The data-intensive, high-bandwidth information era has created massive improvements in economic efficiency. Our roads have been transformed into a consumer product delivery network ruled by those ever-present parcel delivery companies. Internet and data bandwidth provides a superhighway to deliver entertainment and all manner of digital-based information products and services. Large platform companies have persistently created market efficiency as digital brokers providing a virtual marketplace panoply.
Platforming can be very lucrative. Providing products, services, or related content to the platform is a path to being a MILLIONAIRE. Becoming the fly-wheel platform for that content is the path to being a BILLIONAIRE. Just ask Amazon’s founder, Jeff Bezos!
This article builds on the marketplace economic foundation, starting with Adam Smith and the founding of America. The development process of platform companies and the capital investment infrastructure supporting these companies is examined. Then, company models are explored - some are working well, like Spotify and Amazon. Also, company models that are not working well are explored, like the property management firm Vacasa. Observations are made about the challenges and opportunities to improve the platform economy. A criteria-based platform environment assessment approach is offered to score platform companies. The multi-criteria, multi-alternative decision evaluation platform, Definitive Choice is suggested to help investors, founders, or consumers uncover the strengths and weaknesses of platform opportunities.
Table Of Contents
Introduction
Economics and Human Nature
The platform company's capital development process
The three platform company phases
The platform environment that works well
The platform environment that does NOT work as well
Public company behavior – short-term profit tradeoffs, a Vacasa example
Adam Smith got it right
Conclusion, Resources, and Notes
About the author: Jeff Hulett is a career banker, data scientist, behavioral economist, and choice architect. Jeff has held banking and consulting leadership roles at Wells Fargo, Citibank, KPMG, and IBM. Today, Jeff is an executive with the Definitive Companies. He teaches personal finance at James Madison University and provides personal finance seminars. Check out his new book -- Making Choices, Making Money: Your Guide to Making Confident Financial Decisions -- at jeffhulett.com.
2. Economics and Human Nature
Human Nature:
The market economy and platform companies are an expression of human nature. The invisible hand, popularized by Adam Smith over 250 years ago still matters. [i] Modern, digital marketplaces are certainly transforming the traditional market environment. However, the needs of people participating in those markets hardly change over time. People are still people. Our need to trust who we do business with is important and has not changed substantially over millennia. The need to clearly communicate our desired product and service qualities is essential. People still have complex self-interests, including dynamic interactions between selfish and selfless motives. As Adam Smith said:
"Man naturally desires, not only to be loved, but to be lovely."
People’s mental quirks, called cognitive biases, are still at play. We are still likely to overweight the present and discount the future. People are still risk-averse - with uncertainty often causing behaviors far more conservative than the risk-adjusted situation calls for. People still express a “failure of invariance.” [ii] This is a phrase made famous by Nobel Laureate Behavioral Economist Daniel Kahneman and Amos Tversky that means people naturally possess decision quirks causing them to change their minds at different moments and in various situations. This means the traditional, comfortable definition of rationality as a single point is not the way people behave. In practice, individual rationality is user-defined, variant, and situationally dependent. [iii] A failure of invariance means that the best reason given for someone's past decision is often:
"It seemed like a good idea at the time."
People's failure of invariance is why marketing works in the first place. It is the opportunity to influence our natural variance that marketers seek to exploit. Thus, when it comes to the success or failure of the platform economy, the following timeless aphorism rings true. It reminds us that while 'how' our needs are met may change, the nature of those needs hardly change.
"The more things change, the more they stay the same."
While the long-term economic efficiency gain of the platform economy is still being realized – intuition suggests those gains are massive. The intuition is that economies of scale and reduction in marginal costs associated with road or digital delivery are tremendous.
Road efficiency premise: The fact that a) people do not have to drive anywhere - relieving the opportunity costs of driving time, car maintenance, and/or fossil fuels and b) all people have to do is plan a day or 2 ahead to buy a consumer product is massively efficient. Instead of traveling to a local market with limited choices, people can access a global marketplace with virtually unlimited choices. Amazon, eBay, and other consumer product companies have made the entire world 1-2 days away from our front door. The road efficiency premise provides a big societal win by keeping down individual costs and environmental externality costs - all the while - increasing consumer choice. [iv]
Digital delivery efficiency premise: The fact that a) people can listen to exactly the song they want to, when they want to, and listen to an almost infinite number of songs for b) the annual price of a couple of yesteryear albums is tremendously efficient. The quality and availability of music have exploded because of platform companies like Spotify. Whether music or many other digital products and services, the increase in efficiency and reduction in cost is driving massive economic gains. There is also an environmental externality benefit to the digital delivery premise. In yesteryear - carbon-intensive music delivery products were the mass production standard - such as vinyl and plastic production for LPs, cassettes, CDs, and iPods. In today's world, digital delivery includes a reduced tragedy-of-the-commons-based environmental marginal cost by leveraging existing infrastructure, like iPhones and internet bandwidth.
Some suggest the platform economy byproduct poses challenges to those negatively impacted by platform marketplaces. The question may be, “Is the platform economy like a hammer looking for a nail? Where consumers and producers are forced to bend to the will of the platforms?” The answer is “Of course, there are challenges to some in the innovation transformation process.” If a producer used to sell things or a consumer used to buy things in a different market context than the current digital platform market, they need to adapt if they wish to realize the massive efficiency benefits. That is the way innovation works. This is the beauty of market economics, growth, and adaptation.
Creative Destruction:
The legendary Austrian economist Joseph Schumpeter called the changes brought about by platform marketplaces ‘Creative Destruction.’ [v] The trappings and routines of our lives change as society creates economically efficient innovations and people vote with their feet to accept or reject those innovations. There are winners and losers with creative destruction, but on average, society is a big winner. Individual winners within society achieve innovation benefits based on their ability or willingness to adapt to those innovations.
Creative destruction in action: 20 years ago, a 50-year-old may have voted "nay" for the new iPhone released at that time. They wondered why anyone would want such a silly device. It had little benefit because they were comfortable in the world as it was at that time. That world identified with paper, floppy disks, VCRs, snail mail, photo prints, and home telephones. Today, that same person, now 70, votes "yay" for the iPhone and many other technologies that have come of age. They cannot live without their iPhones and are receiving the massive benefits accruing from creative destruction. Today's older 70-year-old 'self' has adapted, whereas their younger 50-year-old 'self' had not yet adapted.
Creative destruction winner: The acceptance and scaling of the iPhone platform and those identifying with the iPhone's benefits.
Creative destruction loser: The VCR, floppy disks, home phone manufacturers, photo developers, and those not identifying with the iPhone's benefits.
Net, net, society wins: Society in total is the big winner after netting creative destruction's winnings and losings. How do we know that? Because Apple, the maker of the iPhone, is one of the most highly valued companies on the planet. Apple's customers and investors have voted with their feet.
That is, until the next big thing comes along to disrupt the iPhone.
Regulatory support for innovation:
Some of the critical U.S. regulations supporting innovation are the U.S. Bankruptcy law and the Limited Liability Company ("LLC"). Bankruptcy and the LLC encourage innovation by giving innovators some downside protection if their innovation is unsuccessful. Also, the U.S. generally follows a permissionless innovation approach. This is where, unless an innovation creates a specific harm to society, innovation is free to proceed. Permissionless innovation traces its roots to 1791, The Bill of Rights, and the ratification of the 10th Amendment of the U.S. Constitution. This is where powers not delegated to the Federal government are reserved to the States.
The 10th Amendment of the U.S Constitution is the green light for innovation.
This 'reserved rights' precedent empowers innovators. Thus, unless explicitly regulated, innovations are reserved for those who wish to innovate. Countries like the U.S. are successful because there is a direct correlation between freedom and innovation. The technology hub of Silicon Valley exists because of permissionless innovation.
Insatiability:
Creative destruction is the outcome of innovation necessary to support people’s natural insatiability. Early 20th-century economist and sociologist Thorstein Veblen’s great observation about people’s natural demand insatiability is certainly relevant [vi]:
“Invention is the mother of necessity.”
Notice Veblen’s pithy reversal of ‘necessity’ and ‘invention.’
But invention is not enough. Bringing inventions to the market requires hard work, adaptability, and the luck found in innovation and those innovating. So, a necessary add-on to Veblen's aphorism is:
Innovation is the mothering of invention
The Insatiability Cycle
An insatiable example: The evolution of music delivery
The next graphic demonstrates how music delivery has evolved by attracting capital and improving quality as signaled by increased market value. People's insatiable desire for music has been met with music delivery innovation. Human insatiability appears to have no upward bound.
Similarly, platform providers equally feel a sense of supply insatiability. After all, companies are made of people. The platform companies wish to grow. In the platform company’s early phases, the fulfillment of insatiable desires is revealed by the growth of consumer demand for the marketplace platform. People are free to vote with their feet and when the platform gets it right, demand will accelerate. The marketplace supply responds with insatiable growth of its own. In the platform company’s later phases, the supply insatiable growth desire often leads to vertical integration as a producer. For example, Amazon is now a producer of products for the marketplace, called Amazon Basic. Netflix is now a movie studio, providing movies to its entertainment marketplace platform.
Economics:
Economics is alive and well because of human nature's insatiability, our failure of invariance, our genome, natural selection, and cognitive biases. Ironically, the most invariant part of human nature is its likelihood to be consistently variant over millennia. Our brains and related decision-making habits are VERY slow to evolve.
Next, discussed is the typical platform company's journey. This describes how the platform economy realizes the great societal benefits while navigating human nature, creative destruction, insatiability, and our common economic mindset. The process is Darwinian, where only a minority of companies that start the process ultimately survive.
3. The platform company's capital development process
The move to the platform economy, like many massive transformations, grows in fits and starts. Capital flows to many innovators, some innovations work and many do not. In fact, investment capital provider companies’ batting average for successful portfolio companies is well below .500. The investment capital model is to invest in many high-potential innovation companies, scale the ones that work, and quickly sunset those that do not. It is a statistical game that works because the upside of the winners more than pays for the cost of the losers. We will discuss an ecosystem of investment capital providers, including Venture Capital, Private Equity, and Public Equity Markets.
Capital Development Model:
Platform companies have 3 capital phases characterizing their growth. As we show in the following section, each capital phase is associated with a type of capital provider. These capital providers specialize in the capital needs of the particular phase.
In the next section, each of these phases is more fully described, along with the typical capital providers for each phase. At the end of the next section is an Investment Capital Ecosystem summary graphic.
Most companies either do not make it to Phase 3 or must significantly adapt their business models to make it to Phase 3. Successful innovators must adapt as the preferences of the fickle consumer are revealed. There is a big difference between having a good idea or invention and the hard work, tenacity, and risk-taking required to innovate, scale, and adapt to consumer preferences. Thomas Edison, the innovator who brought the world the light bulb, comments on the hard work of innovation [vii]:
“Genius is two percent inspiration; ninety-eight percent hard work.”
4. The three platform company phases
Phase 1 -- Good ideas and high-energy founders willing to take innovation risks to attract capital.
Phase 1 Investment Capital Provider: Friends & Family, Angel investors, Venture Capital
Phase 1 starts with a good idea. This is the early stage where only the most innovation-available customers try the new thing. The new thing usually fills a demand gap and/or provides efficiency well over existing providers. But getting people to try 'the new thing' is always a challenge because people are naturally risk averse.
To support the founder’s innovation, capital flows in via early-stage funding and idea development support. At this point, the innovator may or may not have revenue demonstrating customer demand. Capital is attracted to a good idea, the quality of the founding team, and the early-stage demonstration of innovation demand. At this stage, the founders are VERY important because the capital providers know much testing and adaptation needs to occur to properly innovate. Also, the support of idea incubators is common early in the innovation process. Idea incubators help foster network effects. Feedback and input from credible sources are essential in the good idea phase. The mindset and abilities of the founder team are essential to success. It is often said Venture Capitalists invest more in founders’ adaptability than the business plans. [viii]
The legal environment does not see the new entrant as anything other than an entity that needs to follow existing rules. Because market economies like the U.S. generally provide ex-ante law, the rules are established in advance so the innovator can innovate given a known and reasonably stable rule set. This is very important. Varying and fickle ex-post laws as found in totalitarian countries make innovation almost impossible. We don't always like the laws, but at least we know what they are!
Existing rules MAY be more tolerant of smaller companies struggling to get started. For example, when AirBnB started, the municipal taxing authorities generally ignored hosts that allowed guests to stay with them for a couple of nights. This meant sales, lodging, and other municipal taxes were not enforced. AirBnB was small and committed to helping people get places to stay. Without AirBnB, their guest customers would pay more for traditional lodging, if it was available. It allowed hosts with excess capacity, like a bedroom in a house, to provide less expensive housing to those in need and potentially in locations with few alternatives. It was a win for all and generally below the radar screens of both taxing authorities and hotel chains. As we will discuss in later phases, the legal grace shown to smaller companies is likely peeled away as they successfully grow larger. As a fine point, there is an important difference between the knowledge of an ex-ante rule like taxation or consumer protection and whether or not the legal authority chooses to enforce the rule.
Another example of small company legal grace is in FinTechs and the CFPB. "FinTech" is a general name for smaller firms focused on financial industry innovation. The Consumer Financial Protection Bureau ("CFPB") is the U.S. regulator that enforces consumer financial protection laws on financial services companies. The CFPB was created by the Dodd-Frank Act as a result of the 2008-09 financial crisis. The number of regulations has dramatically increased since this time as well as the costs to those financial firms to implement regulations. The CFPB has an explicit minimum size of a regulated entity in its regulatory enforcement scope. This does NOT mean consumer protection laws do not apply to smaller FinTechs. It simply means the CFPB is less likely to enforce those laws until the FinTech gets larger. Thus, this keeps regulatory costs lower for smaller companies to encourage financial innovation.
At the end of Phase 1: Venture capital and related investment capital may be replaced by private equity capital providers. Phase 1 investors harvest their gains and fund another batch of high-potential companies seeking Phase 1 funding opportunities.
Phase 2 -- Growth stage when the platform business gets traction.
Phase 2 Investment Capital Provider: Private Equity and Investment Banks
Once the platform company finds some level of market acceptance and has found a path to profitable growth, it hits the accelerator. This means the new thing has been innovated, demand-tested, and fine-tuned to the point where demand has been confirmed and a path to scalable growth has been identified. There are still risks, but the uncertainty is giving way to more customer demand and a clearer path to profitability. It is an exciting time when the founders lead their platform companies from smaller to larger. Innovation is still important, but the innovation focus shifts from demand identification to scaleable growth.
The capital providers play an important networking role in connecting the high-growth, Phase 2 company with needed support services typical of a more mature business. These support services are technology providers, risk management, data science, accounting and finance, and others. The idea is to let the founder and the startup team focus on customer growth and take the less strategic but still important business activities off them. The capital providers also may become less patient. They may restrict capital to revenue-producing activities instead of testing additional innovations associated with Phase 1. It can create a natural tension between the start-up company culture and the capital owners. The founder may feel stuck in the middle.
At the end of Phase 2: Private Equity and related capital providers will often get bought out at the end of Phase 2. Phase 2 investors harvest their gains and fund another batch of companies transitioning from Phase 1 to Phase 2.
Phase 3 -- Public buy-out.
Phase 3 Investment Capital Provider: Public Equity markets
At this stage, the private capital providers are looking for an exit. This is after the platform company has grown significantly and the initial investment may be worth 10x or more. In the U.S., the public markets are generally SEC registrants selling their equity shares on the major stock markets. The public markets generally have different financial expectations. SEC registrants report profitability every 3 months. The public company incentives generally attract professional managers adept at driving quarterly income. Longer-term investment and innovation become more challenging. The incentives for short-term profits may create short-term thinking.
For example, that same, cuddly AirBnB company of yesterday is a behemoth public company today. The taxing authorities have caught up with the AirBnB platform. The competition with hoteliers and other traditional lodging companies is intense and the difference in prices has all but evaporated.
The Phase 3 behaviors are not always positive. For example, Airbnb plays the “hide the price game” by burying the final price behind a selection wall. The platform enables playing games with cleaning fees and other “junk fees” that make it challenging to compare prices. As a former consumer banker, this behavior feels patently inappropriate. If AirBnB were a mortgage company, they would be breaking several Truth In Lending laws. [ix]
The next table describes the phase and phase transition characteristics of the platform companies assessed for this article. Vacasa and AirBnB are the youngest phase 3 platforms. Vacasa and AirBnB are also the only platform companies to transition to Phase 3 after the pandemic's beginning. Vacasa and AirBnb have the shortest Phase 3 transition following the prior economic downturn. This means the environment into which Vacasa and AirBnb phase transitioned was less stable compared to the other platforms. We will discuss Vacasa more in sections 6 and 7.
At the end of Phase 3: Phase 3 is the terminal point for the platform company's capitalization ‘happy path’: Other than continued growth as a public company, potential Phase 3 transition exits include merger, acquisition, spinoff, and bankruptcy.
The founders and innovation effect: The founders often get kicked to the curb in deference to public company managers. This is the definition of being a ‘serial entrepreneur.’ A founder builds something really cool that ultimately gets bought out in Phase 3. The founder then returns to Phase 1 to develop their next innovation. For many founder-innovators and their capital providers, successful innovation is more process-oriented than product-oriented. Innovators are more likely individuals who can successfully manage the innovation process. When predicting a founder's success, the founder's mindset and ability to manage the innovation process are generally weighted higher than the thing being innovated. A good innovator is more likely to adapt the thing being innovated as needed to enable success. There are exceptions to the 'serial entrepreneur' rule. Jeff Bezos is an example of a founder successfully making the Phase 3 transition.
Innovation is not always rewarded in Phase 3. The Phase 3 company’s focus on short-term earnings is not always a bad thing. This suggests market demand has voted with their feet and deemed the product or service as meeting their needs. The public markets and customers may wish the company to stay in its product or service swim lane. In effect, Phase 3 naturally defers to Phase 1 for innovation.
To be fair, some large companies do innovate. However, the innovation context for a Phase 3 platform is very different than a Phase 1 platform. The relatively rigid structure required to support the size of a Phase 3 company is the very structure that makes it challenging to innovate like a Phase 1 company. This rigidness also creates fragility and makes a Phase 3 company more susceptible to disruption. It is the degree of rigidity that enables the Schumpeterian creative disruption. The more rigid Phase 3 company creates the opportunity for a Phase 1 company to innovate. This rigidity creates demand gaps where insatiable consumer demand is not being met. Phase 1 companies seek to fill the gaps. Since the 1950s, the average age of companies has dropped from about 60 years to less than 20 years today. [x] This suggests that the phase-based creative destruction is only accelerating.
Investment Capital Ecosystem
In the next 2 sections, a platform economy environment assessment approach is introduced. This assessment may be used by:
The consumer to clarify whether they should use a particular platform.
The investor, to determine whether their capital should fund a specific platform innovation solution.
5. The platform environment that works well
The complexity of the sales process is a significant driver of a platform company’s success. Think of the sales process as another way of communicating “the provision of information” or “the uncertainty level.” The platform sales process provides a set of information about products or services (supply) available to the customer (demand) enabling the customer to decide which product or service alternative is the best for them. Uncertainty is the degree to which the product or service information is not complete or otherwise leaves an information gap as to the outcome of that product.
Platform assessment example: Next, is an example of the criteria and rating for a high-potential platform environment. The criteria and rating are found in parenthesis and summarized in the table below the assessment narrative.
Amazon provides a marketplace platform for relatively simple consumer goods, like shoes. (criteria = low product complexity) The products are generally delivered as quickly as needed by the buyer (criteria = immediate delivery) They use AI-based next-product models to help customers decide. (criteria = high information provision) Netflix provides a marketplace platform for relatively simple entertainment goods, like movies. Similarly, Netflix uses AI-based next-show models to help customers decide.
Importantly, the uncertainty is relatively low. People generally can find a product or entertainment that works for their immediate needs. This means the price generally signals the full costs associated with the product and there is no or very little likelihood of unexpected costs arising later. The uncertainty associated with the product is relatively low and there are credible customer ratings to help reduce uncertainty. (criteria = high uncertainty reduction) Also, of importance, in the event the customer needs are not met, the severity (or loss) is relatively small. They can always get another show with only the cost of their time, attention, or a small charge for an unwanted movie or product. (criteria = low uncertainty severity)
This is the best rating for a high-potential platform environment. The next section provides the case for when the rating is lower.
The platform environment assessment approach and tools are described in the resource section at the end of the article. Platform founders, investors, or consumers may use the suggested smartphone tool to evaluate which platforms are best for them.
To summarize: The 5 platform company environmental market criteria for what works well:
The maximum work well platform environment scorecard = 25, A+ grade
Next, is a partial listing of the many platform companies falling into the work well platform environment category. If a platform environment is assessed as a B- or better, its environmental conditions are considered supportive of a well-working platform. These are rated as highly graded environmental platform companies. To some degree, they have already gobbled up the low-hanging fruit.
Facebook – Social community, B+
Google – Search, A-
Amazon – Consumer products, A+
eBay – Consumer products, B+
Netflix – Consumer entertainment, B
Spotify – Music, A+
AirBnB – Lodging, B-
6. The platform environment that does NOT work as well.
Now, let’s use our 5 criteria to evaluate the challenges to the platform economy. Many platform companies look to push below some or all the 5 highly rated criteria to provide other market platforms. These platform companies are meeting mixed results. Let’s use the property management platform Vacasa as an example.
Author's disclosure: The author has utilized Vacasa’s property management services on multiple properties. The author is also a frequent renter of properties managed by Vacasa. As a result, the author has an insider view as both a consumer of and an owner-provider of the Vacasa property management platform.
In the lodging rental ecosystem, the lodging is delivered downstream to the guests after the renter selects the property via AirBnB, VRBO, or related lodging rental sales platform companies. The criteria rating for delivering rental property is very different than facilitating the lodging rental sale. This is where Vacasa’s market platform plays, in the property management delivery space. Let’s walk through the 5 criteria model and rating for a property management firm like Vacasa:
Product or Service Complexity: Medium-Low
Property management is significantly higher in complexity than the initial lodging sale. The property manager handles all the details of maintaining the property, beyond the marketing of the property. The details are often labor intensive, like fixing property issues, handling client complaints, managing home cleaners and maintenance people, etc.
Product or Service delivery timing: Future
The time of property delivery occurs in the future after the initial sale. Time (and entropy) may work against the property manager's job to deliver on the expectations set at the point of rental sale.
Information provision: Medium
There may be a difference between a property’s pictures and the guests’ expectations at lodging rental sales and the actual condition of the property at lodging rental delivery.
Uncertainty level: Medium
AI tools are not as powerful to help reduce uncertainty. Rental properties are less standardized. The platform relies on the reputation generated by past guest ratings. These ratings may be gamed and past ratings may not be indicative of future outcomes. As explored in sections 8 and 9, there is a higher chance of unseen costs such as moral hazard.
Uncertainty Severity: Medium
The cost of getting a lodging decision wrong is certainly higher than smaller consumer product decisions like shoes. The ability to remediate unexpected rental product delivery challenges may be limited. Also, the purpose and length of property stay matters. A renter who is only staying for a night or two for work will likely have very different severity concerns than a two-week destination vacation with their family. This environmental criterion was rated an average of 4, but could easily be lower based on purpose and length of stay.
Vacasa and property management’s platform environment what does NOT work as well scorecard = 16, C- grade
Vacasa is a Phase 3 platform. They went public in December 2021. One may ask, “How did Vacasa reach Phase 3 with a C- platform environment rating?” Great question. Next are a couple of potential answers:
As the prior phase 3 transition chart shows, Vacasa went public about a year after AirBnB. Since Vacasa is downstream in the same rental property value chain, there may have been an association with investors that a successful public offering for AirBnB should bode well for Vacasa. However, as we discussed earlier, the environmental conditions between rental sales and property management of rental properties are different. Thus this association appears to be less-than-accurate. This sort of inaccuracy is a commonly occurring cognitive bias known as "representativeness bias."
Let’s face it, other platform companies have reached Phase 3 that, as time and experience revealed, were not good long-term investments. Have you ever heard of WeWork, the provider of coworking spaces? They provide a market for commercial real estate and office demand. In 2019, their attempt to transition to a phase 3 public company failed. They remained in Phase 2, owned by private investors, including SoftBank. In 2023, WeWork filed for bankruptcy. In this case, Phase 2 investors were left holding the bag. Oops!
By the way, a Phase 2 investor like SoftBank holding the bag for WeWork is the exception, not the rule. Phase 2 investors are notoriously good at selling before a market top and leaving the public markets to deal with businesses lacking business cycle resilience. Pets.com was an early platform company example. Pets.com's PE owners sold just before the massive "Dot.com" bubble burst market sell-off and the resulting recession. Pets.com went out of business not long after its Phase 3 transition. This occurred in the 2000-2001 time frame.
More recent 'just in time' Phase 2 to Phase 3 market transitions occurred in the financial services industry in 2021. This occurred just before inflation wreaked havoc on traditionally low interest rates driving the mortgage business. Notable examples include:
Quicken "Rocket" Mortage went public on 8/14/2020 - Ticker symbol = "RKT". It went public at $25 / share. On 1/22/24 it trades at $12.83.
Finance of America Mortgage went public on 4/1/2021 - Ticker symbol = "FOA". It went public at $10 / share. On 1/22/24 it trades at $.93.
Interest rates have increased dramatically since these mortgage companies went public around 2021. Higher rates cause mortgage demand to drop significantly.
On April 1, 2021 - the typical interest rate was a historically low 3.18%.
On 1/18/2024, typical interest rates are a mortgage demand discouraging 6.6%.
The timing of the Phase 2 to Phase 3 transition occurred just before an inflation-catalyzed mortgage rate increase. This timing makes the Phase 2 PE firms look brilliant and the Phase 3 investors appear less wise.
7. Public company behavior – short-term profit tradeoffs, a Vacasa example
The transition to a public company usually includes many promises. The promise made to the Phase 3 public investors is that shorter-term profit objectives will be met. Earning per share (or "EPS") and EPS growth are almost always central to the public investors' motivations. Speed of valuation accretion is usually a big promise. This essentially means that for the new Phase 3 company to meet public investor’s shorter term profit goals; the Phase 3 professional management need to take out cost in the short term. This is VERY tricky and needs to be handled VERY well. This is not to say that some longer-term investments are not made, however, the weighted premium on short-term performance increases significantly.
In the event investor accretion promises are not handled well, this may sow the seeds of future trouble for the Phase 3 platform company. The companies with the higher platform environment score are more likely to handle this transition well. In effect, they have a more amenable environment in which to make those changes. A platform company with a lower platform environment score is less likely to be able to make the transition. They may end up more like Pets.com.
Vacasa example – Short-term behavior contrary to long-term success: The following are company behavioral examples that, along with a lower platform environment grade, reduce the chances of long-term company success:
Centralized infrastructure creates limited local market penetration – Vacasa is large, but their actual market penetration in local markets tends to be relatively small compared to other property managers. That is, smaller, traditional property management companies tend to dominate individual local markets. Because Vacasa manages a very centralized infrastructure, they are susceptible to being dominated by local players with unique and significant local market knowledge. The smaller company's dominance enables them to create strong local networks of maintenance and cleaning contractors. This local focus creates strong referrals and loyalty from previous renters.
Drive for efficiency reduces property and service quality – Vacasa has made several operational changes that enhance the efficiency of their operation at the expense of their owners’ property's long-term quality. Next are 3 examples: 1) Loss waivers and moral hazard, 2) Flexible cancelation policy and reduced skin in the game, and 3) Standardization and service quality reduction.
1) Loss waivers and moral hazard: Vacasa uses a loss waiver insurance approach instead of the traditional deposit approach to manage potential property damage from the renter. The loss waiver approach allows renters to “buy” their way out of treating the property well since they have bought insurance giving them a license to mistreat the property.
What is Moral Hazard? Moral Hazard is a time-tested risk management and economics concept. Moral Hazard is the degree to which an undesired outcome is caused by an intervention intended to lessen that undesired outcome.
Car insurance is a classic example. An "intervention" like a low deductible auto insurance policy has been shown to increase costs to insurers. This occurs because people with low or no deductible auto insurance policies tend to drive more dangerously and have more accidents - of course, this is "an undesired outcome." After all, the insured has so little skin in the game and motivation to drive safely because the insurance covers the losses. That is why low deductible insurance "intended to lessen the undesired outcome" is much more expensive than higher deductible policies. Insurers must charge more to offset the increased auto claim costs for low deductible policies.
Unfortunately, damage to rental properties does occur. Chronically occurring damage is likely to increase owner costs and decrease the market value of the property. In the case of property management, the traditional deposit or loss waiver alternatives are the "interventions" intended to "lessen the undesired outcome" by providing compensation to the owner if the renter causes property damage.
This is where moral hazard flexes its value-reducing muscles. Deposits or loss waivers are very different in a way that causes populations of renters to self-select.
Property respectors are the renter population more likely to self-select to pay the deposit. They see the deposit as something they get back because they treat the property well. Respectful renters see the flat loss waiver fee as paying for other people's bad behavior. The property respector attitude is "I treat it like I own it."
Property mistreators are the renter population more likely to self-select to pay for a loss waiver. Since they are more likely to mistreat the property, they see the insurance cost as less than the cost of the deposit likely not to be returned. The property mistreator attitude is "It's a rental...."
Please note: The "property respector" and "property mistreator" populations describe each side of a property treatment moral hazard spectrum. As shown at the bottom of the next graphic, moral hazard is best considered as a likelihood or probability existing somewhere in between.
Vacasa’s loss waiver approach creates a higher MORAL HAZARD for its owners. On average, property mistreatment and maintenance costs for Vacasa-managed properties will be higher than for deposit-based property management because more abusive renters are attracted to the loss waiver approach. Also, because of this moral hazard, owners of loss waiver-managed properties are more likely to be more tolerant of property mistreatment and a lower renter experience. Loss waiver-related moral hazard creates a negative, reinforcing feedback loop between the owners, renters, and the property condition.
The point is that platform company operating behavior may cause higher or lower moral hazard leading to higher or lower property costs. In this case, the loss waiver encourages higher-cost property mistreatment and the deposit encourages lower-cost property respect.
The big rub is this: Vacasa does not give its owners the freedom to choose the renter damage protection approach. Vacasa owner clients MUST use loss waiver insurance and do not allow deposits. For Vacasa, loss waivers are much easier to administer. Vacasa does not have to keep up with a deposit escrow and administer claims against the deposit. So Vacasa is putting the long-term negative moral hazard effect on its owners and gets an added efficiency benefit. It is a "win-win" for Vacasa and decidedly a "lose-lose" for the owners. Unfortunately for many owners, they do not fully understand the long-term impacts of moral hazard. Owners are unwittingly increasing their costs and reducing property value, even though Vacasa sells the loss waiver as a benefit to reduce owner costs.
Where are the FTC and "truth in advertising" when you need them?!
2) Flexible cancelation policy and reduced skin in the game: The dependence on third-party sales and marketing platforms, like AirBnB or VRBO, is a challenge – mainly because the large rental sales platforms often encourage flexible cancelation policies. In the name of rental reservation consistency, owners need their renters to have skin in the game so they will share in the loss if they back out 90 days or less before. Traditional property managers tend to have skin-in-the-game-creating cancelation policies requiring upfront deposits from prospective renters. Upfront deposits allow both property owners and renters to share the risk of the property not being utilized during the time reserved by the renter. Flexible cancelation policies mean the cancellation risk is put on the owner.
3) Standardization and service quality reduction: The drive for efficiency promotes process standardization and organizational silos. Standardization and organizational silos only work in high-volume, highly homogenous environments like a car factory. Effectively, Vacasa is organized to produce a highly standardized product at high volume, even though property management continues to be a very heterogeneous, locally unique service. As an example, the Homeowner Associations in which most owner properties reside are very different and exhibit peculiar local customs. This means property management service quality is more likely to suffer because of gaps. This may create a frustrating environment for the renters or owners who have to fill the service gaps left by Vacasa.
A technology-first mindset reduces the priority of the important people part of the property management business - There is no doubt that Vacasa has amazing property management technology. However, Phase 3 budgets are fixed. Thus, the technology-first focus constrains available budget resources and attention from other important property management needs. Property management is intensely local and generally requires a hands-on approach to manage the dynamic environment. The technology-for-people talent and treasure trade is manifest by overloading local property management personnel with heterogeneous, higher-touch properties. The result is often burnout and high local operations turnover. This makes a challenging situation worse for renters and property owners depending on the client experience since the local people frequently lack experience and availability. Technology is like a shiny toy. While the shiny toy is fun to play with now, the renter and owner will soon forget the shiny tech toy if it is not backed with a high-quality property rental experience.
Playing the ‘hide the rate game’ with the rental sales platforms - The final price provided to the renter gets loaded with lots of “junk fees.” The prices are not always easy to compare across alternatives. Also, the loss waiver is associated with the 'hide the rate game.' Moral hazard is a significant but challenging-to-detect problem. As time goes on, the renters may determine the value received is not worth the price, especially when smaller local property managers can deliver high quality at a lower price. At the end of the day, a business model that, in part, depends on fooling its customers or owners should not be worthy of long-term platform success.
The tremendous property management opportunity – Reducing uncertainty, delivering an excellent renter experience, and closely partnering with property owners is the market opportunity. As the current property management and Vacasa's platform environment assessment score suggests, this is a challenge much greater than the low-hanging fruit available to platform companies like Amazon and Spotify. Using AI tools and trust algorithms may help capture the property management opportunity. However, as Vacasa’s score and behavior suggest, capturing the property management opportunity still has significant room for improvement.
8. Adam Smith got it right
We introduced Adam Smith at the beginning of the article. Smith is well regarded as the father of modern market economics and is considered one of the greatest economists that ever lived. [xi] Smith's work is most impressive because it has passed the great validation of time. Countless others have poked, prodded, investigated, and validated Smith's work, 250 years after its creation. One of Smith's timeless human nature deductions is called the "Four Sources of Moral Approval." [xii] Next is an application of Smith's time-tested model to show the very modern platform economy challenge. Vacasa and its property management platform are provided as an example.
The four sources of moral approval are:
Approval of the giving agent. This is the economic supply or the property owner providing property to the rental market.
Approval of the receiving agent. This is the demand of the property renter desiring to rent property.
Approval of the interaction environment. These are the rules or norms governing today’s market interactions. This could be the related property and consumer laws and, especially, Vacasa's behavior acting to facilitate the interaction environment.
Approval of the unseen. This is the long-term and challenging-to-perceive impact of sources 1, 2 & 3. An example is a hidden cost like moral hazard.
All four agents are approving agents to any transaction. It is the 'invisible hand' that guides these 4 sources. It is only when all 4 approving agents have agreed upon a price and other terms of the transaction, that the market is made.
As Smith points out, the 4th source of moral approval is the most challenging, as it is less salient and in the uncertain future. The 4th source does not necessarily have a strong advocate. Smith suggests this is where most people need help. As discussed earlier in section 7, moral hazard is at play based on how the 3rd source of moral approval (Vacasa) is implementing platform rules (the loss waiver). Vacasa's approach creates a hard-to-see moral hazard. Because of its challenge to be seen, Vacasa has craftily hidden a cost by moving it from the visible 2nd source of moral approval - the deposit-paying renter. This cost has been moved to the mostly invisible 4th source of moral approval - the loss waiver and moral hazard. Just like in the case of other externalities such as pollution, the government's role is often to advocate for the 4th source of moral approval. This 4th source advocacy seeks to ensure all costs are born in the transaction price, along with price information associated with the more visible other 3 sources. Circling back to our platform environment assessment framework, the likelihood of moral hazard reduces the 2 "uncertainty" criterion ratings.
9. Conclusion
This article explored the maturity process of platform companies and the capital investment infrastructure supporting these companies. Then, explored were a few company models that seem to work well, some that are not working well, and some observations about the challenges and opportunities to improve platform economy providers. A criteria-based platform environment assessment approach was used to grade a handful of platform companies.
So, will Vacasa go the way of Pets.com and other failed platform companies? The jury is still out. However, if the Phase 3 drive for short-term accretion and EPS outweighs delivery quality, the Vacasa platform may lose both renters and rentable properties to the local providers. However, without intervention, hidden costs like those of moral hazard and the loss waiver may stay hidden from owners or renters for some time. Also, Vacasa may find an equilibrium that works for a subset of renters and owners who do not mind moral hazards and the other challenges mentioned. According to the next chart, though, it does appear Vacasa's Phase 3 investors are voting with their feet. Vacasa'a total market capitalization peaked at $4 Billion not long after its IPO on March 25, 2022. Today, the market capitalization has dropped 95% to .2 Billion. [xiii] Ouch!
But do not count out further property management platform innovation. There is an opportunity for more innovation to close the gap in the local market, as well as to attend to the needs of both the renters and the owners. However, as history shows, the result may be that Phase 3 Vacasa gets disrupted by an up-and-coming Phase 1 property management entrant.
Resources
The platform environment assessment approach uses a criterion weighting and alternative scoring approach. The approach utilizes the time-tested Analytical Hierarchy Process invented by Thomas Saaty. [xiv] The validity of the scoring assessment has been confirmed by cognitive scientists like Robyn Dawes. [xv] Next are the high-level steps for completing the platform environmental assessment criteria for a handful of platform company alternatives:
Specify the 5 criteria most impactful to the platform environment. Typical criteria have been provided as the default. The assessors may add or subtract criteria as warranted.
Clearly define the criteria with the assessment team. Definitions and examples are provided in this article. However, having a dialogue that reconciles private information and the assumptions of the assessors is an essential part of the process.
Weigh the criteria involving a panel of expert assessors. The weighing will consolidate the judgments of this expert panel. Generally, the experts are consumers of the platform services, investors evaluating a platform opportunity, or students of the platform. The criteria model will be the average of all the panel participants.
The criteria assessment is often done in 2 parts. Part 1, the expert assessors independently weigh the criteria. In part 2, the independently assessed part 1 results are discussed, especially those individual assessments that are outliers to the average of the group. The discussion is intended to reveal private information. Then, assessors are allowed to adjust their weights, based on new information revealed. This is an essential step to reduce the impact of groupthink. [xvi]
Each assessor will judgmentally score each platform alternative with the criteria model. As a practice, it is ok for different experts to score the alternatives from those that created the criteria model.
Compare the platform assessment results, indexing to a 25-point scale.
For the platform environment assessment approach, the author utilized Definitive Choice, a smartphone tool providing the criteria and alternative assessment technology.
Notes
[i] Smith, The Theory of Moral Sentiments, 1759
[ii] Tversky, Kahneman. “Rational Choice and the Framing of Decisions” The Journal of Business 59, no. 4 (1986): S251–78.
[iii] Hulett, Becoming Behavioral Economics — How this growing social science is impacting the world, The Curiosity Vine, 2023
[iv] This article generally assumes that more choice leads to more consumer welfare. In a world where available information and choice alternatives are scarce, more choice is likely to lead to higher consumer welfare. In today's information age, the world is more generally skewing away from scarcity and more toward information and alternative abundance. In a world of information and alternative abundance, the premise that choice leads to consumer welfare improvement is not as obvious.
In an information and alternative-abundant world, more choice CAN lead to more consumer welfare. However, the degree to which more choice leads to consumer welfare depends on the decision-maker's abilities and the decision availability of that chooser. Without an able AND available chooser, more choice CAN lead to reduced consumer welfare because the consumer is overwhelmed by the additional data available to inform that choice. Choice architect and psychologist Barry Schwartz sums up the choice concern:
“Learning to choose is hard. Learning to choose well is harder. And learning to choose well in a world of unlimited possibilities is harder still, perhaps too hard.”
Decision abilities and availability may be enhanced, leading to higher consumer welfare. Decision abilities may be improved by the tools of behavioral economics, called choice architecture. Decision availability relates to the time capacity available to the chooser at the time the decision needs to be made. In general, better decision abilities increase decision confidence and the efficiency of the decision-maker. Increased confidence and decision efficiency will lead to increased capacity for decision availability. It is a positive, reinforcing cycle leading to better decision outcomes.
Schwartz, The Paradox of Choice, 2004
Hulett, Achieving the known – how to implement the best information curation framework, The Curiosity Vine, 2023
Choice Architecture available to improve decision abilities, decision confidence, and decision efficiency:
Definitive Choice – a smartphone tool
[v] Schumpeter, Capitalism, Socialism and Democracy, 1942
David Autor does a nice job applying Veblen's insatiability principle to workplace automation.
Autor, Why Are There Still So Many Jobs? The History and Future of Workplace Automation, JOURNAL OF ECONOMIC PERSPECTIVES, VOL. 29, NO. 3, SUMMER 2015
[vii] 1898 April, The Ladies’ Home Journal, The Anecdotal Side of Edison, Subsection: His Estimate of Genius, Start Page 7, Quote Page 8, Column 2, Curtis Publishing Company, Philadelphia. (ProQuest American Periodicals)
[viii] Fratto, 3 ways to measure your adaptability -- and how to improve it, TED Talk, 2019
[ix] The Truth in Lending Act (TILA), 15 U.S.C. 1601 et seq., was enacted on May 29, 1968, as title I of the Consumer Credit Protection Act (Pub. L. 90-321). The TILA, implemented by Regulation Z (12 CFR 1026), became effective July 1, 1969.
[x] Sheetz, Technology killing off corporate America: Average life span of companies under 20 years, CNBC, 2017
[xi] Cohen, GOAT: Who is the Greatest Economist of All Time?, 2023
[xii] Smith, The Theory of Moral Sentiments, 1759
The four sources of moral approval: pp. 326-327, par. VII.III.32: "When we approve of any character or action, the sentiments which we feel, are...". Thanks to Dan Klein of George Mason University for his Adam Smith scholarship. His interview with Russ Roberts is excellent.
Roberts, Dan Klein on The Theory of Moral Sentiments, Episode 1--An Overview, EconTalk Podcast, The Library of Economics and Liberty, 2009
[xiii] Editors, Market capitalization of Vacasa (VCSA), Companiesmarketcap.com, accessed 1/30/2024
[xiv] Saaty, How to make a decision: The analytic hierarchy process, European Journal of Operational Research, Volume 48, Issue 1, Pages 9-26, 1990
[xv] Dawes, The robust beauty of improper linear models in decision making, American Psychologist, 34(7), 571–582, 1979
Dawes' work has been validated by several others, including Daniel Kahneman:
"The immediate implication of Dawes’s work deserves to be widely known: you can make valid statistical predictions without prior data about the outcome that you are trying to predict. All you need is a collection of predictors that you can trust to be correlated with the outcome."
Kahneman, Sibony, Sunstein, Noise: A Flaw in Human Judgment, 2021
[xvi] Janis, Groupthink: Psychological Studies of Policy Decisions and Fiascoes, 1982