The Australian start-up ecosystem has been more visible than ever, thanks largely to the emergence of Canva and Atlassian and the success of venture capital firm Blackbird. However, capital is still extremely scarce for Australia, so the ecosystem's main focus remains on early-stage ventures.

When it comes to early-stage start-ups, outsiders often equate them to gambles where 9 bets out of 10 are off but one is an absolute home run. For insiders, the most commonly expressed strategy is 'believe in the founder'. I'd argue that both viewpoints are too simplistic to be helpful in investing. There are a few necessary sophistications required to avoid throwing your money into the fire.

The first one is understanding the business model and its characteristics. The most common start-up business models today are:

1. SaaS

2. Marketplaces

3. Hardwares

4. Medical Devices

5. Biotechs

In this post, I will focus on how to evaluate marketplace start-ups.

The Marketplace Business Model

Marketplace businesses are extremely challenging because two sides need to be persuaded, not just one. Unsurprisingly, the odds of success are significantly lower than for SaaS. However, the marketplace business model has a special feature: the dynamics and quality of the network prevail over the specific business area the start-up focuses on. For investors, understanding how a successful network starts can enable them to avoid low-quality bets and focus on those that are clearly onto something. Despite the fact that marketplace businesses are hard to succeed in, informed investors are more likely to generate alpha from the selection of promising marketplace start-ups than from other business models.

Marketplace businesses are not uncommon. Many household retail businesses are marketplace businesses, including shopping sites like Amazon, dating apps like Tinder, listing sites like REA Group, and job sites like Hipages.

These businesses are hard to start because, unlike SaaS businesses which often just need to attract their end customers, marketplaces need to attract at least two types of customers: the supply side and the demand side, often simultaneously.

As the marketplace business grows over time, it becomes harder to disrupt because the marketplace becomes more valuable with size. This moat is called the network effect, which encompasses the acquisition effect and the engagement effect.The combination of these features gives two interesting attributes that investors are interested in:

1. Winner takes all: As a business reaches a certain scale, its competitors often throw in the towel.

2. Decisive early product: Early rapid scaling is fate-setting for marketplace businesses. Velocity is life for marketplaces.

The Hard Side

Now that we know marketplace businesses are hard to build, where do we go from there? The hardest part is probably the start, as if there are no suppliers, there won't be consumers. But if there are no consumers, suppliers don't want to come in either. The difficulty of making a start for marketplace businesses even got its own name - the Cold Start Problem, popularised by a16z partner Andrew Chen in his book of the same name.

Luckily, there are almost always an easy side and a hard side for marketplace businesses. The key in getting the wheel spinning is to persuade the hard side to come onboard. The hard side is almost always the supply side. For real estate websites, it's the agents. For dating sites, it's the attractive users. For ride-hailing businesses, it's the drivers.

Once the hard side is onboard, the easy side tends to be resolved quite easily. For Tinder, it went from campus to campus by throwing parties so the initial participants of the network happened to be the supply side. For Uber, it heavily incentivised drivers to come onboard during the initial launch, which explains its reputation for burning money in exchange for getting the supply side onboarded.

How to get the supply side’s buy in depends on the size of the atomic network, the smallest unit of the network that's self-sustaining. It could range from three, in the case of Slack, to a few hundred, in the case of Uber. If the atomic network is small, it is easy to build but also easy to compete. Same goes for large atomic networks, where they are hard to build but also hard to compete. The growth of marketplace start-ups involves building out one atomic network after the other, often manually. When a turning point is hit, the network will be able to grow by itself due to the engagement effect, like an old Chinese saying which describes how marketplace businesses can experience exponential growth once they reach a critical mass of users.:

A Simple Due Diligence Guide

For investors, understanding the characteristics of marketplace businesses is just the start. What moves the needle is how to pick the right early-stage start-ups in this category. Investors should probably never play a strategist role for the founders, so choosing someone who has a clear mind and is realistic about the challenges to overcome is vitally important. Below are some questions that can help investors assess whether the marketplace start-up is on the growth trajectory or is still finding its footing:

• Who are the supply side and demand side? What pains do they have?

• Is the product what they desperately need? Which side is it?

• For the hard side, what’s being done to drive up their participation?

• Is there a functional atomic network yet? What’s the minimum size of it?

• If there is a functional atomic network, what’s next?

For early-stage investors, the sweet spot is to get involved right after the first atomic network is formed. The toughest stage is when the atomic network has not formed, especially after the initial capital has been burned on ineffective strategies. Realistically it's slightly more complicated given there are other factors in play, including the valuation and the learning speed of the founding team.

Traction is arguably the best way to de-risk investing in a marketplace business, especially when it is not bought with investor capital. Look for organic growth and genuine user engagement during the initial phase of forming the atomic network. Look for signals where the founding team displays execution excellence and customer care for the scaling phase to subsequent atomic networks.

In conclusion, while marketplace businesses present unique challenges, they also offer significant opportunities for investors who understand their dynamics. By focusing on the formation of atomic networks, the resolution of the cold start problem, and the potential for network effects, investors can identify promising marketplace start-ups with breakout potentials from those that will inevitably fail.

References

Chen, Andrew. The Cold Start Problem: Using Network Effects to Scale Your Product. United Kingdom: Random House, 2021.

Helmer, Hamilton. 7 Powers: The Foundations of Business Strategy. United States: Deep Strategy LLC, 2016.