This blog was written by former Norwest partner Sergio Monsalve, currently Founding Partner at Roble Ventures.
Key performance metrics I look for as a venture capital investor
I have spent more than 15 years of my career building, investing in, advising, and studying online marketplaces. I am convinced marketplaces possess very unique and fascinating characteristics, which are often counter-intuitive and easily misunderstood.
By “online marketplaces,” I am referring to a central exchange of goods or services whereby a large fragmented supply/seller base meets in one concentrated place to sell to a large and fragmented demand/buyer base. Visually, this many-to-many model for commerce has been captured as a butterfly. Lots of suppliers (one wing) meet lots of buyers (another wing) in one central spot (the body). That “body,” the marketplace, typically has a lot of the concentrated control and power, which results in high equity values.
The online marketplace sector continues to grow despite market woes. By 2023, online marketplaces are expected to dominate the e-commerce space. In the US, the online marketplace sector is expected to grow at 15 percent per year and become as large as direct e-commerce platforms by 2025.
Given that outlook, investing in online marketplaces could prove to be fruitful . However, it’s a crowded, competitive market that’s hard to break into.
Successful online marketplaces tend to enjoy incredible network effects that result in winner-take-most dynamics. For the winners, this is very rewarding and highly defensible. Unlike companies in most technology sectors, where there can be multiple winners, marketplace dynamics offer no prize for second place. The results are often binary.
An early successful example of this is eBay. eBay was able to dominate most of the auction marketplaces in the world but lost the network effect war in China to Alibaba, Latin America to Mercado Libre, and Japan to Yahoo! Japan.
All of these regional online marketplace leaders are now multi-billion dollar businesses. More recently, we have seen several great online marketplaces emerge and thrive in many sectors of the economy, from fintech (e.g., Stripe), to hospitality (e.g., Airbnb), to crafts (e.g., Etsy), to transportation (e.g., Uber), to clothing (e.g., Threadflip), and even to education (e.g., Udemy).
I’ve evaluated each of these winning online marketplaces, and I’ve found that they are very similar to each other yet very different from their less-successful competitors, especially in five key dimensions:
- What do they do differently early on compared to their competitors to emerge as the undisputed leaders in their own sector/category?
- At the same time, what do these specific winners have in common?
- Is there a recipe for success?
I contend that there are five “uber” ingredients (pun intended), which – if present – create the recipe for the successful early detection of a winning marketplace.
1. Trading Liquidity: Methods for increasing and sequencing effective supply & demand “matches”
Marketplaces’ most important value proposition is to deliver high-quality demand to providers and high-quality supply to buyers most efficiently and effectively. In other words, an online marketplace is only as good as its trading liquidity.
Trading liquidity is an essential consideration for any investor, but it is necessary for the context of investing in online marketplaces. That’s because these digital marketplaces are relatively new and dynamic investment opportunities, and they can be subject to large swings in trading liquidity.
When an online marketplace first gets started, the suppliers often need to be patient and wait for the buyers to arrive, so the time to “match” (also called “conversion rate”) is slow. As the marketplace gains momentum, buyer demand increases, and the time to match improves.
Uber, for example, religiously focuses on the time it takes for a driver to be matched with a passenger; response and pick-up time are critical liquidity metrics for them. Of course, many online marketplaces measure this differently. Still, a marketplace needs to do its primary job: satisfy sellers and buyers by delivering liquidity.
2. Trust & Safety Focus
The other key value proposition an online marketplace offers its participants is a transparent, well-behaving community of buyers, and sellers, who follow precise rules of engagement. Trust and safety are critical in any marketplace, and early marketplaces have an advantage if they focus on them.
Trust, safety and confidence are essential to successful online marketplaces. A thriving community of buyers and sellers helps to create this feeling of trust, as it shows that the marketplace is active and growing. Furthermore, transparent policies and procedures help build trust by showing investors that the marketplace is well-run and accountable.
A good example here is Lending Club. Very early on, Lending Club decided to do their loan underwriting partially to ensure the quality of the loans offered to lenders was very high. This resulted in a meager loss ratio early on, which fueled very high trust among lenders and borrowers.
Trust and safety are critical in any marketplace, and early marketplaces have an advantage if they focus on them.
3. Habitual Repeat Usage
Another great sign of initial marketplace success is how the early cohorts of buyers and sellers stick with the marketplace over time and continue to use it more actively. I always focus heavily on how early adopters are retained over time.
Early adopters are essential for several reasons. First, they help validate the marketplace business model. If customers are willing to come back and use the marketplace multiple times, it’s a good sign that the marketplace is providing value. Second, early repeat users help build customer loyalty and brand recognition. As the marketplace grows and attracts new users, those early repeat users will be more likely to stick around and continue using the platform, acting as ambassadors for the brand.
Finally, early repeat users generate valuable data that helps the marketplace improve its algorithms and match buyers and sellers more effectively. This, in turn, leads to more users, which attracts more investment and drives further growth.
For example, I was very happily surprised to see that Udemy’s engagement with consumers of educational videos spans several years, and every year its consumer base becomes increasingly addicted to Udemy. Think about Uber and Airbnb as well. Many of their early adopters are even heavier users and stronger evangelists today. As a result, marketplaces must master the “hook” and generate intrinsic triggers that get customers returning.
As the marketplace grows and attracts new users, those early repeat users will be more likely to stick around and continue using the platform, acting as ambassadors for the brand.
4. Increasing Value Capture
A marketplace should be able to capture more of the value without much change in retention numbers. This is because a network-effect business becomes more valuable as its network effect takes hold. Online marketplaces gain substantial pricing power once they establish evident trust, improve liquidity, and generate a positive brand.
Increasing value capture is crucial. First, it allows the online marketplace to generate more revenue, which can be used to reinvest in the business and drive growth. Second, it helps create a competitive barrier for new entrants. If a marketplace has already established itself as the go-to option for users, it will be much harder for new players to gain traction. Finally, higher value capture can help to increase margins and improve profitability. This is especially important for investor-backed companies that need to show consistent growth to encourage more people investing in online marketplaces and attract more capital.
While sellers and buyers may complain at first, a marketplace can change its value capture as long as they offer more value than they are capturing. Thus, winning marketplaces can charge more; as long as marketplaces don’t become too aggressive, this dynamic should endure.
5. Signs of Increasing Distance between No. 1 and No. 2
Ultimately, if the marketplace network effects are taking hold, the most straightforward measure that a winner is emerging is the increase in distance between No. 1 and No. 2. This distance can be measured in terms of typical key performance metrics (KPIs) such as traffic, engagement, supply, conversion, revenue, margin, etc. In these and other performance metrics, the top marketplace should be performing increasingly better.
The credibility that comes with being a market leader can instill investor confidence and result in more capital being invested. Conversely, being in second place may make it more challenging to attract investment because there could be a perception that the company is not as strong as its competitor. This is why it is vital for online marketplaces to maintain their position as the market leader, as it can significantly impact their ability to raise capital.
By the end of the maturing cycle, the marketplace could end up with a vast majority of the market share and mindshare. Once the market shares and mind shares are cemented, it is difficult to displace the winner. It is not until another disruptive wave of technology comes around that the marketplace becomes vulnerable to displacement. The lifetime value of a winning marketplace is very long and high; hence the public market valuations and multiples are given.
The credibility that comes with being a market leader can instill investor confidence and result in more capital being invested.
The Norwest Difference
At NVP, our early investments in and lessons from now-successful marketplaces have led us to make our newest marketplace investments, including Udemy and others. We believe Udemy exhibits these five characteristics and we are very excited about their funding announcement this week.
These five ingredients are not meant to be completely comprehensive. In each of our investments at NVP, we tend to look at dozens of other key ingredients that make a great marketplace thrive. More importantly, we use our knowledge and best practices to make sure our marketplace partners have a clear competitive advantage. We actively offer our expertise and guidance to help CEO’s and entrepreneurs achieve that coveted winner-take-all position.
