NETWORK EFFECTS AREN’T ENOUGH

In the past 10 years, the number of marketplaces worth more than $1 billion has gone from two — Craigslist and eBay — to more than a dozen in the United States. And that figure is expected to double by 2020, according to Greylock Partners, a Silicon Valley venture capital firm where one of us (Rotham) is a partner.

Yet online marketplaces remain difficult to build. Most entrepreneurs see it as a chicken-and-egg problem: To attain a critical mass of buyers, you need a critical mass of suppliers — but to attract suppliers, you need buyers. However, even after a marketplace has attracted enough buyers and sellers, it’s far from smooth sailing. Our experience with marketplace businesses suggests that other pitfalls can derail marketplaces: growing too fast too early; fostering insufficient trust and safety; using sticks rather than carrots to deter disintermediation; and regulatory risk. Here we discuss how to avoid those hazards.

GROWTH

Once marketplaces reach a critical inflection point, network effects kick in and growth follows an exponential trajectory. These network effects also create barriers to entry: Once many buyers and sellers are using a marketplace, it becomes harder for a rival to lure them away. As a result, entrepreneurs often assume that they need to reach the exponential growth phase as quickly as possible. But this is often unnecessary and can even backfire, for several reasons:

— The importance of first-mover advantage for marketplaces is overstated. Instead, entrepreneurs should focus on being the first to enable mutually beneficial transactions between suppliers and buyers in their segment. Once buyers have access to a sufficient selection of products or services at attractive prices and sellers earn attractive profits, neither side has an incentive to go elsewhere, and strong network effects kick in: More buyers bring more sellers and vice versa.

— Growing too early puts stress on the business model. Because growth for marketplaces can be explosive, it puts more pressure on the business model than linear growth does, amplifying the impact of flaws and making them harder to fix. Indeed, trying to change the model while growing very fast increases the risk of a breakdown. For these reasons, marketplace entrepreneurs should resist accelerating growth before figuring out an optimal supply-demand fit.

— The wrong type of growth can hurt performance. Many marketplaces are tempted to grow through “power sellers” — those who have moved from selling as a hobby to running a full-time business on the marketplace. However, growth through power sellers can be undesirable. For example, after building most of its early growth on power sellers, eBay discovered that their dominance forced the company to make compromises that hurt buyers.

TRUST AND SAFETY

An online marketplace does not directly control the quality of the products or services on its platform, so it must have mechanisms to ensure that participants do not worry about conducting business on the site. Ratings-and-reviews systems are the most widely used method of engendering trust. However, research shows that these systems rarely build sufficient trust or provide adequate safety on their own. Marketplaces must go beyond these systems and accept some responsibility for transactions. This can take several forms, including providing insurance, vetting and certifying participants, and offering dispute resolution and payment security services.

DISINTERMEDIATION

Many marketplaces fear that once they facilitate a successful transaction, the buyer and the seller will conduct their subsequent interactions outside the marketplace. The instinct is often to impose penalties if attempts to take transactions off a platform are detected. But we have yet to see a promising marketplace that has been severely  hindered by this behavior, and we’ve found that carrots are more effective deterrents than sticks. Participants usually prefer to conduct business in a “well-lit showroom” that reduces search or transaction costs and allows deals to be conducted securely.

REGULATION

Online marketplaces that provide new alternatives to conventional business models test the limits of regulatory frameworks. Because they enable new types of transactions, they face serious regulatory challenges more frequently than traditional product or service companies do.

In response to regulatory risks, most entrepreneurs have one of two reflexes: Ignore them or try to fix everything up front. The right approach is in the middle: Strive to engage regulators without breaking stride. It’s impossible to deal with all regulatory challenges perfectly, but four guiding principles — developed by David Hantman, Airbnb’s former head of global public policy — can help:

— Define yourself before your opposition or the media does. Marketplace entrepreneurs should develop a vision of their business model and find the most positive way to describe it. Then they should engage regulators and the media in order to be understood on their terms.

— Pick when to engage with regulators. Entrepreneurs in industries subject to heavy national regulation should consult an attorney to understand all relevant laws. As soon as their buyer-seller proposition is clear, they should initiate a dialogue with regulators to obtain either legal clearance or an implicit safe haven to continue developing the service. Marketplaces operating in spaces that are regulated lightly and only at the city or state level can wait until they reach supply-demand fit in their first city before engaging with regulators. Local regulators are typically less powerful and can be more easily circumvented.

— Don’t just say no; offer constructive ideas. When confronted with regulatory gray areas, marketplace entrepreneurs can turn a potentially adversarial relationship into a partnership. They should strive to find an area where the authorities’ interests align with theirs.

— Speak softly and carry a big stick. Entrepreneurs should avoid regulatory disputes; at the same time, they should have weapons to defend their position. They can use two means of leverage. The first is the power of satisfied buyers and sellers, who are voters and taxpayers likely to resent government interference. The second lever is tax revenue. Marketplaces that generate sizable revenues for local governments have some sway.

The growing number of products and services available through online marketplaces will cause traditional corporate structures to shrink and coexist with networks of independent workers. The result will be a more flexible work environment that empowers both workers and customers. But the challenges of managing growth, building trust, minimizing disintermediation and shaping regulation won’t go away. The solution is to understand the needs of customers, regulators and society, and become an active player in shaping the future.

(Andrei Hagiu is an associate professor in the strategy group at Harvard Business School. Simon Rothman is a partner at Greylock Partners and the former head of operations at eBay.)