Category: marketplaces

competitive advantage, eharmony, marketplaces

Analyzing eHarmony’s Competitive Advantage

Posted on by rogteran

Although Columbia Business School often gets pigeonholed as a finance school, it’s really a top-notch program to learn about strategy. My professors in various subjects – from marketing to tech investing – have pushed my classmates and me to think deeply about competitive advantage. Indeed, this semester I am taking a course called Economics of Strategic Behavior, which provides a focused approach to business strategy and demystifies competitive advantage.

Every business school student is introduced to Michael Porter’s five forces, the most prevalent framework to analyze the structure of an industry. These forces are: 1) barriers to entry, 2) existing industry rivalry, 3) threat of substitutes, 4) bargaining power of suppliers, and 5) bargaining power of buyers.

5-forces

What I like about my “Economics of Strategic Behavior” class is that it builds on Porter’s framework by prioritizing the five forces. My professors opine that barrier to entry is, by far, the most important force when analyzing the competitive dynamics of an industry. Competitive advantage therefore stems from the ability of companies to create moats around their industry in such a way that they deter potential entrants from capturing any value. The outcome is an out-sized return on capital for long periods of time.

Competitive advantage can be derived from unique capabilities or unique positioning. It’s the latter, however, that provides a more durable and sustainable advantage. These positional advantages can be distilled as:

  • Demand advantages in the form of customer captivity and network effects
  • Supply advantages in the form of patents and unique technologies
  • Economies of scale when high fixed costs are spread out to generate low avg. costs
  • Information or regulatory advantages

When an industry incumbent has a pronounced advantage, it’s incredibly difficult for an entrant to gain traction or turn a profit.

eHarmony

During this week’s class, we analyzed eHarmony, the leading online dating site to find Mr. or Mrs. Right. Although the eHarmony case was written in 2008, the company still maintains a leadership position in the relationship-seeking segment, which speaks volumes of its competitive advantage: in fact, about 2% of marriages in the US are due to eHarmony!

As an online marketplace, eHarmony developed a demand advantage that stemmed from targeting, attracting and maintaining a quality pool of singles seeking a serious relationship. One of the toughest things about online marketplaces is that they are devilishly difficult to initialize because of the proverbial chicken-and-egg problem: when there is nobody on the other side of the platform, then there is no real value proposition for an initial user.

To get over this hump, a founder’s credentials, experience and networks can served as the spark of trust essential to seed an online marketplace. As a practicing psychologist, eHarmony’s founder, Dr. Neil Warren, had developed a reputation as an expert after writing several books on the subject of love and marriage, making numerous speeches at conferences, and appearing on national TV and radio programs. By tapping into the psyche of conservative and faith-based communities, eHarmony was able to get over 100,000 quality registrations in just a matter of weeks.

eharmony_founder
Dr. Neil Warren, eHarmony’s founder and relationship expert.

With initial liquidity in the marketplace, eHarmony managed to build several levers that effectively captured customers. Leveraging Dr. Warren’s credibility, eHarmony built a matching algorithm for prospective customers. At the time, no other online dating site provided anything remotely close to effectively match highly compatible people. The algorithm served as a powerful hook to incent users to fill out the 250 question Relationship Questionnaire.

The Relationship Questionnaire was instrumental on two fronts: first, it generated an important filter that weeded out casual daters, thus ensuring the quality of the marketplace by increasing the signal-to-noise ratio; second, the significant upfront investment – in time and effort – to complete the questionnaire lowered the relative cost of the subscription. After users’ personality profiles were fed to the algorithm, users could see but not communicate with their matches – an incredibly effective teaser for non-paying members to purchase a subscription. As a result, eHarmony’s conversion ratio was 3x higher than that of its competitors.

To sustain its customer captivity, eHarmony imposed several measures of control that initially seemed counterintuitive to me. First, eHarmony rejected the membership request of roughly 20% of users who were willing to pay. This additional filter ensured that the quality of paid users was very high, enhancing the value proposition for existing and potential members looking for a serious relationship. Second, unlike other online dating sites, eHarmony deliberately limited the number of matches available to its customers.

Given eHarmony’s target customer, it actually made sense to artificially restrict the set of choices because it reduced the level of competition among users, implicitly increasing their expected payoff. Limiting the number of matches also created an illusion of scarcity. This illusion induced users to pay up since they were not-so-subtly reminded that there were only a couple of fish left in the sea. More powerfully, by controlling and limiting the number of matches, eHarmony mitigated user skewness, the phenomenon in which a few of the “hottest” members command a disproportionate interest and hits throughout the platform. Many dating sites suffer from this, which would often lead to way too many men trying to connect with only a couple of women, consequently producing a poor user experience on both sides. Nearly 60% of eHarmony’s members were women, though, indicating that its user base was well balanced and of high quality.

As eHarmony gained greater control over the serious relationship-seeking customer segment, the company exerted positive network effects. Both sides of the marketplace – men and women – benefited from each additional high quality member of the opposite sex. This virtuous cycle is inherently defensible and difficult to break for competitors looking to gain market share. While eHarmony’s network effects were a function of its high quality and expensive-to-acquire membership base, the network effects also enhanced and reinforced its customer captivity. Accordingly, eHarmony charged a 10% premium relative to Chemistry, its closest competitor.

Strategically, one of the most important decisions eHarmony made was to choose the right niche within the online dating industry. After targeting this niche, eHarmony tailored its product and services in such a way that it efficiently captured the hearts and minds of those souls looking to find “true love.” Online marketplaces are hard to build, but if done right, they can become incredibly successful businesses given their network effects-based competitive advantage.

Latin America, marketplaces, Startups

Launching a Hypothesis-Driven Startup

Posted on by rogteran

There’s nothing like the second year of an MBA program. Although I’m taking a full 15 credit course load, I had a ton of leeway in choosing my schedule and decided to stack all my classes on Mondays and Tuesdays. With a “5-day weekend”, I plan to dedicate quite a bit of time in honing a business idea my Dad and I have been tinkering with.

As a quick recap, I learned to code this summer and for my final project I built a prototype of an online marketplace. It’s by no means a finished product, but it is a product that I can demo to prospective customers. With my 5-day weekend, I decided to fly down to Panama – the initial target market – where I attended a tradeshow. In just a few days, I’ve gained a lot of insight into both the market and the customer.

Panama is a strategically located and business friendly country, making it an ideal market to launch a Latam startup.
Panama is a strategically located and business friendly country, making it an ideal market to launch a Latam startup.

There are a lot of ways to define a startup, but the best definition I’ve found is the one proposed by entrepreneurship guru Steve Blank: “A startup is an organization formed to search for a repeatable and scalable business model.” In essence, a startup is a set of well-formulated – and therefore testable – hypotheses that the entrepreneur must either validate or debunk. With every customer insight, the entrepreneur then tweaks the business model to reflect and ultimately solve the real needs of the market. It’s an iterative process, but constantly adjusting to arrive at product-market fit is how you build a scalable business without investing huge amounts of capital upfront.

During the few days here, I spoke with a lot of people in the “vertical” my Dad and I are targeting. Three interviews with domain experts where incredibly insightful. I had a set of 10 questions that I felt would lead to a lot of insight. Although I never went through all 10, I was able to touch upon key elements that will help refine the marketplace going forward. In particular, I gained deep insight into the following:

Customer discovery: buying and selling in this market is prohibitively expensive and incredibly inefficient. I now have estimates of how much it costs to the prospective seller using the current solutions, and even how much it costs – in time and money – when a sale is unsuccessful.

The customer development cycle espoused by Steve Blank.
The customer development cycle espoused by Steve Blank.

Market size and market dynamic: talking with several experts, I was able to triangulate an estimate of how many potential customers exist and what the total gross merchandise value of the marketplace could be. I also learned much more about what drives sales cycle and sales channels in this industry. Most importantly, even though this is a relatively small market, I believe there are enough players to create initial liquidity in the marketplace.

Competitive landscape: I was able to piece together a pretty comprehensive map of online players and their limited solutions, as well as more traditional brokers and dealers. There are a lot of relatively small players, which leads me to believe that the supply side of the market is very fragmented. A verticalized marketplace could very well add a lot of value, not just by reducing search costs but also my reducing transaction costs.

I also learned that a key challenge of building this business in Panama will be changing the mindset of potential customers that transacting online is a viable and much better option than existing solutions. Nonetheless, the heat and vibrancy throughout Panama was intoxicating, and I am convinced that this is an optimal market to launch a Latin American startup.

marketplaces, Rails, Ruby

Building an Online Marketplace MVP

Posted on by rogteran

I’ve officially “graduated” from General Assembly‘s web development immersive. What an incredible journey it’s been – from learning the basics of a loop to building full-blown web applications.

For my final project I decided to work on a business idea my Dad and I have been thinking about for the better part of this year. The company is an online marketplace. I won’t go into more details at the moment since we are still in “stealth” mode, but over the next year at Columbia, I plan to dedicate a substantial amount of time building out the business.

marketplace

Needless to say, I’m stoked that I’ve been able to build a “minimum viable product” (MVP) for the business – in other words, I have a prototype of the marketplace which I can use to validate whether it’s something potential users would consider paying for. I coded non-stop for about 2 weeks to get the application running. And while it’s a fairly basic platform, much of the core functionality is there. Education aside, I’ve spent less than $100 to get this up and running.

I built this application using a very “English-like” programming language called Ruby and a popular app-building framework called Rails. As a programming noob, Ruby on Rails is pretty remarkable since you’ll have the basics of an application up in a matter of minutes. This allowed me to focus more on the unique aspects of my application instead of the basic plumbing. Rails is fairly opinionated and stresses “convention over configuration”, but if you stick the to Rails Way of doing things, building an application becomes a lot less daunting.

ruby_rails
Ruby on Rails makes building web apps much easier – and much more fun.

As I built the application, I faced three big challenges:

1) Database manipulation: I built the application using a relational database called PostgreSQL. Personally, I struggled to figure out how to link my users to listed items and any possible orders. This was further complicated by the two-sided nature of a marketplace. Users could be categorized as either “sellers” or “buyers”, and their orders broken down into “sales” or “purchases”. Conceptually, this is not difficult to grasp; correctly connecting the associations, however, was tough to get right.

2) Payments: These days, getting payment processing on your application is fairly straight-forward thanks to application programming interfaces (APIs) such as PayPal or Stripe. APIs sound fancy, but they are nothing more than instructions for applications to talk to each other. In my case, rather than build out a payment processing platform from scratch, I incorporated a couple lines of code from Stripe, and voila – I can now process transactions! Although incorporating APIs is much easier – and arguably more secure – than building something as complex as a payment platform, placing the code in the right place and grabbing the right objects resulted trickier than what I initially anticipated.

Stripe allows users of my platform to make purchases. Their sensitive information never touches my database.
Stripe allows users of my platform to make purchases. Customers’ sensitive information never touches my database.

3) Design: For this application, I incorporated a styling framework called Bootstrap. The framework injects some basic styling into the application, but what I particularly like about Bootstrap is that it takes a lot less work to get the app to be “mobile-responsive”. That said, re-formatting the entire application to make it look professional is very time-consuming and tedious. I wanted my application to look simple and professional, which is easier said than done when you don’t have a design background.

I love the fact that I’ve been able to build something (actually, several things) this summer. Skipping a summer internship and learning to code instead has been one of the best decisions I’ve ever made. Programming has pushed me to my intellectual limits and humbled me so much. Programming has also taught me to think about things from very different angles, and challenged me to leverage my teammates in unexpected ways. Most powerfully, programming has opened my mind and afforded me the confidence to tackle difficult problems by using software in productive and creative ways. As I get ready to go back to b-school, I look forward to present the marketplace to potential customers, further flesh out the MVP, and eventually build a real technology business in Latin America.

Airbnb, marketplaces

Assessing Airbnb’s Billion Dollar Round

Posted on by rogteran

Airbnb is the premier online marketplace for short-term rentals. The Wall Street Journal reported that the company is raising a $1B round on a $24B valuation – approximately 26x this year’s projected revenue. That would make Airbnb more valuable than Marriott International, which is valued at ~$21B. How can we make sense of this seemingly crazy valuation?

Here’s how I think about it:

Timing: Smartphone penetration and social media growth have enabled consumers to grant each other temporary access to their under-utilized physical assets by removing key friction points to asset owners and potential users. In other words, these key Internet trends have unleashed the “sharing economy.”

Market Size: Airbnb is competing in a massive market. Nobody knows exactly how big this market is. Beyond vacation rentals (an $85B market), Airbnb has enabled people living in cities to rent out spare rooms or entire apartments, creating a market that didn’t even exist seven years ago. Going forward, Airbnb will eat into parts of the hotel industry as well as other low-utilization-to-asset-value sectors. I estimate Airbnb’s total addressable market to be between $500B-$600B. It’s incredible to think that not-too-long ago Airbnb’s founders thought the total market was under $20B.

Business Model: I love online marketplaces because the economics are amazing. Marketplaces often command +60% gross margins and +20% operating margins. Moreover, as an online marketplace, Airbnb is asset-light and does not hold any spare-room inventory. Unlike hotels such as Marriott or Hilton, Airbnb is unconstrained by real estate and can add thousands of rooms in a matter of weeks rather than months or years. Airbnb’s +1M listings are more than Marriott’s 700K rooms. On a per room basis, the valuation starts to look more reasonable.

Competitive Advantage: Airbnb has created a very defensible company by building a global – and somewhat fanatical – community through its trusted service. Online verification techniques, a $1M host guarantee, and a secure payment platform have all helped build trust throughout its customer base. Airbnb also creates a continuous stamp of approval since each additional review is another valuable datapoint that fosters further trust among members. This, in turn, generates powerful “network effects.” What’s particularly unique about Airbnb’s network effects is that supply and demand are often one and the same, creating overlapping network effects. Guests are often hosts, and vice versa. From a competitor standpoint, this dynamic is incredibly difficult to break and even more difficult to replicate.

Team: Lastly, Airbnb’s founding team is just so tenacious and creative. This may be less important when we are talking about billion-dollar companies than those at the seed or Series A level, but it inspires confidence going forward (they still have much to execute). This blog by Fred Wilson about Airbnb’s founders designing cereal boxes and then selling them to keep their business afloat back in 2008 sums up their abilities quite nicely.

I put together a short investment recommendation on Airbnb last month. The deck highlights and expounds upon some of the points I’ve mentioned above. I definitely think Airbnb is a phenomenal company, and if it maintains its growth trajectory, it could very well be worth ~$24B – in fact, $24B is what I thought Airbnb was worth in my upside scenario. But that doesn’t mean I’d invest in Airbnb this late in the game. Separating a great company from a great investment is arguably one of the most valuable lessons I’ve learned at Columbia so far.

In case you’re interested, I’ve shared the deck below. Please note the context has slightly changed over the last few months, but I think the main takeaways still stand.

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