Online Market Makers

1. Online Market Makers internet business models text and cases Tony Gauvin

2. Overview • What are Online Market Makers? • A Taxonomy For Market Makers • Creating Value • Economics • GBF or GIRF? • Summary

3. What are market Makers • Market makers are intermediaries whose central purpose is to organize a marketplace by providing, on behalf of multiple buyers and sellers: • a place to trade, physical or virtual • rules for trading and the ability to enforce those rules • infrastructure to enable and enhance trading • The Central purpose of markets makers is to organize a marketplace • Excludes brokers, whose central purpose is client representation • Excludes retailers and distributors, who take title to inventory, speculating that they will sell it for a profit (market makers may take title, but only in the context of specific transactions) • Excludes single companies that have web-enabled their procurement processes

4. Taxonomy • Product focus • Customized vs. standardized • Horizontal vs. Vertical • Direct vs. Indirect purchases

5. Taxonomy • Transaction Type • Catalog • Fixed prices, • Napster, OrderZone, Ventro • Auction • Seller or buyers initiated • B2B, Request for Quotations • Can have high price volatility • eBay, Sotheby, FreeMarket • Exchange • Continuous auctions for standardized products • NYSE, NASDAQ, PaperExchange

6. Taxonomy • Affiliation: Who is at advantage? • Buyer • Concentrated buyers but fragmented suppliers • Seller • Concentrated sellers but fragmented buyers • Neutral • Fragmented buyers and seller

7. Creating value • Always ask: where’s the pain? • Stages of the buying process: • Search > negotiation > transaction processing • Marketplace participants seek: • Liquidity benefits • Transaction processing cost savings • Integration benefits

8. Liquidity Benefits • If search and negotiation costs are reduced, you can afford to consider more trading partners, and thereby increase transparency with respect to price, product availability, and/or product selection • Buyers: find the right product (in stock) at the right price • Sellers: reach more/better buyers • B2B exchanges dramatically reduce search costs by aggregating multiple suppliers’ inventory online (with search tools) and thereby eliminating print catalogs, phone/fax contacts

9. Price Impact of Liquidity • With one-of-a-kind items and RFQs, party initiating auction should generally realize a better price (RFQ: more sellers + one buyer = lower price) • For commodities or items with close substitutes, impact of increased liquidity on price will depend on relative increase in numbers of buyers and sellers. • There may be no change in average prices, but variability of prices should decline • Losers: sellers who exploit the ignorance of uninformed buyers (or vice versa) • Winners: low cost or differentiated sellers

10. Liquidity Benefits are Greatest When: • Asset-intensity is high and inventory is perishable (e.g., Air travel; bandwidth; trucking services) • Customers are willing to switch suppliers; are not locked in by relationships, contracts, system integration, etc. • Suppliers are differentiated. If they aren’t, there’s not much point to increasing liquidity. Basis for differentiation: • Many SKUs • Supply/demand swings (with #1 and #2, stockouts are an issue) • Lots of new and/or substitutable products (so availability and advice matter)

11. Transaction-Processing Cost Savings • Processing a purchase order involves an average of 14 information-rich, labor-intensive steps. Exceptions are common; so is need to check on order status. Big savings from automation – can be as great as 90%. • Automation also can reduce “maverick” purchasing of indirect goods and services • Transaction processing cost savings are greatest when: • TPCs are large in relation to order value • Trading partners lack EDI • Orders involve large number of items • Orders require close coordination (e.g.., With JIT procurement) • Orders require multiple levels of approval

12. Integration benefits • By integration of processes seek asset liquidity (speed by which assets are monetized) • Inventory management • Inventory is “the physical embodiment of bad information” Paul Bell from Dell Computer • Solving accounts payable paradox (net30-net90)

13. Anonymity and Off exchange Trading • Anonymity • Desire to “hide” identity • Institutional stock traders • Mutual funds • Prevent off exchange trading • eBay member id

14. Economics • Sources of Revenue • Transaction fees • Markup (Spread) • Membership and Subscription fees • Data sold to 3rd Parties • Aggregate market stats • Buyer behaviors • Software sales and Integration fees • Ancillary Services • Advertising fees

15. Revenue Recognition • Gross revenue or net revenue • SEC policy on Gross Revenue • Acts as the principal in the transaction • Takes title to the products • Has risks and rewards of ownership, such as risk of loss for collections, delivery or returns • Acts as an agent or broker with compensation on a commission or fee basis • SEC policy on Net Revenue • If the company performs as an agent or broker without assuming the risks and rewards of ownership of the goods, sales should be reported on a net basis • eBay does net revenue • Priceline does gross revenue

16. Cost categories • Cost of revenue • Depends on accounting practice • eBay 24% • Priceline 94% • Product development • Large and recurring • from 2% to 44% • Sales and marketing • 11% to 61% • Many different approaches

17. Prospective Profitability • In 2000 out of all companies sampled • Only eBay has shown a profit • Priceline lost $19 million • VerticalNet lost $52 million • Ventro lost $92 million

18. GBF? • Condition #1: • over the longer term, will the category exhibit winner-take-all structural attributes? • Network effects • Scale economies • Retention rates

19. GBF? • Condition #2: • Over the short term, do you face: • Few rivals • Many closely-matched rivals (but none in the lead) • Entrenched market leaders

20. GBF? • Can you get big fast? • Condition #3: • can you raise the capital required to fund accelerated growth?

21. NETWORK EFFECTS • Network effects are stronger when: • Network membership is exclusionary (e.g., Sothebys.Com versus monster.Com) • Buyers and sellers are idiosyncratic (e.g., The market for homes versus the market for life insurance policies) • Barriers to network participation are low • Sensitivity to aggregate participation rates: is everyone i really want to trade with part of the network?? • Costs and risks related to adoption • System integration cost • Career risk if operations are disrupted

22. GBF? • Scale economies • Site development costs are fixed • Direct selling and system integration costs vary with number of market participants (but not with volume) • Retention • Strong network effects > high retention • Opportunities for differentiation: • Database development • Interface design • Switching costs • Data reentry • Retraining costs • Reintegration of information systems • Forfeiture of transaction profile

23. Growth Patterns for Online Networks Probability of Prospect Joining Online Network % of Prospect’s Existing Offline Partners Already Active in Online Network Scenario 1: Low Switching Costs and Low Sensitivity to Participation Rates (e.g., eBay, Napster)

24. Growth Patterns for Online Networks Scenario 2: High Switching Costs and High Sensitivity to Participation Rates (e.g., B2B exchange in construction supplies) Probability of Prospect Joining Online Network % of Prospect’s Existing Offline Partners Already Active in Online Network

25. B2B market makers • What happened?? • Scientific products marketplaces have failed • Ventro shut down ChemDex in 12/00; repositioned as service/software provider for brick & mortar companies moving online; stock dropped from $243 to $0.25 • “It’s not that we thought we could never get ChemDex to be profitable. It had been growing at 20-30% per quarter. But it was burning through a lot of money. We decided that, in an environment where raising capital is difficult, it wasn’t where we wanted to spend the fixed amount of money we have.” Dave Perry, founder and CEO, 5/01 • Sciquest shut down e-commerce marketplace; fired two-thirds of its staff of 450 as it repositioned as b2b software provider; stock dropped from $80 to $0.80 after company burned through over $100 million • Abandoned little guys in favor of big players • Scenario has been replayed in sector after sector. Of 1,000 B2B exchanges launched, only 100 now facilitate transactions • There are a few bright spots, • e.g., Pantellos in utilities; Chemconnect

26. B2B market makers • Neutral exchanges have given way to industry consortia (which have been slow to launch due to internal conflicts & trading partner resistance) and private procurement solutions (which, unlike consortia, offer a competitive edge) • Neutral exchanges underestimated complexity/tenacity of real world relationships and the cost of enabling transactions (“we thought the task of digitizing supplier catalogs would be straightforward, but it has taken an incredible effort” CEO Petrocosm, 5/01) • Solution: layer in value added services (around supply chain, contract, or product life cycle management) • This is one way to reduce sellers’ concern about price pressure • But solution is expensive, and money has fled the sector! • Failure of B2B market makers is perhaps the biggest disappointment of the web’s crash: We saw huge promise and potential, followed by huge losses! • This is much harder to understand than failures in online retailing, broadband content, and access businesses