The most lucrative revenue stream for a modern marketplace is to “own” the entire purchase and payment process and charge a commission from each transaction.
The model works well because you extract a chunk of all the value going through your site. However, the flip side of this is that since you extract so much value, you need to provide a lot of value for your users in the process. If you fail to do that, users will find ways to circumvent your payment system to avoid your fees. This is called marketplace platform leakage (or disintermediation), and it’s a challenge faced by many marketplace founders.
Avoid marketplace leakage by providing value in the transaction
How can you avoid marketplace leakage? Since we’re dealing with two-sided marketplaces, you have two parties in each transaction: the provider (the party providing the product or the service) and the customer (the party receiving the product or the service). You need to consider how to provide value for both of them. The best strategy depends a lot on your particular concept. Is it about high-value or low-value items? Is it about selling products, renting them out, or providing services? Is the marketplace consumer-to-consumer, (C2C), business-to-consumer (B2C) or business-to-business (B2B)?
In this article, we will go through the most common ways to provide value for both parties in the transaction.
The value for individuals offering products: Security
If your providers are individuals, the best way to provide value (and thus prevent marketplace leakage) is to focus on trust and safety. People are hesitant to trust strangers. If I am renting my car or power drill to a stranger, how can I be sure they will not steal it, trash it, or break it? This distrust creates lots of friction in C2C marketplaces. The marketplace itself can reduce friction by acting as a trusted middleman.
If you have a rental marketplace, you can offer insurance. If an item is stolen or broken, you cover it—but only if the payment was conducted through your marketplace’s payment system. Peer-to-peer carsharing marketplace RelayRides prides on offering an insurance of up to $1 million, and it covers not only the damage to the car, but also potential claims from third parties for damage or injuries. KitSplit focuses on low-value items (cameras and other creative equipment), so in their case lower coverage of up to $10,000 is enough.
Simply having a formal contract between parties can be enough to offer a sense of security.
If you initially cannot afford to offer insurance or are unable to find an insurance company willing to tailor a suitable package for you, another option is to use a rental deposit. Essentially, the customer pays an upfront deposit that is returned to them if the item is not damaged. This is what I did when I rented a car from the French car-sharing platform Deways. I managed to test the insurance first-hand by accidentally scratching the rental car. Deways took some of my deposit money to pay for the car repair, and the rest was returned to me. The process was smooth, but the upfront deposit felt quite hefty. This can be an issue with deposits: people are wary of transferring large sums of money, while smaller deposits might not cover serious incidents.
Simply having a formal contract between parties can be enough to offer a sense of security. The customer usually needs to accept the terms of a rental marketplace when making a booking. In these terms, the marketplace can lay out what happens in case of fraud or damaged goods. If the customer violates these terms, they can face legal consequences in which the transaction can easily be proven.
If you are selling goods instead of renting them, you do not need to be concerned about items being damaged; you most likely don’t care what happens to the item after receiving your money. However, there are other issues that can cause trouble for sellers, especially if they are shipping items. For instance, the buyer can claim they didn’t receive an item, or that it was broken, and demand a refund. Or they can simply file a dispute with their credit card company and get their money back that way. This can be a big problem for the seller. The marketplace can decide to mitigate this risk by handling all dispute situations to protect sellers. If you do not want to take on the financial risk related to this, you can leave it to your payment provider. PayPal, for instance, offers a comprehensive seller protection program.
Reputation systems are another way of providing security. eBay pioneered the practice of the buyer and the seller leaving each other feedback after a successful transaction. Both parties then have the incentive to behave well, since getting a bad rating might ruin their future transactions. Today, almost every successful marketplace uses a similar system. Furthermore, as this talk by Upwork’s Jessica Tiwari illustrates, there are many tactics marketplaces can use to make feedback systems even more meaningful for marketplaces.
Reputation systems have an additional benefit for providers: it helps them sell more. Many studies have shown that eBay sellers with good reputations are able to charge higher prices than sellers of similar products with inferior ratings or no reviews. Airbnb hosts typically start with a lower price and increase it while building up their reputation. Since a review can usually be given only if the transaction happened through the marketplace’s payment system, they are a great way to provide value in the transaction.
In service marketplaces, online payment in itself may provide security for providers. Uber is a prime example of this. A taxi driver is a likely target for a robbery because they are known to carry a lot of cash. With Uber, the monetary transaction happens online, eliminating the need to carry cash.
The value for professional service providers: Tools
If your service marketplace providers are professionals who make their entire living (or at least a substantial part of it) by providing the said service, you may need to provide value in additional ways. Transactions in these marketplaces—for cleaners, dog sitting, teaching guitar—are typically recurring in nature: after a customer finds a provider they like, they’re likely to use the provider’s services again.
What often happens is that the first transaction goes through the marketplace, but the ensuing ones are handled through other channels. The reasons for this are obvious: the customer and the provider trust one another after the first successful transaction. They do not get additional value from the security provided by the marketplace. They have likely exchanged their contact information, and no longer need to communicate through the platform. Since the provider can offer the customer a cheaper price—one without the marketplace commission—this option becomes quite tempting.
Marketplaces can be relatively successful by focusing on solely capturing the first transaction between customers and providers. However, there are strategies to capture subsequent ones as well.
Help providers run their business by automating mundane tasks.
One such strategy is to become a Software-as-a-Service tool for your providers. Your marketplace is no longer just about acquiring new customers—you also help the providers run their business by automating mundane tasks. Providers won’t want to bypass your marketplace payments if that means loosing invaluable tools.
Freelancer marketplace UpWork (previously oDesk and Elance) is a great example of this approach. From the point of view of a freelancer, getting a new gig requires many tedious tasks. They need to work on a proposal with the client, get their approval, agree on the compensation, invoice the customer, deliver the results, pay their taxes, and handle accounting. UpWork has created a smooth workflow for freelancers, automating all these steps. The freelancer saves a lot of time thanks to this process—enough for it to be worth the commission.
There are many different ways to provide value for the supply side. If your providers need to deliver their services during an exact time (think hairdresser, cleaner, babysitter, or rental provider), you likely want to help them manage their availability with a scheduling feature. If the professionals are shipping goods (like in Etsy), you can help them manage their inventory and handle delivery. By providing good enough tools, you can be an essential part of your provider’s’ business process, and your commission is a small price to pay for that level of service.
The value for customers: Reduce friction
From a customer’s point of view, a marketplace’s most important function is to make the transaction as smooth and easy as possible. There are many different ways to do this: by removing steps from the transaction process, by removing the need to carry cash, and by increasing trust, for example. All of these strategies may prevent marketplace leakage on the customers’ side.
Paying for something is always a hurdle. Studies have shown that if purchasing is easier, people will buy more. People may give up on a transaction simply because paying is too tedious.
Airbnb initially built their payment system after the founder, Brian Chesky, had an awkward experience using the site: he was staying with a host he didn’t know, and forgot to bring enough cash with him. When it came time to pay, he had to ask the host if he could go pick up some cash from an ATM. The trust between him and the host was broken. After Airbnb started offering online payments, the problem disappeared. The guest and the host no longer had to have the money conversation. Uber customers get a similar benefit: there is no need to ask the taxi driver to make an ATM stop.
If the payment is made in advance, the customer takes on the risk that the provider is a no-show or that they do not get the product they ordered. Again, the marketplace can help by becoming a middleman. An “escrow” service is one way to do this: the marketplace captures the payment and notifies the provider about it, but doesn’t move the money to the provider before they have completed the service in question.
The challenge with escrow is that it is quite heavily regulated, and regulation varies by country. Luckily, payment service providers focusing on marketplaces have different ways of navigating the regulation.
If you do not want to offer escrow, you have two alternatives. You can preauthorize the customer’s credit card without charging it, and keep the preauthorization until the money needs to be moved. This is enough in most cases. However, the longer the hold period, the bigger the risk that the money transfer fails when you finally initiate it. This would leave the provider in trouble. WePay describes this approach in more detail.
The other alternative is to offer buyer’s protection for cases where the provided service did not meet their needs or expectations. PayPal has buyers covered as well with their comprehensive buyer protection program.
Building a good reputation is important from a customer’s point of view as well. Airbnb hosts use reviews as a vetting mechanism, and might only accept bookings from people with positive reviews. If the customer wants to build their reputation as a trusted guest, they need to use Airbnb’s booking system.
Communication strategies can discourage platform leakage – but they’re not bullet proof
If you are unable to provide enough value in the transaction process, there are a few strategies that might help combat marketplace leakage. However, none of them are bulletproof, and some of them can do more harm than good. They should thus be used with care. They are best used as a complement to the strategies discussed above.
One approach is to communicate with your users: remind them that commissions are what keep the site running, and if people bypass it, your site will disappear. Alternatively, instead of appealing to the good nature of your users, you can take a more draconian approach and remind users that those who bypass the system will be banned. However, this might not be the best way to build a sense of community.
You could also consider making it harder for people to exchange contact information before a transaction takes place. This approach is currently in use on a few big platforms. Airbnb removes contact details (like email addresses and phone numbers) from private messages between users. It is, however, always possible to circumvent this limitation—by writing a phone number with letters, for instance. Airbnb says they do this to protect their users, but it is quite clear the underlying motive is to prevent users from bypassing their payment system. BlaBlaCar does not allow private messages before transactions at all; instead, all questions need to be asked publicly.
You can, of course, choose to not provide a messaging system at all. But in most cases, this will simply not work since the customer needs to have a conversation with the provider before making a purchase decision. Putting excessive communication barriers in place will create friction on your site, annoy your users, and will likely lead to them abandoning your site.
A stake in your marketplace can prevent bypassing
Your providers are your partners. Your goals and their goals should be aligned: if they win, you win. If you try to extract too much value without providing enough for them, this reciprocal relationship is shattered, and your business will ultimately fail. To be really successful, a marketplace must get to a point where it has a loyal group of providers who feel that the best interest of the marketplace is also in their best interest. Build a such a community of providers, and you won’t have to worry about marketplace leakage.
One (perhaps quite radical) way to achieve this is to offer the providers a stake in your business. The most natural company structure for this is a provider-owned cooperative. What you might lose due to the slowed down decision-making—democracy takes time, after all—can be gained by having providers who are really aligned with your goals, who promote your marketplace to everyone they know, who are more inclined to provide good service to your customers—and who will definitely not bypass your payment system. If you are interested in this option, there is a whole movement, platform cooperativism, that is currently being built around this particular approach.
If you do not want to go down the cooperative route, there are other possible ways to set up your company. You can have a regular limited company and issue small amounts of shares to providers. You could even experiment with new technology. The popular content community site Reddit recently announced plans to share 10% of their recent funding round ($5 million in total) with their users. Their plan is to utilize their own cryptocurrency powered by the blockchain protocol. While this is currently a rather complicated path to take, new innovations are constantly happening in technology, and we will likely see it become a more viable option.
The golden rule of avoiding marketplace leakage: Provide value to get value
If you want to own the purchase process, you need to provide enough value in the transaction—both for the customer and the provider. If your providers are individuals renting or selling products, you should focus on trust and security. If your providers are professionals, consider building tools that help them run their business. Make it as effortless as possible for your customers to make the purchase.
Your providers should be your partners. You can consider playing hardball and imposing communication-related limitations to make users behave well, but this approach can easily backfire since it breaches your relationship that is based on mutual trust. A better approach might be to align your interest with your providers’ by offering them a stake in your business.
In chapter 5, we discuss one essential aspect that affects your users’ likelihood to bypass your platform: your pricing.