larger investments from venture partners who are looking for the next Facebook, not the next boutique distillery.

One of the reasons that online marketplaces are seen as darlings at the moment is their capacity for rapid growth. Because they facilitate a transaction rather than actually taking part in it, their labor force does not need to grow on pace with the number of transactions.

They aren’t making, packaging, or delivering the product in question; they only need the staff necessary to maintain the platform at increasing levels of use. To put it another way, the number of people hired by Ebay is not directly connected with the number of goods bought at auction through their platform.

In practical terms, an online marketplace is theoretically capable of much faster growth than other types of businesses, which in turn attracts interest, investment, and top-tier talent.

Online Marketplace - Party City vs Etsy

Party City (Traditional Reseller) vs Etsy (Online Marketplace)

Party City, a traditional manufacturer and reseller of discount party paraphernalia, and Etsy, the online marketplace for homemade crafts, both went public in 2015 with very similar financials. Both were also valued similarly with Etsy at $1.8 billion and Party City at $2 billion.

Both companies oversaw a similar value of transactions. Party City brought in $2.27 billion in 2014, while Etsy saw $2 billion of merchandise exchange hands via its platform during the same period.

But here’s the big difference: Etsy was launched in 2005 and employs 685 people. Party City was founded in 1986 and employs 6,296 full-time employees, plus over 8,000 part-time employees, according to its IPO filing.

That’s the growth power of a successful online marketplace.

Downsides of an Online Marketplace

We’ve presented some of the key benefits of structuring your startup as an online marketplace. It’s important to remember, though, that there are also some downsides to this business model.

In particular, online marketplaces are notoriously difficult to spark — what is often called “the chicken and egg problem” (which we will explore in a future post).

The customer experience can also be difficult to control, just ask the Airbnb host whose home was vandalized by her guests.

But if you can overcome these challenges, an online marketplace could be the ticket to creating a large, successful company with lasting impact.

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