Marketplace Startups: Here's A Magic Number For Efficient Growth
In March 2019, consumer-marketplace businesses were on a tear. But some high-profile stumbles, including Uber and WeWork, dragged down our Battery Marketplace Index early in 2020 — and that was before Covid-19 hit. Drilling into the numbers, it’s clear investors are still flocking to some marketplace companies — the ones that are growing efficiently. As a marketplace investor, I wanted to quantify what efficient growth looks like right now.
In this mini-series of posts, I’ll dig deeper into a few metrics that startups should watch to ensure they’re growing in the sustainable, efficient way investors now look for.
My previous post explained the “Rule of 40.” It’s a back-of-the-envelope calculation that captures something crucial about how a company is growing, particularly in its pre-profitability stages.
Here, I’ll tackle what our firm has dubbed the Battery Growth Magic Number. Like the Rule of 40, the Growth Magic Number is simple to calculate — but don’t be fooled by the easy math. This metric reveals not just whether your company is growing, but how it’s growing — and it can be a remarkable harbinger of success for consumer-marketplace businesses in the current climate.
Growth magic happens when revenues grow faster than sales-and-marketing spend.
Here’s the rule: Your annual revenue-growth percentage should be higher than your combined sales-and-marketing spend as a percentage of revenue. For example, if your revenue is growing 30% per year, but you’re spending more than 50% of revenue on sales and marketing, your sales/marketing function is inefficient. On the flip side, if your revenue is growing 50% per year and you’re only spending 30% of revenue on sales and marketing, you’re getting a ton of leverage out of your spending and growing efficiently.
The bottom line: If your Growth Magic Number is positive, you’re running an efficient sales-and-marketing organization that investors will value highly right now.
Let’s look at a couple of publicly traded examples. Netflix also grew revenue by 28% in 2019 and spent only 13% of revenue on sales and marketing. Its Growth Magic Number is 15 — very strong. Pinduoduo, China’s second-largest e-commerce company, saw revenue growth of 130% in 2019 and spent 90% of revenue on sales and marketing. Its Growth Magic Number is 40 — even better.
How do you create an efficient sales-and-marketing organization?
It’s one thing to perform this simple calculation and see if your company’s Growth Magic Number measures up. If it doesn’t, what should you do to fix it?
Ultimately, the key differentiator is free product- or user-led growth versus paid growth. Your goal as a consumer-marketplace startup should be to engineer growth directly into the core product experience, so you’re not dependent on paid acquisition channels to grow.
Netflix’s well-known recommendation engine for streaming video, for example, naturally drives increases in content consumption. This, in turn, improves engagement, subscriber renewal and customer lifetime value. The more users Netflix has, the better its recommendation algorithms get, creating a robust network effect.
Pinduoduo has created a fascinating “group purchase” model where users recruit friends or other users to join a “team” to purchase items. If the team becomes large enough, they unlock a discount, and the user who created the team gets the product at a very steep discount (up to 90% off). Users also get rewards points when their friends click on links they share, even if they don’t purchase the product. By gamifying the act of recruiting new users, Pinduoduo has built a powerful engine for organic growth right into its product.
On the other hand, Yelp — a company I discussed in my Rule of 40 post — relies heavily on commissioned salespeople in local markets. Yelp has thousands of sales reps selling advertising to small businesses. Every dollar of new revenue is expensive for them to acquire, and that’s reflected in their very low Growth Magic Number, negative 41.
The best way to grow efficiently is to build growth levers directly into your product so that you grow organically — and cheaply.
What else can marketplace companies do to drive organic growth?
The examples below suggest a few other strategies for driving organic growth:
Create a hands-off freemium funnel that, once established, keeps converting new users without much effort.
The key here is great content and carefully designing the steps along the path to conversion. Chegg, an example we examined previously, has a well-designed freemium funnel driving strong organic growth. (They also have a Growth Magic Number of roughly 12.5.)
Build network effects into your product.
Ideally your product should be great to start but get even better the more people use it — again, without much effort on your part. Netflix, Etsy and Airbnb all benefit from strong network effects.
Turn users into your salespeople.
Pinduoduo has done this to great effect — users directly benefit from persuading their friends to view products or purchase items.
Build heterogeneous (versus homogenous) supply.
Uber and Lyft have a homogenous supply: Cars and drivers are not that different. Food delivery apps are similar — you can order pizza from your favorite parlor from three or four different apps. Homogeneous-supply companies must compete on price, driving down their profit potential.
By contrast, Airbnb has a heterogeneous supply. One apartment or home is very different from another, in terms of price, location and amenities offered. A heterogeneous supply takes time to build but creates a strong, defensible moat once it’s in place.
The growth-at-any-cost phase is over for consumer marketplace startups. Acquiring new revenue without spending excessively is a key part of demonstrating to investors that your company is growing sustainably and smartly — not just burning through cash.