The chicken-and-egg problem of marketplaces

Network effects are a double-edged sword. On the one hand, they are the key source of exponential growth and defensibility for marketplaces. On the other hand, this only happens after the marketplace has attracted a critical mass of users on each side – and attracting those initial users is much harder than for regular businesses. Indeed, the whole value proposition for buyers is that the marketplace allows them to discover sellers, and vice-versa for sellers. Without sellers, buyers have no reason to join, and without buyers, sellers have no reason to join either. Therein lies the chicken-and-egg (or cold-start) problem.

The chicken-and-egg problem is often the toughest hurdle for founders of marketplaces and other network effects businesses to overcome. Indeed, most marketplaces never get past this stage. But the problem is not insurmountable: all successful marketplaces (indeed, network effects businesses more generally) have found ways to solve it, each using their own specific set of hacks to fit their circumstances (e.g. Airbnb, Alibaba, eBay, Facebook, PayPal, etc.).

By now, a number of investors and academics have written about a wide range of tactics that founders can consider using to solve the chicken-and-egg problem. Rather than simply repeat them here, in this post we group them in four broad categories, so that one can more easily grasp the fundamental principles underlying the various strategies. This may also be helpful in uncovering new variations of these broad strategies as applied to different circumstances.

1. Single-side mode

The idea here is to attract an initial base of users on one side, by making them willing to join even if they expect few (or even no) users on the other side. In some cases, it may be enough to make it extremely easy for one of the two sides to sign up (e.g. creating a profile for them) combined with only charging fees when they make successful transactions, which means there is no downside to signing up. But in many other cases, this is not enough, either because signing up requires more of an investment, or because signing up is insufficient to create any value for the other side (users need to be active, not just have accounts). In such cases, users may need to be incentivized to actively participate. This requires offering something that has sufficient standalone value for them to do so; i.e. that does not depend on there being any users on the other side.

There are many ways to do so.

• Pay users to join: PayPal initially paid users $20 to open an account and $20 to refer a friend (later dropped to $10, then $5). This also gave them some initial funds to spend in PayPal.

• Employ/hire the supply side: Uber started off by hiring drivers by the hour to drive in specific areas of San Francisco at specific times in case anyone called for a ride. After generating enough demand, it was able to convince drivers to move to the current revenue-sharing model, without any fixed guaranteed payment.

• Offer free services: Zillow’s free Zestimate allows homeowners to get an estimate of their house’s value – the estimates are more accurate if users update information about it. Similarly, Credit Karma offers users the ability to check their credit score for free. And Hipcamp started off by offering information about public campsite availability to attract the demand side, before opening up for private hosts to list their properties.

• Offer one side a compelling standalone product: OpenTable started off by selling restaurants an electronic reservation system to manage bookings (regardless of where they came from). After signing up many restaurants, it was able to launch the OpenTable website to consumers, who could use it to book tables at all restaurants that had installed OpenTable’s reservation systems. Similarly, Amazon started by selling books (and later other products) as a retailer to attract consumers, before opening up to third-party sellers.

This last strategy, of offering a standalone product, is often referred to as single-player mode. The terminology comes from video games. By making a game attractive for users to play on their own, the game developer can attract a large enough installed base, at which point it can turn on multiplayer mode, enabling player interactions.

It is worth noting that selling a product to one side first is not always part of a deliberate strategy to seed one side of a marketplace. For instance, it is not clear whether Jeff Bezos had the two-sided marketplace vision in mind when he started selling books online. And certainly Steve Jobs had no plans for an App Store when Apple launched the iPhone with only its own apps. In such cases, firms later realize the opportunity to turn their popular products into platforms, something we’ve written about at length starting with this post.

2. BYO demand (or supply)

The bring-your-own-demand approach relies on incentivizing suppliers (or creators) to bring their own existing customers (or fans) to the marketplace. The appeal for suppliers is having a better platform for interacting with their existing customers (e.g. managing schedules, payments, records). Examples of bring-your-own-demand include Clubhouse, Patreon, and Playbook.

This strategy is similar to the single-side mode approach described above. The difference is that here suppliers invite (or onboard) their existing customers onto the marketplace. In other words, supply brings its own demand, rather than the marketplace going after demand by itself (e.g. OpenTable going after consumers after having attracted restaurants with its initial reservation management system).

Of course, a very similar logic applies to bring-your-own-supply, i.e. incentivizing buyers to bring their own existing suppliers to the marketplace. Examples of this approach include Marketboomer and Fairmarkit. More generally, it can be applied by any sourcing/procurement marketplace.

The bring-your-own demand/supply strategy does however have an important limitation. If customers/suppliers mainly stick with the suppliers/buyers that onboarded them (i.e. discovery of new suppliers/buyers is limited), the marketplace is not very defensible. Just like the marketplace convinced suppliers/buyers to onboard their customers/suppliers, a copycat with a slightly better software platform can convince suppliers/buyers to switch and take their customers/suppliers with them. We have discussed this issue in this post. Therefore, the key to building a defensible moat is to quickly move to enable each supplier’s/buyer’s customers/suppliers to discover other suppliers/buyers, and also attract new customers/suppliers.

3. Fake one side

Whenever we see an early-stage marketplace that hides its supply side, we immediately assume it’s because it lacks a critical mass of suppliers. Such marketplaces might ask buyers to submit RFPs, which they promise to send to their “large base of suppliers”. In practice this means, after receiving a request, the marketplace tries to manually find suppliers who can fulfill it. Ideally, these suppliers are eager for extra jobs, and are onboarded onto the marketplace in the process. Sometimes however, the marketplace founders might need to act as suppliers themselves at the very beginning to get things going: the founder of Cambly reveals here that the initial English tutors on Cambly were himself and his co-founder.

Another version of this approach is to post suppliers’ offerings without their approval, provided the marketplace is confident it can manually fulfill orders from them if required. DoorDash famously did this in its early days around the Stanford campus, with the founders posting menus of nearby restaurants, taking the orders, picking up the food and delivering it to customers themselves. Zappos used a similar strategy for online shoe orders.

It is important to note that faking one side does not necessarily involve outright lying or mis-representing availability. For instance, in Taobao’s early days, Alibaba employees were listing and buying listed items from each other to create a sense of activity. Founder Jack Ma even listed his watch. Airbnb enabled its hosts to automatically post their listings on Craigslist, to boost their demand, thereby piggybacking on the liquidity of Craigslist. More generally, a marketplace can just guarantee to fulfill demand, and leave the logistics of how they actually do so unclear at first.

However, some marketplaces have engaged in more suspect practices. Our own experience using OfferUp in its early days was that most of the so-called “buyers” seemed to be bots sending requests for more information (and then going silent), presumably to create the impression of lots of buyer activity. Apparently, we were not alone in drawing that conclusion. According to James Currier of NFX,  “Reddit used fake persona accounts to plant interesting questions. And PayPal built a bot that posed as a human, purchased things on eBay, and insisted on paying with PayPal.”

4. Change expectations

The most fundamental reason why the three broad strategies described above work is that they break the spell of “unfavorable expectations” that plague early-stage marketplaces: buyers don’t join because they don’t expect sellers to join, and vice versa. The three strategies above are ways to make it worthwhile for one side to join regardless of its expectations for the other side: because they get some standalone value, or because sellers can bring their own buyers, or because buyers are “fooled” into thinking there are some sellers present.

Rather than making users willing to join regardless of expectations, another approach is to try to change users’ expectations in the first place, from unfavorable to favorable. If users have favorable expectations and there is some advantage for users to come on board early (e.g. gaining a head start in building up their reputation on the marketplace), they will have an incentive to join even if others haven’t.

One way to do so is attract a “whale” on one side, i.e. a large or particularly sought-after supplier (or superstar). Once the whale comes on board, everyone expects the marketplace is going to work, and so users are willing to make the necessary effort to participate. This is inspired by the standard shopping mall tactic of first signing up one or two key anchor stores, which ensures there will be enough interest from shoppers in the future, which in turn attracts other retailers, who otherwise might have been hesitant to commit to the remaining slots. This can be a particularly valuable tactic for B2B marketplaces: getting commitments from a handful of major buyers or sellers may be enough to get everyone else to come on board.

A modern-day, blockchain-era version of this strategy is to offer early users/adopters cryptocurrency tokens together with a compelling white paper. The tokens may be worth little initially, but if there is enough belief in the project, people will participate on the expectation their tokens will be worth a lot more in the future, when many users participate. These beliefs can be self-fulfilling if more demand for tokens drives up the token’s price, and early users recruit others to the blockchain to further increase demand for tokens. Note the token approach has a built-in incentive for users to join earlier rather than later – more upside from token value appreciation and possibly also more generous token distribution by the platform.

Other strategies, hacks and considerations

One way to simplify (though not enough to fully solve) a two-sided chicken-and-egg problem is to reduce it to a one-sided chicken-and-egg problem, by focusing on users that can act as both buyers and sellers. Examples of platforms that have used this approach in their early days include Airbnb, Craigslist, eBay, Etsy and Taobao.

There are many other hacks that are insufficient on their own but can be used to complement the strategies described above, although these apply to almost any startup trying to get off the ground. Examples include: creating the illusion of exclusivity and the fear of missing out by initially making membership invite-only (e.g. Clubhouse, Gmail, Facebook), making use of free press (e.g. Swimply, the Airbnb for swimming pools, S’more, the love-is-blind of dating apps), holding events to attract and on-board potential users (e.g. PartySlate did this with its own launch party), referral programs (e.g. Airbnb, PayPal), etc.

For a marketplace, we’ve talked about how to attract one side without the other. But how to decide which side to focus on first? The usual advice is, all else equal, to focus on building the supply side first. In most cases, suppliers are fewer in number than buyers, and they are more willing to try things out in the hope of obtaining new customers. Having a sufficient variety of supply also tends to be more important in making a marketplace viable. But there are exceptions to focusing on supply first, and sometimes it may be easier to offer something of standalone value to buyers first (e.g. Amazon). Also, buyers might not care about the number of suppliers as much as vice-versa, so that attracting buyers first would then make more sense (e.g. the Credit Karma example mentioned above). Of course, having said this, in practice startups need to use somewhat of a “zig-zag” strategy: sign up enough users on one side to start offering some value to the other side, then attract some users on the other side, which then makes it easier to get some more users on the first side, and so on.  

Finally, another general piece of advice is to focus on a narrow segment/vertical first, and then expand out. eBay got a lot of its early traction with Beanie Babies; today, it has around 1.6 billion live listings at any given time, covering almost everything imaginable. Rover started with dog sitting in Seattle, and later expanded to pet sitting and dog walking, both across North America and parts of Europe. The idea is to get “liquidity” within a narrow vertical by getting a set of high-demand users on both sides before expanding out from there. Narrowing the segment also includes narrowing the relevant time period (so as to get more liquidity), a strategy stock markets and auction houses have long used. There are many benefits of narrowing down the initial target segment: (i) figuring out whether the unit-economics work before spending significant resources to expand to other locations/use-cases; (ii) creating a reliable playbook that can then be rolled out to other locations/use-cases; (iii) leveraging the sellers and/or buyers obtained in the first location/use-case to attract users in/for other locations/use-cases (when possible).

Concluding remarks

We have discussed four high-level strategies for solving the chicken-and-egg problem, each of which covers a wide variety of possible tactics and can be supplemented by many other hacks and shortcuts. It is important to realize that there are no wave-your-magic-wand solutions here: overcoming the chicken-and-egg problem for network effects businesses usually involves lots of hustle, out-of-the-box thinking and trial-and-error.