Part 1: Understanding the Platform Businesses
In the digital age, the concept of multi-sided platforms has revolutionized the business landscape. From tech giants like Apple and Google to emerging players like Ola and Swiggy, the power of network effects has reshaped how companies operate and thrive in today’s interconnected world. At the heart of these transformations lies a fundamental principle: matchmakers.
In this series of blog posts, Discovering the Power of Platform Businesses, we delve into the stages of platform evolution, demystifying the journey from inception to super-normal profitability. We look into the framework that helps us identify good platforms and our thesis on digital platforms.
For part 1 of this series, we start with tackling the daunting cold-start problem to monetization strategies that drive profitability, each stage presents its own set of hurdles and opportunities.
Introduction
Many of the world’s largest companies, including Apple, Meta, Google, Microsoft, Tencent, Alibaba, Visa, and Mastercard, operate as matchmakers. Matchmakers are companies built on the concept of network effects. Essentially, the theory behind network effects suggests that platforms and products with network effects improve as they grow larger — not only in value to users but also in accruing more resources to enhance their product, thus strengthening the “flywheel”. A multisided platform is one of the most challenging business models to master. Entrepreneurs must solve a complex puzzle and employ counterintuitive strategies to succeed. We have witnessed significant wealth creation based on this simple yet challenging-to-implement concept in the USA.
Stages of Platform Evolution Simplified
Let’s start with the fundamentals. In simple terms, networks are platforms that connect mutually dependent groups of participants in a way that benefits all parties involved. To comprehend the emergence of such models, at Valcreate, we’ve simplified the evolution of a platform business into four easy-to-understand stages:
- Stage 1 – Network creation: At this stage, the company focuses on solving the cold-start problem (or the chicken and egg problem)
- Stage 2- Focus on Driving Consumer Behaviour and Establishing Dominance: With a strong product-market fit, companies now focus on lifting the network to a critical level while shaping user behaviour on the network
- Stage 3 – Monetisation Stage: Companies pull levers of monetisation to drive profitability
- Stage 4 – Super-normal Profits and Value Creation: Dominance and entry barriers along with low marginal cost of incremental revenue add up to super-normal profitability over time.
Now, let’s dive a bit into each of these
Stage 1 – Network Creation
Multi-sided platforms require critical mass across different participant categories. However, consumers resist joining if there aren’t enough providers, and providers resist joining if there aren’t enough consumers, making it a chicken-and-egg problem. For example, let’s consider Ola cabs. Taxi drivers won’t join the app/network unless there is sufficient demand. Similarly, riders won’t join the app/network if they can’t find ride options. Who do you onboard first, and how?
Unlike traditional “vertical” manufacturing companies, which can procure raw materials first (supply-side), manufacture, and then find customers to sell (demand-side), internet companies’ raw materials are the different groups of customers that they bring together, not anything they purchase. They need to match supply and demand instantly for transactions to occur on the platform. This cold-start problem is typically, though not always, solved by aggressive spending to attract the required mass of stakeholders on both sides of the platform. This is achieved by making network usage extremely cost-effective (zero initial fees, significant discounts, subsidies, or salary-type payments, etc.), typically funded by significant initial losses.
Internationally, companies like Meta, YouTube, and Google prioritize achieving critical mass initially to ensure that the network enters a virtuous cycle. Indian platforms, if you recall, have employed a similar strategy. Uber and Ola rides were heavily discounted and used to be cheaper than regular auto/cab rides. Swiggy and Zomato, along with early entrants in food delivery, had no delivery charges, and orders were heavily subsidized through offers. Payment apps such as Paytm, PhonePe, and GooglePay (Tez) offered aggressive cashback incentives on wallet/UPI usage. All of this is aimed at attracting different parties to the network and scaling it to critical mass.
Stage 2 – Focus on Driving Consumer Behaviour and Establishing Dominance
Network companies tend to continue investing in ensuring customer loyalty on their platform, reaching a point where reverting to traditional interactions or switching to a new platform (without critical mass on both sides) becomes increasingly unlikely – a significant entry barrier for new players. For instance, booking a ride through Ola or Uber is simpler than negotiating with an auto driver. Ordering food from a delivery platform is more convenient than contacting a restaurant and waiting for their limited delivery fleet (in many cases, only a handful have a fleet) to bring the food to your home.
The intriguing aspect of network effects is that only a few of them can yield substantial value due to the inherent reliance on participant interaction. Consequently, the dominance of a few players emerges, making funding for new entrants targeting the same use case scarce.
From a financial standpoint, as customer loyalty and behaviour become established – which can be tracked by the frequency of use cases and order value on the platform – the initially subsidized discounts for these users begin to diminish. In other words, the availability of discount coupons and cashback decreases, as companies now understand that their customers’ behavior is highly unlikely to change.
Stage 3 – Monetisation Stage
Until this stage, companies make significant upfront investments to drive growth and achieve scale. In many cases, these substantial investments are allocated to handle a network magnitude multiple times its current scale. The platform naturally attracts new customers and producers, thereby reducing customer acquisition costs. Additionally, the initial cost of entering new territories and segments experiences a dramatic reduction.
The company then shifts focus towards reducing losses and becoming profitable, leveraging the valuable network it has built. Various forms of platform fees are introduced, and with no superior alternative, customers and producers are willing to pay for the service. With most costs now accounted for, except for those related to incentivizing new customers, which are typically low, operating leverage begins to take effect. Platforms that focus on the scale in the initial years to kick-start the virtuous network effects are more likely to have spent enough resources for a larger scale. The upfront cost of employees for tech development and server capacity are all built for scale. Therefore, the incremental revenue driver higher operating leverage.
We have witnessed this scenario unfold with companies like Meta, YouTube, and Google through ad monetization. Indian companies have also followed a similar trajectory. Ola and Uber, for example, have started charging higher prices, even at a premium compared to other alternatives. Food delivery companies have begun implementing delivery fees, and payment companies such as PhonePe and Paytm have introduced various forms of monetization.
Stage 4 – Super-normal Profits and Value Creation
Given that internet/platform companies are primarily composed of intangible assets, the marginal cost of serving incremental transactions on the platform is minimal. This results in improved profitability. Once dominance is established, the virtuous cycle continues to reinforce moats and enhancements in business economics.
While this scenario has yet to fully materialize in most Indian companies, we have observed it in the United States. Amazon, Google, Meta, Apple, and Microsoft have all achieved super-normal profitability (in terms of high ROCEs) with robust entry barriers over the past decade.
We anticipate that a few dominant Indian platforms will similarly emerge in the coming decade.
Lastly, a few points about network effects. Network effects alone do not guarantee a company’s success or the existence of a moat. Additionally, network effects or multi-sided platforms are not exclusive to internet-based companies. Shopping malls and nightclubs also demonstrate similar characteristics. Network effects become exceedingly valuable at scale, and companies must continue to innovate and solve new problems. Otherwise, they may face a fate similar to Facebook disrupting Myspace, Friendster, and Orkut.
Moreover, they must address a large, valuable market for dollar profitability and capturing added value. Otherwise, they risk weak business economics. While not directly comparable, Wikipedia serves as an example to illustrate this point.
In summary, the evolution of multi-sided platforms presents a fascinating journey through the stages of network creation, consumer behaviour shaping, monetization, and ultimately, super-normal profits and value creation. From tackling the chicken-and-egg problem to establishing dominance and implementing monetization strategies, the path to success for platform businesses is multifaceted and challenging.
As part of this series of blog posts, Discovering the Power of Platform Businesses, we continue to explore the intricacies of multi-sided platforms and uncover the untapped potential of digital disruption. In the upcoming blog, we will discuss how this phenomenon played out in the US.
Note: The examples/companies mentioned above are purely for informational purposes. Please note, they are not to be deemed as investment advice/recommendation.
Further Resources to Understand Digital Platforms
Modern Monopolies: What It Takes to Dominate the 21st Century Economy (Book) – Link
The Matchmakers: The New Economics of Multisided Platforms (Book) – Link
How the Internet Happened: From Netscape to the iPhone (Book) – Link
Acquired (Podcast) – Link
Aggregation Theory (Blog) – Link
Why Software is Eating the World (Blog) – Link