Can You Build A Two-Sided Marketplace by Selling Below Cost?

Over the past few months, we have heard some reputed venture capitalists like Mike Moritz (Sequoia Capital) and Bill Gurley (Benchmark) warn us about frothiness in the tech sector. As Fred Wilson captures in this blogpost, this is primarily stemming from concerns over negative gross margins. While the tech bubble in the late 90s was fueled by companies without a revenue model, there is worry that today’s companies are creating a different bubble by showing growth by selling products or services below cost. While these are private companies and their gross margins aren’t known, media reports and conversations with suppliers (drivers, delivery people) indicate that companies like Instacart, Doordash, Handy, Homejoy, Uber, Lyft and Postmates have adopted this across the board or in some markets. So, the main question for online marketplaces today is whether you can sell below cost to create adoption and build liquidity in the marketplace?

To answer this question, let us first understand why companies might resort to selling below cost since that goes against business basics.

1) Large market- markets like transportations, groceries, food delivery, cleaning services are worth tens of billions of dollars. There is obviously investor interest in these sectors. Companies are looking to build a foothold and gain market share here before anyone else.

2) Building liquidity in a two sided marketplace is hard- building demand and supply in balance can be a slow organic process. The easiest way to do this is to make it attractive financially for both the supplier and customer to use it. So, for an Uber, this would imply paying drivers more than the actual trips they do and subsidizing consumers below the actual cost of the ride. Here is an article which talks about Uber adopting this strategy in India.


3) Lack of differentiation pushing companies to grab share- the biggest barrier to entry in many two sided marketplaces is liquidity. By pricing below cost, companies attract greater demand and hence a greater share of the market. This helps them show faster growth.

4) Vicious cycle of fundraising- showing faster growth by subsidizing consumers/suppliers helps these companies raise capital. To sustain investor’s expectation growth, they are forced to resort to more subsidization.

Now that we have given some rationale for selling below cost, let us look at some conditions under which this can be successful. This is obviously not going to work across all two-sided marketplaces.

1) Network effects- subsidizing the market can help grow the market but comes at the risk of a competitor raising more capital. For this strategy to work, it clearly indicates a need for the early entrant or leader following this strategy to believe that there are strong network effects. It is widely believed that India’s e-commerce market leader Flipkart had followed the subsidization strategy. Once Amazon entered the market, the lack of strong network effects has helped them to catch up. As this article indicates they are neck to neck in traffic though they entered the market 5–6 years after Flipkart.

2) Preventing disintermediation- subsidizing consumers for growth implicitly assumes consumer loyalty. Only if there are enough repeat purchases would the LTV/CAC (life time value of customer divided by customer acquisition cost) be greater than one. Preventing disintermediation requires randomness and unpredictability. In Uber’s case, given every trip has a different source and destination and the availability of drivers around is variant, it adds this degree of uncertainty. In the cleaning services space, this does not seem to be the case. As this article on Homejoy’s failure explains, once a user found a cleaner they liked, they disintermediated Homejoy .

3) Winner take all market- the first two points are prerequisites for a winner take all market. If the market is large and is likely winner take all, it could work out. Paypal followed this strategy of offering their service below cost (the famous $10 sign in bonus strategy) but were able to manage it because peer to peer payments is a sticky product where the winner takes most or all value. Unless it is a winner take all market, the company will either be stuck with prices below cost (perennial clearance sale) or risk losing customers to a competitor or due to a lower demand at higher prices.

4) Ability to raise capital in the interim- selling below cost puts companies in a weird situation where they burn more cash as they grow. This requires a patient investor who can write large checks and support the company over the long term. The graph below shows an illustrative example of how selling below cost can change the cash burn situation and the cash required to build a business. While the value of the prize maybe large, the cost of the capital to support the higher cash burn has to be lower the expected return on investment. We have seen more businesses sell below cost in the last 5 years since capital availability has been cheap. This drastically changes how much you can subsidize the consumer/supplier.

With many unicorns today not satisfying some of these prerequisites for selling below cost and with the Fed looking to raise rates, the alarm from notable VCs seems aptly timed or it might already be too late. As Mike Moritz said in his interview to Bloomberg, “Gravity hasn’t been repealed”. Not yet at least.


Featured on www.managermint.com The Most Valuable Business Resource

About Manager Mint: Our Mission is simple: To become the most valuable business resource by allocating and providing the best tools, resources, and recommendations to help you manage your business. Our Business is to help you build yours, whether your starting at zero, or looking to reach new customers, overcome challenges or maximize successes, we are here to guide you and your organization from where you are to where you want to be.



Gain Access To Over 1,000 Royalty Free Images For Under $1/mo!
Monthly Subscription