Platform Business vs. Pipeline Business: How to Leverage Your Network

Platform businesses of all kinds are hot in the startup world, but even pipeline businesses can benefit from the principles that make a platform business model successful.

Once the domain of Silicon Valley technology wizards, nontech businesses from WeWork to Sweetgreen are adopting some variation of the platform business model to boost their value.

At their most basic, platform businesses “bring together producers and consumers in high-value exchanges. Their chief assets are information and interactions, which together are also the source of the value they create and their competitive advantage,” according to Boston University School of Business professor Marshall Van Alstyne, Dartmouth College professor of engineering Geoffrey Parker, and platform business consultant Sangeet Paul Choudary, co-authors of Platform Revolution.

Platforms are booming. Understanding what makes them so successful can help owners of any kind of business catalyze growth.

What Makes a Platform Business Different?

It’s important to note that while platform businesses facilitate high-value exchanges, they’re not necessarily the ones directly responsible for providing goods or services the way that pipeline businesses do.

In order to better illustrate this point, let’s use a simple comparison between two familiar businesses: Target, a traditional pipeline business, and Amazon’s marketplace segment, a platform business.

As a pipeline business, Target has relationships with a number of suppliers from whom it purchases products to sell in its stores. Target is responsible for the capital required to maintain inventory and for marketing to ensure customers enter its stores (among many other costs). Ultimately, its goal is to sell the inventory for a markup that takes into account all these various costs.

On the other hand, Amazon’s marketplace business does not maintain inventory and the sellers are largely responsible for their own marketing—which may include purchasing ads from Amazon.

While neither business is a pure example of a pipeline or a platform, they serve as useful references for discussion. By the end of 2020, according to analysts at Marketplace Pulse, Amazon’s platform was worth more than one-and-a-half times its pipeline business. On the other hand, although Target does dip its toes into the platform model with regard to its in-store Starbucks counters, Ulta beauty stores, and Target Plus marketplace, it is still only a very small part of its overall business.

The Network Effect

The benefit of the platform model is due to something called the network effect. According to Van Alstyne, Parker, and Choudary, the network effect describes the phenomenon in which the increase in vendors and shoppers creates an increase in value.

We can clearly see the difference in the example of Target and Amazon.

Thanks to its marketplace business, Amazon is able to benefit from a virtuous cycle: As more sellers join the platform, more buyers are able to find what they want, which leads to more sellers, and on and on. Because Amazon does not have to worry about scaling inventory or paying for marketing, the company is able to continuously onboard new merchants efficiently, which further expands the company’s competitive advantage across the board.

Target, on the other hand, has a finite ability to expand its product offerings, and those decisions are often a zero-sum game. In order to stock one product, Target must move allocation from another product or decide not to carry something entirely. Furthermore, an increase in the number of shoppers at one Target location does not necessarily result directly in additional vendors selling through Target as a whole.

While the network effect could turn from a virtuous cycle to a vicious one—if users rapidly abandon a platform, for example—the companies that have capitalized on the network effects have been rewarded handsomely.

Financial Analysis: Amazon vs. Target

The benefits of the platform model bear out in a financial comparison. Again, it’s worth recalling that while neither business is a textbook example of the business model it represents, the numbers are instructive.

Financial Comparison

Amazon outperforms Target in all the metrics related to balance sheet efficiency. Due in part to Target’s pipeline business model, the company has to keep more than twice as much inventory on its balance sheet as a percentage of total assets. When using enterprise value, or EV, as a proxy for value created by balance sheet assets, this discrepancy becomes even more apparent, since Target has on average 15.38% of its EV tied up in inventory, while Amazon has just 2.21%.

Income generation statistics tell a similar story, with Target needing to spend meaningfully greater amounts on goods sold—70.52% of revenues on average, compared to Amazon’s 60.53%. Likewise, Target spends much more on sales, general, and administrative costs, which include marketing—20.59% versus Amazon’s 7.88%. Amazon’s relative efficiencies give it an EBITDA—earnings before interest, taxes, depreciation, and amortization—margin of 11.91% versus Target’s of 9.25%.

As a result of this overall efficiency outperformance, it is no surprise that Amazon has been able to grow revenues by a simple average annual rate of 29.67% since 2017, while Target has generated only 9.02%.

Markets have consistently rewarded Amazon for this strength (among a number of other factors) with an average EV-to-EBITDA multiple that is more than three times that of Target’s.

How to Incorporate Platform Best Practices Into Your Business

Given all of the potential benefits, it makes sense to apply some platform business model elements into an existing business.

While Silicon Valley may lead people to believe that platforms are a revolutionary model, the argument can be made that platforms have been around for a long time.

Take the fast-food restaurant franchise, for instance. Burger King, which consists almost entirely of franchises, provides a general outline for a restaurant, including menu and branding, but ultimately it is up to the franchisee to provide the value to a consumer. In establishing this network, Burger King takes a commission in much the same way Amazon takes a percentage of sales on its marketplace.

That’s just one example of how incorporating platform practices can benefit a business. Here are some tips to get you thinking about how you can do the same for yours:

Best Practice No. 1: Think “Asset Light”

A platform business has the advantage of fewer assets (inventory and other fixed capital) on its balance sheet. Avoiding asset drag increases the company’s efficiency.

Best Practice No. 2: Increase Commission-based Revenue, Lowering Reliance on Inventory Turnover

The best platform businesses can generate revenue without the costs associated with inventory turnover. Any business that can continue to take a percentage of a transaction between two other parties will be able to scale in a capital-efficient manner.

Best Practice No. 3: Encourage Third-party Value Producers to Incentivize Customers to Join the Network

By putting incentivization into the hands of third-party producers, a platform business can leverage additional members of the ecosystem to help with the marketing of the platform. Effectively, this allows the platform company to outsource some of its marketing and customer acquisition costs.

Best Practice No. 4: Leverage Increased Consumer Demand to Encourage More Producer Participation

This is the opposite side of the coin in Best Practice No. 3. You can nurture a virtuous cycle by bringing in more producers to meet rising customer demand—which brings in more customers, and so on.

Best Practice No. 5: Identify Value to Third Parties Within Your Ecosystem to Create a New Revenue Stream

The classic example of this is social networks—whose entire business model is about providing value to third parties. The bread-and-butter producers and consumers of social content aren’t themselves involved in any financial transaction, but the data they generate within the ecosystem is very valuable to third-party advertisers. Likewise, leveraging the infrastructure your business has built may yield additional opportunities to create new revenue streams.

Case Study: How a Department Store Implements Platform Best Practices

Since best practices may seem abstract on their own, it is instructive to look at a familiar example: a hypothetical American department store.

By almost any metric, the American department store is struggling. With the rise of e-commerce competition and the perpetual expense of real estate, few businesses may be in greater need to implement platform best practices than these former American commerce behemoths.

How are they doing it?

Using Subsidiary Stores to Reduce Their Assets

Rather than remaining solely responsible for sourcing and purchasing inventory (and holding it on their balance sheets), some department stores are allowing brands to rent out space—for example, the way cosmetics brand Sephora now rents space inside JCPenney in addition to mall storefronts. Brands are able to create subsidiary stores and are responsible for holding their inventory on their own balance sheets.

Bringing in Rent and Commissions From Subsidiary Stores

The subsidiary store typically pays the host department store a combination of rent and a percentage of sales. This model is very similar to Amazon, which charges sellers a small fee for being on the platform and then takes a commission on each sale. In both cases, there is less reliance on direct inventory turnover, as the platform is earning a percentage of topline revenue instead.

Encouraging Subsidiary Stores to Shoulder Some of the Responsibility for Attracting Customers

In a traditional wholesale model, the brand receives its revenue when selling to the retailer, while the retailer assumes the risk that items may or may not sell. However, with a subsidiary brand store, the brand carries the inventory risk and thus has greater incentive to provide the sales and marketing required to attract customers.

Leveraging Increased Foot Traffic for Subsidiary Stores to Attract More Brands

Here we see the second part of the virtuous cycle. As more customers visit department stores to engage with the subsidiary store, additional brands may see value in joining the department store. While a department store’s real-estate commitment limits its ability to expand compared to an online retailer, the opportunity to add more brands remains. ### Partnering With a Third-party Finance Provider to Increase Revenue Through Store-branded Credit Cards

This is an older strategy, but almost all department stores have branded credit cards that allow a third-party financing partner to benefit from the transaction between the department store and the consumer. By offering discounts to shoppers using the card, stores can encourage repeat visits, while the financing partner often benefits from higher interest rates than traditional credit cards.

How Can You Implement Platform Best Practices?

With all that in mind, here are the questions to ask yourself as you think about “platforming” your business:

• How might you remove some of the balance sheet risk to the business? In other words, how can the business model become more “asset light”?
• How might the revenue stream become less dependent on asset turnover (typically inventory) and more reliant on commissions or fees?
• How might third parties become profitable producers (or value providers) and incentivize consumers to join the network?
• How might increasing consumer activity help drive additional producers to your company?
• How might third parties find value in the producers and consumers in your ecosystem?

Takeaways

While not every business will be able to—or want to—transition into an Uber or Facebook, that doesn’t mean that business owners shouldn’t think about ways that platform best practices can increase their business’s efficiency.

The most important thing to remember when applying the lessons of the platform to your own business is that even incremental change may have a large positive impact. If nothing else, simply considering how platform best practices could fit into your business could help you find opportunities you might not have realized were there.