Welcome to Episode 3 of Beyond the Cart! In this episode, I am going to be sharing our thoughts on tech-enabled marketplaces, and the key analyses that are top of mind during Inovia’s due diligence process.
What is a Tech-Enabled Marketplace?
One positive outcome of the lockdowns is people have taken a step back to think about the services they use daily and how technology can significantly improve them. These new service models seek to replace traditional cumbersome processes and are what we consider “tech-enabled marketplaces” comprised of two parts:
- Tech-enabled – they utilize technology to bring new efficiencies to a product/service.
- Marketplace – they act as a third party to match supply and demand for services.
At Inovia, we are always looking for ways to help build companies leveraging technology to improve traditional ways of accessing goods/services. We spend a lot of time analyzing marketplaces and want to shed some light on our key standouts when looking at new businesses.
Unit economics are to a VC what on-base percentage is to Billy Bean from Moneyball – we often jump into unit economics to determine how efficiently a start-up generates new revenue on a per-customer basis. One of the key metrics we look at is customer acquisition cost (CAC) payback, the time (# of months) it takes for a business to recover the cost of acquiring a new customer; this is a key determinant in assessing a business’s go-to-market motion efficiency.
CAC Payback = (Sales & Marketing Expenses in Period) ÷ (Net New MRR in Period * Gross Margin)
Generally speaking, a lower CAC payback is better, but like any SaaS metric, it should be part of a holistic analysis that serves as a guideline and not gospel. As the table below illustrates, it is crucial to benchmark against the right comparable company set because CAC payback is particularly sensitive to customer size and go-to-market motion (Openview has a great overview of CAC payback).
A simple approach to CAC is looking at direct marketing spend, which can be thought of as advertising (eg. social media, search engine marketing, etc.). We like to take this a step further and ‘bake in’ other expenses that contribute to go-to-market efforts, resulting in a ‘fully-baked’ CAC:
- Indirect Marketing Spend: Brand spend is the most common indirect marketing spend; it includes review sites (e.g., G2, Capterra), market research firms (e.g., Gartner, Forrester), and more classic TV / radio / billboard ads.
- Sales & Marketing Salaries: The sales and marketing team are the engine behind customer acquisition, particularly as a company achieves scale and needs a dedicated team to run ad campaigns.
When considering the marketplace perspective, it is unique because it has to manage both the supply and demand of the market in order to play matchmaker. People commonly think about the demand side first, because it is the easiest to wrap your head around: attracting customers that will be buying goods/services on the marketplace.
Demand-Side CAC: Acquiring New Paying Customers
Many marketplaces forecast network effects on the demand side, as word-of-mouth referrals create a powerful organic customer acquisition engine that drives CAC down over time. Free referrals mean less ad spend to attract new customers. This is true for many at-scale two-sided marketplaces and there are numerous examples that come to mind – Airbnb, Uber, Lyft, etc.
There is ample opportunity to create a marketplace that aggregates demand and makes search and discovery more convenient for the consumer; this is what supports credible “hockey-stick” growth of total spend on the platform (aka. gross merchandise value or “GMV”). CAC payback may look attractive at first glance as a company effectively attracts demand and the flywheel takes effect for demand aggregation.
Supply-Side CAC Has Entered The Chat
The costs of attracting supply to the marketplace can pose a challenge and this is where the intricacies of a two-sided marketplace CAC get interesting; there is an acquisition cost for the supply side which is often overlooked. Supply-side costs are incentives/commissions, such as promotional pricing or bonuses. An easy way to think about this is the incentives Uber gives its drivers to reward high performance:
These are technically contra-revenue line items that are non-cash expenses, but the aggregate incentives can be seen as a “paper-cost” that should be factored into CAC – hence the creation of two-sided CAC.
Fully Baked Two-Sided CAC
It is crucial to evaluate the two-sided CAC of a marketplace because there is often a systemic challenge with supply-side retention. While it is logical to assume that once a business has established itself in a market, there would be the same network effect for the supply-side as there is on the demand-side, that is often not the case. We have observed that maintaining supply density is an ongoing challenge for tech-enabled businesses.
If we bring back the Uber example, at time of its IPO in 2020, its retention rate was <20% after 30 days:
Uber (and Lyft) had driver incentive programs that offered a guaranteed cash bonus to drivers if they hit a ride quota in their first 30 days; this created an organic attrition point because it was an easy cash grab for gig-economy workers who gamified the system by signing up for one platform, receiving the incentive, then doing the same on the other. The result was high turnover as drivers subsequently fled, searching for higher income potential elsewhere. Uber then had to onboard a new driver, with the same 30-day incentive, establishing an ongoing rinse-and-repeat cycle. At first glance, supply-side CAC can appear a one-time event, but should be accounted for as a recurring expense that creates a drag on margins. Further, if there is a high attrition rate on the supply side of a marketplace, the market needs to have a sufficient theoretical supplier base to serve as a top-of-the-funnel for the business – you can only churn through so many new drivers that try out Uber until you run out of new drivers to onboard.
Rapid Fire Food for Thought on Tech-Enabled Marketplaces
Below is a rapid fire of lessons Inovia has learned over the years when analyzing tech-enabled businesses:
Deliberate Rollout Strategy
Establishing supply side density is paramount to achieve marketplace liquidity. This may require patience with a new market entry because not every market dynamic will be the same. Though blitzing several new markets at once can get you the illustrious hockey stick growth, it is best to be patient with each geographic rollout and ensure the flywheel effects can establish themselves on both the supply and demand sides of the equation.
It is imperative for a business to demonstrate high retention and utilization of the supply-side for a tech-enabled service to avoid margin erosion from paying out recurring incentives.This can be achieved by reducing latent, underutilized supply. Uber achieved this with UberEats, giving drivers the opportunity to be productive during downtimes in ridership. For more on marketplace lessons, see our blog on Marketplace Lessons from a Seat on the Uber Rocketship.
Gross Merchandise Value (GMV)
GMV is the amount a customer is spending on a marketplace – it is the equivalent of gross revenue. GMV growth is a positive signal to evaluate the health of a business from a topline perspective. However, the nuance for GMV lies in the structure of a marketplace, where it’s important to differentiate between a merchant of record vs. a broker model to determine if GMV or net revenue is a better indicator of topline growth:
- Merchant of Record: The definition for a merchant of record can be confusing – we think about it as the merchant who is selling their goods and services. This gives the merchant of record more pricing control, with the trade-off of inventory risk. Under this scenario, the merchant of record’s GMV represents their gross revenue, which makes the topline growth picture simple.
- Broker Model: We consider a broker model to be a branded marketplace that serves as an intermediary in a transaction between buyer and seller (eg. Airbnb). The broker is playing matchmaker between the buy-side and supply-side of a transaction and taking a fee for their services. This is a lower-touch model, which derisks revenue. For brokers, GMV growth is important to see how total spend is changing, but they are typically taking a small percentage per transaction (take rate), which is their primary pricing lever. A more telling measure of broker model topline growth is net revenue.
Net Revenue Run Rate (ie. Not ARR)
Net revenue is the total spend on a marketplace (or gross merchandise value [GMV]), multiplied by a take rate. A take rate is the take-home percentage for a business. Imagine you pay $10 for an Uber and there is a 20% take rate; Uber’s net revenue on the transaction is $2 and the driver takes home the rest.
We often see people conflating net revenue run rates and ARR when looking at marketplace businesses. Marketplaces are transactional by nature and net revenue is the appropriate topline revenue measure. For marketplaces, there is seldom a contractual software subscription that locks-in recurring revenue, therefore, it is not ‘ARR’. Rather, you are evaluating an annualized net revenue figure, which is inherently more risky because it is subject to transaction volume fluctuation and it does not have the same reliable subscription structure as ARR.
Conversion vs. Retention
Another driver of topline growth is revenue retention and repeat purchases from existing customers. It’s important to contextualize high intent (ie. user purchase conversion) and high engagement (ie. user repeat rate) marketplace purchases. Ideally, you want both high intent and engagement, but if it’s not possible, here are the key drivers to measure sustainable topline growth:
- High Intent Purchases: Think about real estate marketplaces: there is a lower repeat purchase rate, but larger ticket prices and high intent to purchase once you start using a real estate broker (rather than browsing vacation plans on Airbnb). For these types of businesses, focus on i) user conversion to purchase, and ii) positive contribution profit on a per-transaction basis, where:
Contribution Profit = (GMV x Take Rate) – Fully-Baked CAC
- High Engagement Purchases: Think about hospitality marketplaces (ie. Airbnb): there is a lower user-to-purchase conversion (because people love browsing!), smaller ticket sizes, but much higher repeat purchase rates. For high engagement businesses, looking at customer lifetime value (LTV) LTV/CAC is a better metric because it factors in retention and repeat purchases, which may occur over a longer time period.
Measuring Unit Economic Profitability via Contribution Margin
Contribution margin is often highlighted to show profitable unit economics and an attractive break-even point, which can be a red herring if you’re not careful. The problem is the lack of a standardized contribution margin definition for tech-enabled service models because companies take different approaches to what is considered cost of goods sold (COGS) vs. what is OPEX. There can be labor expenses that get tucked into OPEX that should be considered cost of goods sold (COGS), which should be pulled into the contribution margin calculation to avoid window dressing. Any labor expense that is tied directly to a sale is therefore cost of revenue and should be reflected in the take rate. Looking at contribution margin with a properly adjusted take rate is a good way to analyze the unit economic profitability of a tech-enabled marketplace, but it should be taken with a grain of salt because it doesn’t reflect operating profit.
When In Doubt, Look at (Unadjusted) EBITDA & FCF for At-Scale Businesses
The fundamental question we ask ourselves is “can this business generate free cash flow and be profitable in the long-run?”, particularly for more mature businesses. If there’s one thing we learned from looking at Opendoor and Uber, it’s that contribution profit and adjusted EBITDA are accounting tricks that window dress a company’s ability to reach profitability. Once a company reaches scale and is no longer cash burning for growth, the priority is shareholder returns. This means the company needs positive earnings, inclusive of all bottomline accounting expenses (including stock-based compensation, which is a real expense, even for Opendoor!).
That’s all for Episode 3 of Beyond the Cart! Please see our website to read more about our commerce portfolio companies and more thoughts on the topics.