A big part of our investing at Union Square Ventures is to find businesses that have network effects. Marketplaces fit with that because participating in a marketplace tends to become more valuable as the marketplace grows (that’s assuming the marketplace does a good job spreading liquidity among participants). The reason to be interested in network effects from an investor perspective is that they offer a source of defensible competitive advantage. That in return implies that a company that operates a network can obtain some level of economics from the network. In the case of marketplaces that is measured most directly by the take rate. The take rate is the company’s revenues expressed as a percentage of the total volume of activity in the marketplace.

I have written about take rate before here on Continuations. I am revisiting this because last week’s topic of the week at USV.com was “What will undo today’s incumbent marketplaces?” I think one answer is marketplaces with a lower take rate. I don’t see take rates of 20% or more as sustainable in the long run. Why? Because they (a) impose too heavy a tax on marketplace activity and (b) produce too much profitability for the marketplace operator. The first is bad from the perspective of efficiency as it will crowd out some transactions that would benefit from taking place in the market. The second is will provide the incentive for competing marketplaces to be created.

The process of unseating an incumbent with a lower take rate is, however, long and arduous. The network effects of the existing marketplace make it tough for a challenger to build momentum. And the challenger may need other forms of differentiation in addition to a lower take rate. Or better yet it will have to grow initially in an area that is not at all (or only very poorly) served by the incumbent. The growth of Etsy is a case in point. eBay had tried to grow their take rate over time – largely by raising listing fees – and increasingly focused on power sellers of commodity items. That left open the opportunity to build a new marketplace with a lower take rate and focused on lower volume arts and crafts sellers. Over time this has happened to eBay in a number of different markets and has put pressure on their take rate.

More recently there are startups including OfferUp and VarageSale that are going after eBay and Craigslist with a natively mobile strategy. For now they are both free to list and buy so their take rate – like that of Craigslist in these categories – is zero. That is of course the lowest possibility but then the operation of the marketplace needs to be subsidized. Craigslist does this by charging for other parts of their business (real estate and job classifieds in select cities only). It will be interesting to see how this segment plays itself out over time. A first step to establishing a take rate for the newcomers will likely be to close the payments loop. From there though it is a lot less clear where to go and how much to charge. I suspect that the winning strategy will be to keep the take rate as small as possible while still building a sustainable business.