Getting a new product off the ground is one of the great challenges in business. That’s well documented for entrepreneurs. VCs don’t get any return from more than 40 percent of their first-round investments and get back less than they put in for two-thirds. I haven’t come across any stats for major companies that launch new products but my experienced guess is that a lot of really new products go bust too. Google Video, Microsoft Kin, and the Apple Lisa are just a few that come to mind.
The start-up problem is really hard for firms that are based on multi-sided platforms as I’ve explained in the previous posts in this series. Besides the usual problems faced by new firms they often must contend with a difficult coordination issue, the so-called the chicken-and-egg problem. This contribution describes some high level strategies on how to ignite a multi-sided platform business. You won’t learn the real tricks of the trade here. For that I have been known to succumb to monetary inducements, water torture, and being tickled.
Catalyst Framework
Let’s start with some basics. A business is an “economic catalyst” if it creates value by bringing two or more groups of customers together and getting them to interact. Catalysts create value by reducing transactions costs faced by multiple distinct economic agents that would benefit from coming together. Catalysts reduce search efforts, facilitate matching, and make it easier for the two groups of economic agents to exchange value between each other.
The economic value created by the catalytic reaction is essential for understanding the feasible set of business strategies that a multi-sided platform can use. That value must be big enough to warrant the cost and risk of investment in developing the platform. The value also provides the “pie” that can be split among the distinct groups of economic agents to provide incentives for them to join and interact on the platform with a portion of the pie going to the platform for performing its role. Some of the pie can be used to subsidize certain groups of economic agents, or members of those groups, to join the platform.
In “chemical catalysis” it is necessary to get the catalytic agent and the chemical agents in the right proportions to ignite and accelerate a reaction. The same is true for economic catalysis. Both economic agents have to be present on the platform in the right parts and levels to create any value at all and to accelerate value creation.
This conundrum is often referred to as the chicken-and-egg problem. The problem that platforms face is sometimes sequential as the children’s riddle suggests—does the platform need to get economic agents A on board the platform before economic agents B; or B before A? Other times, though, it is simultaneous—how does the platform secure the participation of economic agents A and B so that both will be present on the platform when members from each group show up. That typically involves solving a very difficult coordination problem between the platform and these two groups of economic agents.
The problem, however, is not just getting members of the two groups of economic agents to show up at the same time to create value. There have to be enough members of group A to make it valuable to members of group B to incur the costs of participating in the platform and to return it in subsequent periods; and vice versa. Strength in numbers arises primarily because economic agents in one group are searching for appropriate value-creating matches among members of the other group. There have to be enough members to make it likely that economic agents will find valuable matches.
Catalytic Ignition and Critical Mass
Figure 1 shows the basic concept of critical mass and catalytic ignition. (For those of you who like differential equations and lots of Greek notation the technical details are in Failure to Launch which I wrote with Dick Schmalensee.) There is a range of minimal numbers of customers in each group that, if achieved, provides a “thick enough market” or a sufficiently “liquid” market to permit sustainable growth. When the mass of customers on either side is insufficient a catalyst fizzles rather than ignites. Once a catalyst achieves critical mass on C’-C”, for example, it can grow to its profit-maximizing potential of D*; if it does not achieve critical mass on the segment C’-C’’ it contracts and fails.
The growth paths to critical mass depend on many factors including pricing. But the point here is that achieving critical mass is essential. Google Video, for example, failed to achieve critical mass because it did not generate enough content to attract viewers and did not attract enough viewers to attract paid or user-generated content.
The optimal growth path to critical mass and to long-run equilibrium is well away from the horizontal and vertical axes in most plausible cases. New multi-sided platforms generally need to have balanced growth. Having too many of one side and too few of another side will lead to quick failure. (This is reflected in Figure 1 in that the equilibrium growth path to critical mass must occur within the triangle 0-C’-C”.)
The challenge that catalyst entrepreneurs face is how to achieve the critical mass that is necessary for ignition. That means getting to critical mass over some reasonable space of time. One can think of this phase as the ignition phase of the product launch process, in which customers are trying the platform and assessing its value; these early adopters will stop coming back, and stop recommending it to their friends, if the platform does not grow quickly enough. The entrepreneur must increase the number of customers on each side to a point where there are enough to reach critical mass. That involves horizontal and vertical movements within the cone-shaped area in the Figure. A transaction platform, for example, needs to take actions that increase buyers and sellers. The entrepreneur must also maintain the right proportions of customers on each side so that there are enough participants on each side to interest the participants on the other side. That involves diagonal movements to the northeast in Figure. An exchange platforms needs to make sure there are enough buyers to interest sellers and vice versa.
Figure 1 Catalytic Ignition and Critical Mass
The Basics of New Product Introduction
There is an extensive literature on launching new products. Key tactics involve logistics; advertising, sales, and marketing; and pricing. Companies should make sure they have a production and distribution system for getting products and services to consumers. They need to provide sell consumers on the merits of trying a product through the dissemination of information as well as persuasion. Finally, they need to set prices recognizing both the competition and the fact that consumers may need an incentive to try to a new and unproven product. These traditional strategies facilitate obtaining consumers on both sides of a two-sided platform, that is, in making horizontal and vertical movements.
The original models of product diffusion distinguished between two types of consumers: innovators who would try a product as a result of direct communication with them and imitators who would try a product as a result of communication with someone else who had tried the product. The innovator might learn about the product through advertisements in the mass media. The imitator might learn about the product either from the innovator or from other people who learned about it directly or indirectly from the imitator. The word-of-mouth aspect to this model gives rise to the well-known S-curve of product diffusion where there is a convex rise in adoption, an inflection point, and a concave rise that levels off at some saturation point. The population of economic agents is sometimes broken down into innovators, early adopters, early majority, late majority, and laggards. Figure 2 shows the standard framework.
Figure 2: The Basic Model Of Product Diffusion.
Source: Mahajan, Muller, and Bass (1990)
The literature on social networks provides insights into the process of word-of-mouth communication. The social graph describes the relationships among members of a network. It consists of nodes which reflect the agents and lines that show the connection between the agents. The connections can be uni-directional (x communicates with y) or bi-directional (x and y communicate with each other). The nature of the relationships among members of the network can provide insights into the organic workings of the network. There are three key ramifications for product diffusion. Word of mouth will spread more quickly: (1) the more connections innovators have; (2) the more connections friends of the innovators have; and (3) the denser the network is in the sense of there being fewer degrees of separation among members of the network.
Two types of agents facilitate the diffusion information within the network. “Influencers”—or gregarious members—account for a disproportionate share of communications. They send a lot of messages out to a broad range of connections. “Centers” have connections with many people who are not connected to other agents. They are important because they are the only way to reach isolated agents within the network.
Product diffusion may provide double duty for two-sided businesses in which economic agents have shifting roles in the platform. Individuals who upload photos on the photo-sharing network Flickr may view photos from their friends. People who use eBay’s auto exchange may use it for both buying and selling, though some users may specialize in selling, and some may never sell.
Consumers may value a product more if similar consumers use that product as well. This is known as a positive direct network effect. It can arise because it is easier to connect to people using the product or because there are knowledge spillovers among them. Consumers may also value a product less if similar consumers use that product. This is known as a negative direct network effect. That might happen because of congestion or because people want to be different. For simplicity, we will assume that direct network effects are positive unless noted otherwise.
Direct network effects act as an accelerant to a catalytic reaction. Diffusion happens more quickly. The value of the network is higher to each additional member who is contacted. All else equal direct network effects increase the likelihood that each subsequent agent that is contacted by an earlier adopter will adopt the product also. Figure 3 shows how direct network effects modify the S-curve of diffusion.
Social networking theory provides some guidance on how to use direct network effects strategically. I would conjecture that economic agents that are more densely connected in a network have stronger direct network effects among them. Thus using influencers to connect to more densely connected portions of networks will tend to have higher payoffs.
Figure 3. Network Effects and Diffusion
One type of economic agent may value a product more if more of another group of economic agents uses that product as well. This is known as a positive indirect network effect. It can arise because one type of economic agents (e.g. a buyer, a man, cardholder) wants to search for and transact with another type of economic agent (e.g., a seller, a woman, a merchant) and vice versa. It can also arise because one type of economic agent (e.g. a computer user, a video game user) wants to be able to find complementary products for the platform they use (e.g., applications, video games) and the maker of those products want to be focus its efforts on platforms that have users who will demand its products. There are also negative indirect network effects: one type of economic agent on the network harms another type of agent. The leading case of this for platform businesses is advertising-supported media. Consumers may dislike the advertisements. The platform solves the externality problem between advertisers and consumers by using content to bribe people into viewing ads.
Indirect network effects are the key aspect of multi-sided platforms. They are the source of the catalytic reaction—and much of the value—created by the platform. A key practical aspect of these indirect network effects is that they require that the platform “balance” the two sides to maximize the value of the platform to either side. The platform has zero value to either side if the other side is not on board. For many platforms the optimal balance is likely well into the interior and away from the axes as was shown in Figure 1.
The analysis above has already pointed to the fact that not all customers are created equal for multi-sided platforms. It is useful to pull these concepts together here and summarize their implications for platform ignition. There are three major kinds of heterogeneity.
Strategies for Igniting Catalytic Reactions
This section focuses on diagonal strategies for getting both sides on board in the right proportions. Catalyst entrepreneurs must ultimately solve a coordination problem to get both sets of economic agents to get on board their platforms. The dynamics of this coordination problem can vary considerably depending on the nature of the platform business.
Sequential entry. In some cases it is possible to get one group of agents on board over time and then make these agents available to the other group of agents later in time. That is the situation with advertising-supported media. One can use content to attract viewers and then bring advertisers on board later. This dynamic works because there are non-positive indirect network effects between the two sides: viewers do not care about advertisers (and may dislike advertising) but come to platform for the content.
Entry with significant pre-commitment investment. In other cases one group of economic agents need to make investments over time to participate in the platform. That is the case with software-based platforms such as video game consoles. Game developers must invest in creating games for the next release of a console without knowing how many consumers will be interested in using that platform when their development is done. The video-game console platform must either convince game developers that buyers will show up, provide them with some financial guarantees that buyers will show up, or self-produce games until the platform has demonstrated itself.
Simultaneous entry of sides. In some cases the economic agents are making decisions to join the platform around the same time and have to both join around the same time for the platform to provide value. A dating venue demands almost perfect simultaneity. Heterosexual men would quickly leave a new nightclub that had no women and vice versa. Other platforms provide more latitude. Buyers may not desert an exchange platform right away if there are no sellers but they will arrive soon.
In all cases, however, platform growth is not sustainable until the platform reaches critical mass. Therefore the key challenge for new platforms is figuring out ways to reach critical mass quickly.
The basic zig-zag
A basic strategy for reaching critical mass is to build participation on the two sides incrementally. The platform starts with a small number of economic agents on both sides. It then persuades agents on either side to join. It also relies on the natural processes of product diffusion. Because of indirect network effects, the platform is more valuable to each successive group of prospective customers. Figure 4 shows that basic zig-zag approach to growth.
eBilleMe provides an example of this strategy. Consumers who click on the eBillMe sign at the checkout for an e-tailer can pay with their online banking account. They then send an email which contains details for paying from their online banking account. After they enter the information into their online banking account they receive a receipt and the product is shipped. This payment alternative is attractive to people who are either concerned about the security of paying with cards online or do not happen to have a card conveniently available. A small but significant fraction of consumers, as it turns out, like paying this way.
Figure 4. Basic Zig-Zag to Critical Mass
To get started, eBilleMe persuaded ToolKing to offer eBillMe at checkout. A small percentage of customers used this payment alternative. eBillMe then went to other online retailers. Each led to eBillMe having more people who were accustomed to using its service. For each subsequent merchant it went to it offered an increasingly valuable offer since it had more users who were predisposed to use this payment alternative. At the same time it let its users know that they could pay at more places thereby increasing the value to the merchants. eBilleMe grew from 1 merchant and hundreds of users during its first year of entry in 2005 to hundreds of online stores taking 2% to 10% of the merchant’s transaction volume by 2008.
Pre-commitment to both sides
Some platforms such as eBillMe are able to start with one member on one side that it uses to attract members on the other side. More commonly platforms need to have multiple members of both sides to begin the zig-zag process above. They therefore need to persuade a minimum number of early adopters on both sides to show up at the start of the platform to make it credible. That requires getting both sides to believe that when the platform opens for business there will be members of the other side present.
Diners Club is the classic example of this strategy. Although the precise sequence is lost to history it persuaded 14 restaurants in Manhattan to accept Diners Club cards for payment. At the same time it persuaded several hundred people in Manhattan to take the Diners Club Card. Those commitments were enough to start the platform. Over the next year Diners Club zig-zagged its way to 330 restaurants and 42,000 cardholders.
Customers may require more assurance that the other side will in fact show up especially if they have to invest resources to join. Contingent contracts can be entered into for this purpose. Customers agree to commit to join the platform conditional on other customers on the same and other side also joining. Once these contracts have been entered into the catalyst only needs to persuade one customer to sign on because that will have a domino effect on all the other customers. MobiTV serves as an example where contingent contracts play an important role for “catalyzing” the platform. Started in 1999, MobiTV’s planned to offer TV service to customers on their mobile phones for a subscription fee. It needed to persuade TV content providers and mobile operators to join its platform. Neither of the two wanted to embark on the new project unless they were assured that the other side would also join. MobiTV used contingent contracts to ignite the platform. It signed an agreement with Sprint that if television channels join, Sprint would offer service and agreements with MSNBC and other TV channels that if Sprint join they would broadcast. It was enough for MobiTV to get Sprint to agree and everyone else followed.
The video-console example considered by Hagiu is an extreme example of this phenomenon. Video-games and other software application are platforms that connect application developers and video game players. The game player will not purchase a video console without enough applications and games, and the former will not put the time to develop such if they are not sure that people will buy their applications. Because game developing is a long process, the vendors have to secure sellers a long time before the new game is launched in order to make sure that developers will provide the applications.
Single and Double-Marquee Strategies
The marquee strategy discussed above is another way to obtain enough members on both sides to begin the zigzag to critical mass. In a single-sided marquee strategy the platform acquires an “influential” or “prestige” member of one side. Announcement of that may attract enough members of the other side at the beginning. The shopping mall strategy is the classic: the mall gets an anchor tenant which many shoppers want to connect to. In a two-sided marquee strategy the platform acquires “influential” or “prestige” members on both sides. They provide value to each other as well as attract other members. Nightclubs are common users of this strategy. They try to get popular men and women to come on opening night. They want to connect to each other and less popular men and women want to connect with them.
The Two Step
The two-step strategy involves getting enough members of one side on board first and then getting members of the other side on board. As mentioned earlier this works when the first side does not value access to the second side which is often the case for advertising-supported media. Search engines followed this strategy. They attracted users who did searches of the world-wide-web. The search results were displayed on a series of pages. Once they obtained enough page views they sold access to those pages to advertisers. Google, for example, operated its search engine for 23 months (including a beta version) before it opened it search results pages to advertisers. At that time it had more than a billion pages indexed and 18 million user queries per day.
Ziz-zag with self-supply
Catalysts may be able to jumpstart their platforms by providing one of the sides themselves at least initially. Consider YouTube which is a three-sided platform: user-generated content attracts viewers, viewers attract content providers who want an audience, and access to be viewers can then be sold to advertisers. YouTube started by focusing on users and viewers. Its founders seeded the site with content they generated themselves and started the process of diffusion by suggesting that members of their personal social networks check out the content. They also used various marketing strategies to attract viewers: they posted an ad on craigslist to compensate attractive women to post on the site and promised to give an iPod to a random user every day till the end of the year.
Going from Strategies to Tactics
These strategies are only examples of what catalysts can do in practice to ignite their platforms. Every ignition strategy needs to be implemented through a series of tactics. As we saw earlier those tactics are time-sensitive. Catalysts in practice often have a limited amount of time to succeed. They are just like rockets. If they don’t get enough momentum to escape the earth’s atmosphere they will crash and burn. Having a great strategy for blasting off into out of space doesn’t do much good if by the time you implement it your rocket ship is on the bottom of the Atlantic Ocean.
Having an ignition strategy is no guarantee of success of course. Some new platform businesses just don’t create enough value to create critical mass. The failure to have a well-though out launch plan that can quickly get a platform to critical mass is almost a sure guarantee of failure even for the best platform ideas. That’s why every investor, board, and company exec should insist on seeing an ignition plan. I will discuss that more in the final entry to this series.
I. Why Every Payments Product Needs an Ignition Strategy
An ignition plan won’t guarantee success. But it does force entrepreneurs and investors to think carefully about how they are going to get both buyers and sellers on board, in sufficient numbers, and quickly enough, to ignite. In doing so they may realize that ignition is too difficult and save their money.
II. What the Little Engine that Could and Nuclear Physics Have to Do With Ignition Strategies
The basic problem for a two-sided business is that it needs “critical mass” to get ignited. That’s a concept from nuclear physics and a pretty good analogy to what goes on with two-sided platforms.
III. Blast Off! How Two-Sided Platforms Ignited
Facebook wunderkind Mark Zuckerberg and his partners made it look easy. The social networking platform ignited almost immediately after it was introduced at Harvard College.
IV. Why Even Great Payments Ideas Crash and Burn
This brings me to a stark point: There are lots of great ideas out there, but precious few entrepreneurs who can turn great ideas into successful businesses.
V. How Long Does a New Platform Have to Ignite or Fizzle
Not long is the short answer. A completely unscientific but reasonably educated guess is a couple of years. Here I explain why. To some degree all new firms face an hourglass. Most firms fail and do so, mercifully, quickly. That happens because the firms aren’t nearly as good as they thought they were.
VI. Ignition Strategies: How to Launch a Platform Business
Getting a new product off the ground is one of the great challenges in business. That’s well documented for entrepreneurs. VCs don’t get any return from more than 40 percent of their first-round investments and get back less than they put in for two-thirds.
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