Marketplaces and network effects
The flaws of horizontal marketplaces
A new type of customer experience
Horizontal markets make a lot of sense in the physical world. Retailers like Walmart and Target cater to every need, are affordable, and can be found just about everywhere. The online world has its own horizontal giants. Amazon, Alibaba, eBay and Craigslist command significant market share, scale, and power.
From an investment standpoint, marketplaces are particularly interesting opportunities since a leading company can easily assume a winner-take-all or winner-take-most position. Marketplaces are also one of the few business models that exhibit true network effects; supply and demand follow each other. Look, for example, at the ongoing battle between Uber and Lyft.
There is no incentive – for drivers or passengers – to align with the second most popular transportation marketplace service, and solving this through crazy financial incentives isn’t sustainable. It’s simple: drivers maximize their income by tapping the largest pool of potential passengers (demand). Passengers, meanwhile, have no incentive to choose the second largest transportation provider. Accessing the largest pool of drivers (supply) increases the odds that they’ll find an available driver nearby and minimize wait.
It’s a high stakes battle: when one company controls a market with strong network effects, they can generate huge profits, retain customers and keep competitors at bay – which usually means the leader takes all.
If you can identify the winner early, an investment has less risk. First mover advantage often provides an “unfair advantage” — the first company to reach meaningful scale stands a much better chance of owning the category. Being the biggest in a winner-take-all world means a bigger exit (or bigger company), since the ecosystem doesn’t get fragmented. The reduced competition lets companies grow faster. Even a winner in a smaller market can sometimes be more lucrative than a second or third – or even first – in a much bigger category, simply because there’s less competition.
The problem with horizontal marketplaces is the winners have already been declared – and they’re very difficult to disrupt head on. Because there’s not room for many (if any) more horizontal Goliaths, vertical marketplaces (businesses that cherry-pick elements from broader horizontal incumbents) become more compelling. By exploiting the inherent weaknesses of horizontal leaders and intently focusing on a single product or good, these companies can deliver a vastly improved customer experience, presenting an opportunity for vertical competitors to gain traction.
As an example let’s use the classic horizontal marketplace: the flea market. While there are a huge variety of goods at these gatherings, it’s often hard to find what you want, due to the overwhelming number of choices. Assuming you do find what you’re looking for, you then have to haggle with individual sellers. And, there are no guarantees as to the quality or reliability of your purchase.
In many ways, the flea market is an offline analogy for what we see on horizontal Internet markets like Craigslist, right down to the flaws. Horizontal marketplaces may enjoy massive scale and liquidity, but shortfalls in consumer experience leave them vulnerable to disruption by focused “vertical” players.
An effective, intuitive and painless customer experience is critical for vertical marketplace companies. It’s the Achilles’ heel of horizontal marketplaces – and it’s the best way to make your business capture the coveted market leadership position.
The early rollout of verticals was fairly slow. Over the past few years, though, they have emerged at a more rapid pace.
For example, hust in secondhand apparel and accessories, we saw how companies like Poshmark, Twice, ThredUP, Tradesy, and The Real Real grew very quickly.
In other verticals, we saw how companies like Raise (gift cards and store credits, a Bessemer portfolio company), MIND BODY (a fitness and wellness marketplace, a Bessemer portfolio company), and Chairish (furniture) emerged. This proliferation took place for a few reasons:
We’re only at the beginning of the road for vertical marketplaces – and that’s an exhilarating place to be for both venture capitalists and entrepreneurs. With so many verticals that are still untapped, there’s plenty of room for startups to make an impact – and for those that already have, the growth potential is massive.