Why we invest in online marketplaces [Opinion]

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Driven by mobile penetration rates and user growth, online marketplaces present tantalizing oportunities for investors. (Image via Hollandfintech)

Online marketplaces are gaining popularity in the Arab world.

Propelled by internet users, whose number is growing yearly at about 10 percent, smartphone penetration rates topping 100 percent in some countries, and consumers’ increasing appetite for transacting online, the numbers are too good for venture capital firms to ignore.

Our regional fund, Middle East Venture Fund II, has invested over $4.5 million in online marketplaces over the past few months, with some of our key portfolio companies being The Luxury Closet, YouGotAGift (YGAG), Altibbi, Volt and Fishfishme.

Marketplaces unlock value

An online marketplace bridges the supply and demand gap around specific products and services.

For example, The Luxury Closet provides owners of luxury items with a medium to sell to those who demand authenticated, pre-owned items at discounted prices.

Value is unlocked, and derived, largely from the interactions on the platform where buyers find good deals.

Unlimited supply

Online marketplaces unlock new avenues through which products can be sold, such as Amazon or the Luxury Closet for example, or at least make current sources of products more readily available.

For instance, Volt allows any car owner to find riders. YGAG brings online a product - gifts - traditionally sold at brick-and-mortar shops.

The focus becomes less on increasing supply, in the traditional economic sense, and more about optimizing and efficiently distributing the products already available. This breakdown of the access barrier rewards the supplier, who could end up depending on the site to earn a living, and the marketplace itself.

Unlimited demand

Transacting offline offers limited options for consumers in MENA.

Through online marketplaces, people have access to more choice – be it type, price or quality - from within or outside their countries. With services like ridesharing and bookings, the benefits become more about convenience as well as the potential for more options.

A recent statistic on Wamda showed how businesses in the region are not using about 80 percent of the data they generate from everyday activities. Data can be used to build a more intelligent online platform, which, in turn, makes it better at catering to unlimited demand. This can be particularly rewarding in MENA, where taking into account local and even individual needs is paramount.

Key success factors

Given the dual sided nature of marketplaces, startups need to focus on building supply as well as the demand. Therefore, certain factors need to be kept in mind for them to do so successfully in the region. We will discuss three: curation, critical mass and economics.

Curation

Proper curation leads to trust in the platform. The intensity of the curation exercise as well as its target (supply side, demand side or both) ultimately depends on the business itself.

Altibbi builds relationships with doctors starting at the onboarding stage. The Luxury Closet employs a whole team focused on curating all the items made available on its site. Volt prides itself on the safety that its communities provide. Users are connected with trusted and verified fellow community members and can then rate and review each other.

On a global level, Airbnb has an extensive verification process and relies heavily on user reviews.

The more there is trust, the more people in the region will be willing to transact and pay online. Increasing levels of online payments suggest this is already taking place.

Critical mass

Critical mass leads to transactions. The success of a marketplace depends on the critical mass it achieves on the supply and demand sides.

This critical mass kicks in the network effect where the site becomes more valuable as more users use it, and this, in turn, increases transactions or liquidity on the platform.

For that to happen, the company needs to scale fast and ensure its site is intuitive and frictionless for users on both sides of the equation.

Economics

Achieving favorable economics on both sides keeps the platform alive.

Marketplaces require significant funding to build a brand that users trust and achieve the critical mass necessary for its success. For such sums to be deployed, there needs to be a clear idea about economics. For example, an increasingly popular benchmark when it comes to LTV/CAC (ratio user lifetime value to acquisition cost) is for it to be above 3.

The challenge in marketplaces is that dynamics on both sides need to be taken into account to assess such a metric. For example, is marketing allocated fully to acquire suppliers or consumers, or with some percentage to both?

All in all, the revenue model needs to be clear and justified, be it a percentage of transactions on the marketplace with, say, ancillary service fees or a subscription model.

Linked to that is keeping user churn low and stickiness high. Cohort analysis can be used to optimize spending and minimize marketing spend as a percentage of revenue, as a lot of focus is spent on acquiring users when it is cheaper to retain them, especially active suppliers and loyal consumers. The tracking of other costs is equally crucial.

Conclusion

A marketplace can successfully unlock value on both the demand and supply sides. To sustain its edge, it must ensure trust in the platform. Furthermore, it needs to scale and do so profitably or at least with a break-even point in sight.

Ultimately, growth with no favorable economics is only half the story, if not less.

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