Unit economics in new marketplaces: Why we don’t “nail it then scale it”
When taking a new product to market, a common saying is “nail it then scale it”… but when the product being launched is a marketplace: it’s a little more complicated than that.
In this post, we’ll take a look at the unit economics of igniting a new marketplace and how — since these unit economics evolve over time with scale and network effects — what we do in the early days may on the surface appear a little crazy!
Let’s start by defining the term unit economics. Unit economics refers to the equation that determines the profit (or loss) we make on an individual per customer basis.
Unit Economics:
LTV — CAC = Profit or Loss
Where:
LTV = Lifetime Value (amount of revenue we earn per customer in a period of time)
CAC = Customer Acquisition Cost (amount we spend to acquire a new customer)
Profit or Loss = amount we make if LTV > CAC (or lose if LTV < CAC)
Now the saying “first nail it then scale it” in marketing terms means first getting our unit economics positive (ie. make a profit) on a single customer before then scaling those unit economics to more customers. And for most products, this concept makes total sense — why would we do more of something until we know it makes sense on a per unit basis?
For marketplaces, the answer lies in the value of network effects that develop as more customers are acquired…
Unit economics for traditional (non-marketplace) products
For most non-marketplace products: the value of the product is a constant* so the CAC and LTV remain the same as the total number of customers acquired grows. Because of this, it makes sense to first focus on “nailing it” — ie. figuring out how to get product-market-channel fit and achieve positive unit economics for a single customer. Then, once positive unit economics are achieved, it makes sense to shift focus towards “scaling it” — that is, investing more capital into acquiring a higher volume of customers.
*Of course, in practice CAC and LTV do change over time as the quality of a product improves (or declines) or as the effectiveness of marketing increases (or decreases) — but the observation here is that the CAC and LTV don’t change as a direct result of the number of customers acquired.
Unit economics for marketplaces
For marketplaces: as the total number of customers acquired grows, the value of the product for each individual customer increases (due to network effects). This results in the CAC and LTV for each individual customer changing as more customers are acquired.
Why does this phenomenon occur? Remember:
A Marketplace = Software + Liquidity
Liquidity = lots of active buyers, lots of active sellers, lots of service offerings
So in the early stages of building a new marketplace before we’ve acquired any customers: the value of the product is only software (since by definition the marketplace has no liquidity).
Then, as the marketplace acquires more customers and starts to generate liquidity (and eventually network effects) the value of the product increases:
Generally, the more value a product provides to customers, the less we need to spend on marketing to acquire each customer — which results in CAC decreasing over time:
And the more value the product provides, the more that each Customer wants to spend — which results in LTV increasing over time:
Overlaying these two functions, we can see that unit economics evolve and generally improve as the marketplace acquires more customers:
We can also see that there is a period of time in which marketplace unit economics will be negative until it reaches sustainability — the point at which the marketplace moves from making a loss to making a profit on each customer:
It’s also worth noting that even from the point of sustainability onwards, marketplace unit economics will continue to improve — resulting in increasing profits on a per customer basis. Yay!
On a separate note: as the total number of customers acquired grows, a marketplace also becomes more defensible which even further compounds positive effects on unit economics — but more on that in a later post…
What does this mean for igniting new marketplaces?
In the early stages of building new markets: we will almost certainly need to invest into acquiring customers on a negative unit economic (loss making) basis which may feel a little unintuitive or uncomfortable at times. But since we logically know that we must invest upfront to build liquidity — the question becomes: what is the right amount of capital to allocate to acquiring customers on a loss-making basis?
In traditional product companies, the amount of capital allocated to acquiring customers is driven by individual unit economics. The framework for capital allocation is simple: “each customer must demonstrate positive unit economics” then “acquire as many customers as possible”. In other words “nail it then scale it”.
But in the early stages of new marketplaces, we need to allocate capital to acquiring individual customers on a negative unit economic basis with the goal of creating a collective network effect that will eventually allow us to acquire customers on a positive unit economic basis.
This makes deciding how much money we pour into acquiring customers in new markets a little more complex. Here are the main things I believe we need to consider:
- Overall affordability. We allocate a fixed amount of capital that we can afford to dedicate to acquiring customers across all new markets for a fixed period of time.
- Concentration. We balance providing enough capital to each new market to give it a strong chance of success — whilst having as many new markets as possible growing simultaneously.
- Absolute velocity. We acquire as many customers as we can as quickly as possible so that we can achieve liquidity, network effects and sustainability as soon as possible — whilst keeping our marketing efficient and not putting all of our eggs in one basket.
As you can see, with each of these considerations there are a significant number of balancing acts required to make good capital allocation decisions over time and there are simply no right answers.
This is why building new marketplaces is so hard (and so exciting) — we literally need to “nail it while we’re scaling it” :)
