Surviving the Shakeout: Where B2B Exchanges Went Wrong

As the dust settles in the Internet shakeout, business owners are realizing that it’s the market that matters – not necessarily the technology.

 

In a new study, Wharton marketing professor George Day, consultant Adam Fein and analyst Gregg Ruppersberger look at the winners and losers in one sector of the Internet marketplace, and come up with key lessons for incumbents and entrepreneurs alike.

 

During the Internet boom, startups such as Metal Site and Neoforma saw opportunities to hook up big buyers and sellers as “business to business exchanges,” aiming to make their money through transaction or listing fees. But new companies entering the B2B exchange market flooded the sector too fast, didn’t carve out individual niches and overlooked the power of incumbent leaders, Day and Fein say. The result: a shakeout cutting the number of exchanges from 1520 in 2001 to a projected 180 in 2003.

 

This kind of shakeout has occurred in new-technology markets throughout the past century, Day says. But the speed of the Internet boom and bust – less than six years, as compared to the usual 20 to 30 – made the B2B exchange market prime for study. “It was an extreme situation, with a very low barrier to entry,” Day says. “Everything happened at Internet speed.”

 

The study, “Shakeouts in Digital Markets: Lessons from B2B Exchanges,” will be published in the winter 2003 issue of the California Management Review.

 

Breakthrough vs. Re-formed Markets

The key to where B2B exchanges went wrong, the study says, is in not knowing the difference between ‘breakthrough’ and ‘re-formed’ markets.

 

Breakthrough markets are every entrepreneur’s dream – a new, level playing field, created by technology, where the assumptions and strategies of existing players don’t help or can even prove to be a hindrance. In an earlier generation, television was a breakthrough market: Between 1941 and 1951, 90 manufacturers entered the marketplace, each experimenting with different features to try to hit the sweet spot of their ‘new economy.’

 

On the Net, meanwhile, eBay is one of the best examples of a breakthrough leader, Day and Fein say. Before eBay, there were few outlets for consumers to connect with other consumers to trade goods. Garage sales and flea markets are erratic and unreliable; eBay created a genuinely new marketplace with customer-centric features such as its ‘feedback’ system for rating buyers and sellers.

 

In breakthrough markets, “a single-minded focus” is helpful, as is “the ability to continuously adapt while resisting the impulse to grow as quickly as possible.” Through smart growth and a first-mover advantage, eBay has secured its position as a profitable leader in the brand new market of consumer-to-consumer sales. They’re now expanding to sell excess inventory from manufacturers to consumers, another previously under-served market.

 

But the B2B exchange market turned out to be more of a ‘re-formed’ market, Day and Fein’s study finds. Re-formed markets use technology to adapt existing ways of doing business, rather than creating entirely new ways of doing business. Instead of creating genuinely new markets, the B2B exchanges were mainly about facilitating interactions and squeezing costs, but they didn’t change the basic structure and functioning of the existing markets.

 

So new entrants in re-formed markets must look at existing leaders, not at other startups, as their true competition. “The odds favor the leading incumbents in markets being re-formed by the Internet and the first movers in breakthrough markets,” the study says.

 

Other online markets fit in various places on the continuum between breakthrough and re-formed, Day says. Portals and search engines, for example, opened up brand-new markets where existing media companies had no advantage – thus the success of Google and Yahoo! But much online retailing is really just a re-formation of the catalog business, so we now see Amazon.com partnering with existing large-scale retailers, such as Target, to prosper.

 

The Downside of Auctions

Many Internet-based B2B exchanges came into the market with the idea that they could lower purchasing costs, the study finds. But that’s not what customers wanted. Suppliers didn’t want to compete in a purely price-focused marketplace, and purchasers stayed with existing channels because of strong customer service and lower lifecycle costs, leaving the new independent exchanges floundering.

 

Usability and security concerns also hurt independent exchanges; private networks offer more efficient logistics and more protection against data leakage, according to the study. “Business customers are very reluctant to disrupt systems that work, particularly when the stakes are high,” says Fein, who has a Ph.D. from Wharton and is now president of Pembroke Consulting in Philadelphia.

 

Auctions were one example of a financially-efficient technology that didn’t take into account customer needs. While they may deliver parts at lower prices, they added compliance, quality, and reliability questions that buyers just didn’t think were worth the hassle. “Auctions have a rather unhappy characteristic of undermining long-standing [supplier] relationships,” Day says.

 

This mis-gauging of markets happened in B2C realms as well. Online pharmacies couldn’t break the relationship of pharmaceutical benefit managers with major employers and health plans, the study says, and on-line auto dealerships were hobbled by restrictive state regulations that prevented them from clinching sales.

 

But startups can still find success in re-formed markets. “The winners will be the companies enhancing, not replacing, traditional industry relationships,” the study says.

 

Take Neoforma, which started out as an open exchange for medical products. After its IPO, it used the money to transform itself into a software company that builds marketplaces to help manage existing relationships. SciQuest started out as an independent exchange for life sciences customers, but eventually ratcheted down to building private markets for a score of top-tier drug companies.

 

Lessons for Entrepreneurs

The fate of B2B exchanges offers important lessons for entrepreneurs, Day and Fein say.

 

  • Play the right game. Is your market breakthrough or re-formed? Startups in a new market should check to see if they really have an advantage against existing incumbents. In re-formed markets there’s still plenty of profit potential, but you’ve got to work with, rather than against, the existing leaders. “If you are playing the re-formed game, become a service provider,” Day says.

  • Know the competition. In re-formed markets, startups should find a niche that’s underserved, rather than aiming for the center of the market, Day says. And scope out the other players. “You have to know the game, know whether you’ve got competitive advantage over the probable entrants and not assume you’re going to be alone.”

  • Be realistic about market size. “Many of these companies overestimated the ultimate scale of their business,” Fein says. A business that locates hard-to-find items and liquidates excess inventory might make a great $50 million business – but don’t sell investors on the idea that it’s a $5 billion business, he says.

  • Grow smart. EBay and FreeMarkets have paid just as much attention to market dynamics as to technology, making key alliances (such as eBay’s with AOL) and adapting continuously to new competition. “The rewards were early profitability, large market capitalization and strong brand quality,” the study says.

Be prepared to take U-turns. Just because you picked the wrong initial strategy doesn’t mean you can’t restructure yourself into profitability. “When the loser profile fits, it is better to choose a viable strategy than to let market forces drive your fate,” the study says. The best chance for survival as an also-ran is to find a less competitive market niche; second-tier players have also found profitable homes as service providers to existing market leaders.

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