Transcript: (disclaimer: may contain unintentionally confusing, inaccurate and/or amusing transcription errors)

Sarah: People talk about minimum viable product. What I think for marketplaces, I call that minimum viable happiness. The idea is how do you know? We're talking about happiness. At one point I called it the hippie version of liquidity because how do you articulate? How do you measure happiness? It must be frustrating for engineers to hear that's the optimization function.

Ben: [...] NPS score?

Sarah: Don't get me started with NPS. I'm happy to talk about NPS. I have a bone to pick with it.

Ben: Welcome to this special episode preview of the Acquired Limited Partner show. As many of you know, the LP show has been focusing recently on the fundamentals of venture capital. For our latest episode, we were joined by Sarah Tavel, a General Partner at Benchmark to go deep on the topic with us. Sarah is one of the great consumer investing thinkers out there having made an early investment in Pinterest, then joining the company early in her career and early in the company, and later returning to be a VC.

We decided to create this preview of the episode with some of our favorite nuggets since the applicability is so vast and something that we think all Acquired listeners would enjoy. That and we did the same thing with her partner Chetan last year on enterprise investing so it seemed only fair. Here’s our first segment where we ask Sarah for the 30,000-foot view on why backing consumer companies or B2C companies is attractive to investors.

Sarah: There are two big things that come to mind for me with consumer. The first is just the size of the market. The whole idea of consumer is that all consumers are potential customers. When you think about building massive companies that reach a tremendous scale, there's really no bigger scale than you can ask for than consumers in terms of spending the time.

It has the potential if you can unlock an opportunity that is universal, you have the opportunity to build something really really big. The second thing is that a lot of consumer companies, at least the ones that we focus on, have a dynamic that leads to winner-take-most outcomes. That's largely thanks to network effects. The Facebooks of this world or more economies at scale, so you can think of Amazon as an example.

You bring those two attributes together where you have a company that has a massive market to go after and can escape competition. That just leads to the type of asymmetric outcomes that drive big returns and ventures. That's why we focus on those types of opportunities.

Ben: Digging a little deeper there, enormous markets that have winner-take-all or winner-take-most possibilities, there's a higher upside. Is there a higher risk? Do you think about this as a category that's higher beta than enterprise investing?

Sarah: There's a higher risk for a couple of reasons. One is that there's something that’s more about taste. We talk about capturing lightning in a bottle in consumer where it's so hard to know where a hit (as they call it) might come from where you never could have looked at a market sizing diagram or Gartner report, and then deduce from that that there should be a social network that starts with colleges and sprouts from there. You never would have thought of a company like Cameo.

There's rarely a top-down or bottom-up analysis that leads to an insight that creates an experience that captures something and leads to tremendous consumer growth. That's just capturing lightning in a bottle. It's so hard to go from there and actually reach escape velocity, unlock a monetization model. There are so many more steps or hurdles that there's a much higher rate of companies being started going after consumer opportunities. Iterating, iterating, iterating, and never quite unlocking or capturing that lightning in a bottle.

On the B2B side, Chetan, Eric, and Peter on the Benchmark team sometimes joke that they are coal diggers. There's much clearer, oftentimes, where you're digging. There's a much higher—

David: You're looking for diamonds. They’re looking for the coal byproducts.

Sarah: Yes, exactly. There's a much higher recipe for success in B2B of finding a great founder, who really knows the space, is able to get that go to market motion going and start to build equity value, whereas, on the consumer side, there's no recipe for success.

Ben: When these consumer businesses are in the business of finding something that isn't any sort of research report and then 10–20 years later, it's one of the biggest total addressable markets there is, how do you evaluate that in a venture capital context when the classic notion is we invest in big markets?

Sarah: There's so much to unpack there. One of the hard things of unpacking that is the consumer is a big umbrella. There are so many different types of consumer companies. If we're talking about a marketplace, I'll have a different answer for you. If we're talking about a social product, I'll have a different answer for you. If we're talking about a gaming company, I'll have a different answer for you.

The thing that I focus the most on is what at the earliest stages can you see in a founder, in the product they've built, in the market that they're going after that maximizes the chances that that company, that founding team will be able to go to the distance.

It's funny because a lot of the lessons that we take from that thinking are actually contrarian to what a lot of people think about in venture. As an example, you talk about a big market. Most VCs you talk to, most people think that you have to go after a big market, and founders will come in and their market sizing slide, and it will show these big hundred billion dollar market numbers.

When I see that, my eyes completely glaze over because I'd much much rather, for a market place in particular, but I think this transcends marketplaces. I'd much rather have someone have a core insight into a small market. I describe it as the [thimble] of a market and have adjacencies have the ability to expand beyond that than to be going after a big market from the beginning.

I just think if we loop back to that idea, that premise that we started this conversation with which is driving towards winner-takes-most markets, if we're going after a huge market, you're boiling the ocean. The only way to have a chance to do that is to start with something very small. But that's contrarian. That's not what you'll hear from 9 out of 10 VCs I assume.

Ben: Sarah then goes into more detail on when a simple market has the ability to expand into adjacencies versus what might be a small market with no access to that growth.

The next topic we cover is Sarah’s recent set of three epic blog posts—her hierarchy of marketplaces. What follows is effectively the director’s cut commentary of this three-part series. Here’s her take on what she calls Level 1 marketplace.

Sarah: What I talked about in the post and what I think about is I call it happiness. My point is this, GMV is not to say that it's not a useful measure, but it's not a thing you want to drive towards. If you're just driving towards maximizing GMV, you're going to end up with the scenarios that we described earlier where you're getting big numbers but you're not actually creating any enduring value.

Instead what you want to do is focus on creating what I think of as happiness. Happiness is a funny word to use. It's one that I actually hesitated a lot on. I was thinking of liquidity or value. Happiness to me is something that incorporates the holistic experience that you create for your buyers and your sellers. It's almost the delta in a way the value you create and the value you capture from your marketplace.

People talk about minimum viable product. What I think for marketplaces, I call that minimum viable happiness. The idea is how do you know? We're talking about happiness. At one point I called it the hippie version of liquidity because how do you articulate? How do you measure happiness? It must be frustrating for engineers to hear that's the optimization function.

Ben: [...] NPS score?

Sarah: Don't get me started with NPS. I'm happy to talk about NPS. I have a bone to pick with it. What I ended up coming down to is retention. My friend, Casey Winters, who I work with at Pinterest and is now the Chief Product Officer at Eventbrite—just a great marketplace thinker—said something when I was talking to him about happiness.

He told his team that product/market fit isn't when your user stops complaining. It's when they stop leaving. I think that is a great distillation of it which is that the marketplaces I've seen that have succeeded have all reached two points. One, the cohorts that they have plateaued. You get to a point where you don't have to retain everybody. You never do with a marketplace, but you get to a point where you get to some point where you're making enough of your users happy on either the buy- or sell-side that they retain. That's number one.

On the second side, I actually think that a lot of the time, you'll see one side that has actually net revenue usage retention or net usage retention that's above 100%. You have one side that has more than 100% net revenue retention and you have another side that you do have plateauing. It may not be at 100% net revenue retention, but it works well enough that you can see how the economics will work, for you to pay back your going-to-market motion and keep putting more and more into growing.

Ben: To just illustrate an example of that, if Uber one month acquires a million riders and by six months in, it's plateaued where only half of those riders are still using the service, but each one is spending more than twice as much money on the service then it satisfies that rule because the total revenue from that cohort has stayed flat or increased.

Sarah: What's interesting is that for different verticals, you have different dynamics. Uber is a great example where the net revenue retention that you're going to see above 100% is going to be on the demand side. You're going to have retention that plateaus on the supply side, the driver side, but there's a lot more acquisition you have to do on the driver side all the time.

Travel, on the other hand, like Airbnb, is actually going to have that net revenue retention occur on the supply side because the repeat usage for staying at an Airbnb is just not very high. It's not because of Airbnb's product and losing those consumers to substitutes. It's because people don't just travel that often.

You want to get as much share of wallet as possible, but you're still going to see cohorts that take a long time to show the evidence of repeat usage. It's much more about on that side of seeing some plateauing, but really it's about the net revenue retention you have on the supply side and having really scalable, ideally free sources on the demand side.

Ben: Sarah then takes us through Level 2 marketplace after minimum viable happiness when a marketplace business tips. This is when you become so much better than any substitute that the market tips in your direction, which is when it’s time to start growing systematically and in scalable ways to increase happiness, not just GMV at all costs. Now, back to the interview.

This feels like the moment that a company would start really thinking about Level 3, which I'm going to paraphrase here and it's going to be maybe too aggressive of a paraphrasing, but when you know you have an advantage, press it. Does that feel encapsulation?

Sarah: Yeah. That's a good encapsulation. I'll provide the why, which is there's this company, Schibsted, that is this online classifieds sites. They did this analysis where they looked across their portfolio of online classifieds and realized that how profitable one of their online classified sites was a function of how much bigger that site was relative to the number two in its particular market. It’s kind of back to that winner-take-most idea, which is that the bigger you are relative to the number two, the more value you're able to create and therefore capture.

To your point, Ben, if you have that opportunity, something's tipping, and you're ahead of your competition, then you've just got to double down on that and push and push and push. It's not enough to be number one. You have to be number one by a mile in order to really create the value that we all look for in these companies.

Ben: Sarah then walked us through how that value creation isn’t just for the company and its shareholders, which of course benefit, but that acceleration to be number one by a mile has value that accrues to customers and suppliers on the marketplace too.

In the rest of the episode, we do a lightning round on other consumer business models. Consumer social, content, the rare consumer SaaS business, and how gaming and social are merging into one. If you want to hear the whole episode and go deeper with us specifically on consumer investing for the full hour and get access to all of our VC fundamentals episodes, you can click the link in the show notes or become an Acquired Limited Partner.

Of course, all new members get a 7-day free trial and you’ll get access to the other LP benefits such as the book club, chats with some of our book club authors, and LP calls about once a month with David and I.

Thanks so much for listening and we will talk to you next time.

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