In construction, a platform is something that lifts you up and on which others can stand. The same is true in business. By building a digital platform, other businesses can easily connect their business with yours, build products and services on top of it, and co-create value.
-Harvard Business Review, Three Elements of a Successful Platform
Two-sided Markets, Platforms, Marketplaces, or Aggregators – whatever you call them, they are all the rage. Facebook, Uber, AirBnB, Yelp and other breakout platform companies of the last decade have popularized this business model for entrepreneurs and VCs alike. First identified and analyzed in pioneering work by Nobel Laureate Prof. Tirole and research partner Prof. Rochet, “two-sided markets” or “two-sided platforms” refer to businesses that cater to two interdependent groups of customers.1 Since then, several theoretical and empirical papers have emerged, and platform markets has become a very active area of research in economics – primarily in network effects and reputational systems. Work by Prof. Jonathan Levin, who thinks of platforms as intermediaries that bring users together to enable economic or social exchange, and by Prof. Hagiu, who provides a mathematical function for multi-sided platforms to choose between reseller and marketplace business models, are more recent examples of interesting research in this area.
Outside academia, VC Bill Gurley is perhaps the most famous proponent of marketplaces and its potential.2 His 10 factors to evaluate a new marketplace and optimal marketplace pricing strategy blogposts are required reading for anyone interested in platforms/marketplaces. Recently, Stratechery author and blogger Ben Thompson has garnered significant praise for rightly explaining this business model through his “Aggregation Theory”. In this post, I am going to expand on Bill’s pricing blogpost to classify platform businesses from a pricing perspective and then elucidate why it is important to do so.
When viewed through a pricing lens, there are four kinds of platforms:
Paid Cross-side Platforms – These platforms create value primarily by enabling direct exchanges between its consumers and producers, and benefit from cross-side network effects, i.e. the volume and nature of merchants attract users, and more users attract more merchants (more sellers -> more customers, more customers -> more sellers). Interaction is cross-directional, from sellers to customers and customers to sellers. Customers don’t necessarily interact with other customers (and merchants do not necessarily interact with other merchants), and even if they do (Uber Pool etc.), that communication is not the primary goal for the platform. Examples are eBay, Amazon Marketplace, Alibaba’s Tmall, Uber, Lyft etc. They are called “paid” platforms because merchants are charged a rake (or revenue share) when they sell to customers. These platforms are price elastic with respect to the rake that they can charge merchants because higher rakes are passed on to the end-customer as higher prices.3
Hardware Cross-side Platforms – Cross-side platforms or marketplaces built on top of a hardware or physical layer is unique because these platforms do not attract users primarily by the volume and nature of the merchants on their platforms; rather the hardware attracts users, and the users then attract merchants. As a result, these platforms are more price inelastic (compared to other platforms) with respect to the revenue share they charge merchants. Examples include Apple Appstore, Xbox Gamestore, Google Playstore. Even a physical marketplace in a unique location that allows merchants to sell their wares and charges them on a revenue share model falls in this category.
Free Cross-side Platforms – These platforms enable exchanges between its consumers and producers almost always for free, and use an ad-based model (free for users, producers pay for ads) for monetization. They benefit from cross-side network effects. Google, Yelp are examples.
Same-side Platforms – These platforms create value by enabling direct exchange amongst its users, and are monetized either by charging the users directly (rarely), or by charging advertisers to sell services to users (most often). They benefit from both same-side effects (more users -> more users) and one-way cross-side effects (more users -> more advertisers). Note that more advertisers do not directly mean more customers. In fact, more ads -> bad customer experience -> less customers. WhatsApp, Facebook, WeChat, Skype are examples.
So why is a pricing view of these platforms4 important? Because the rake that a company (rather a product) can charge depends on where it falls in this spectrum. Paid Cross-side Platforms are more price elastic with respect to the rake that they can charge merchants because a competing platform with lower rake can attract users with lower eventual consumer prices. Hardware Platforms get away with higher rake because of their hardware differentiation. In other words, Apple’s Appstore can get away (and they have for the past 10 years) with charging developers a high rake (30% revenue sharing) because a competing platform with lower rake for merchants is unlikely to cause users to shift (as long as Apple’s hardware continues to attract users). In Free Platforms, prices charged to advertisers don’t (directly) affect the prices on customers, so theoretically new platforms cannot undercut the price (charged to advertisers) of the dominant platform and capture more users. Similar to Free Platforms, prices charged to advertisers in Same-side Platforms don’t (directly) affect the prices on customers, so theoretically new platforms cannot undercut the price of the dominant platform and capture more users. The way to capture marketshare is to offer differentiated service (Facebook vs. Myspace, Snapchat vs. Facebook).
From a cost point of view, there are three costs at play in any business. An upfront capital expense (in case of platforms, this is incurred in developing the platform and is primarily in software development and in some cases physical assets and hardware costs), and variable costs that vary with each unit of output (i.e. costs that vary with the number of sellers and customers serviced such as platform maintenance costs, customer service, payment processing etc.).
So in cross-side platforms (other than hardware), your pricing/rake strategy can take two approaches:
- In the absence of sufficient funding, you charge sufficiently high enough to account for your variable costs and capital expense as a percentage of revenue. While this rake is likely to provide sufficient cash flow to keep you in business, it will also mean slower seller (and thus customer) acquisition for your platform. The less the rake, the faster your seller acquisition. As you grow, though, you should continue to reduce your rake to build a moat around your business and make it harder for new entrants. That is, as you reduce your rake, other startups like yourself will not be able to enter the market since they will have to charge a higher rake than you to generate sufficient cash flow to stay in business. Think about it this way: if you had to charge the high rake in the beginning, arguably new startups would have to do the same, unless they have deep pocketed investors willing to fund the lower rake.
- The second (and, in my view, better strategy) is to charge a rake that is only slightly higher than your variable costs. This way, you will acquire sellers (and thus customers) faster, and with each seller and customer acquired you will discourage other new entrants from competing. Your high initial capital expenses (fixed costs) will be depreciated completely anyway, and with more customers and orders, you can distribute your fixed costs over more customers. With a lower long-term capital expenses as a percentage of revenue, you can charge a rake that is slightly higher than both your capital expense and marginal cost combined, that others Such a low rake will not only attract sellers and provide low prices for customers, it will also make it cost prohibitive for any new entrant platform trying to enter the market. This second strategy requires patient investors willing to fund the initial capital expenses.
In both strategies though, in the long-term, if your marginal cost of serving an order is 5% of revenue, then unless you are a hardware cross-side platform (like Apple’s Appstore) you should not be charging sellers a rake of 20% giving you an operating margin of 75% ($20 rake, $5 marginal cost, $15 operating profit on a sale of $100), because someone else could charge lower rake and capture both sellers and customers.
So the next time you are deciding on the pricing strategy for your Uber for X startup, remember – some rakes are more hazardous than others.
PS: In traditional software parlance, platforms are those where other developers can build applications and software on top of your application (platform). I take a more broader view of platforms, one that includes marketplaces for sellers and buyers to connect, or advertisers and customers to interact.
Think sellers and buyers at Amazon, riders and drivers of uber, and so on.↩
With winning bets on several marketplace successes such as eBay and Uber.↩
That said, Uber, Lyft and other “price setting” Cross-side Platforms are less price elastic because they set the final price to the customer irrespective of the rake. Lower rake directly affects bottomline instead of topline. Also, a managed platform can charge higher rake if customers or merchants value the platform’s “management”.↩
Some companies sit across multiple models but products typically pertain to one model. For example, Google is a Free Cross-side Platform for search, but Gmail is a Same-side Platform.↩