Building a Better Middleman – O’Reilly

What comes to mind when you hear the term “two-sided market?” Maybe you imagine a Party A who needs something, so they interact with Party B who provides it, and that’s that.  Despite the number “two” in the name, there’s actually someone else involved: the middleman.  This entity sits between the parties to make it easier for them to interact. (We can generalize that “two” to some arbitrary number and call this an N-sided market or multi-sided marketplace. But we’ll focus on the two-sided form for now.)

Two-sided markets are a fascinating study. They are also quite common in the business world, and therefore, so are middlemen. Record labels, rideshare companies, even dating apps all fall under this umbrella.  The role has plenty of perks, as well as some sizable pitfalls.  “Middleman” often carries a negative connotation because, in all fairness, some of them provide little value compared to what they ask in return.

Still, there’s room for everyone involved—Party A, Party B, and the middleman—to engage in a happy and healthy relationship.  In this first article, I’ll explain more about the middleman’s role and the challenges they face.  In the next article, I’ll explore what it takes to make a better middleman and how technology can play a role.

Paving the Path

When I say that middlemen make interactions easier, I mean that they address a variety of barriers:

• Discovery: “Where do I find the other side of my need or transaction?” Dating apps like OKCupid, classified ads services such as Craigslist, and directory sites like Angi (formerly Angie’s List) are all a twist on a search engine. Party A posts a description of themself or their service, Party B scrolls and sifts the list while evaluating potential matches for fit.
• Matching: “Should we interact? Are our needs compatible?” Many middlemen that help with discovery also handle the matching for you, as with ride-share apps.  Instead of you having to scroll through lists of drivers, Uber and Lyft use your phone’s GPS to pair you with someone nearby.  (Compared to the Discovery case, Matching works best when one or both counterparties are easily interchangeable.)
• Standardization: “The middleman sets the rules of engagement, so we all know what to expect.” A common example would be when a middleman like eBay sets the accepted methods of payment.  By narrowing the scope of what’s possible—by limiting options—the middleman standardizes how the parties interact.
• Safety: “I don’t have to know you in order to exchange money with you.” Stock market exchanges and credit card companies build trust with Party A and Party B, individually, so the two parties (indirectly) trust each other through the transitive property.
• Simplicity: “You two already know each other; I’ll insert myself into the middle, to make the relationship smoother.” Stripe and Squarespace make it easier for companies to sell goods and services by handling payments.  And then there’s Squire, which co-founder Songe Laron describes as the “operating system for the barber shop, [handling] everything from the booking, to the payment, to the point of sales system, to payroll,” and a host of other frictions between barber and customer.  In all cases, each party gets to focus on what it does best (selling goods or cutting hair) while the middleman handles the drudgework.

Nice Work, If You can Get It

As far as their business model, middlemen usually take a cut of transactions as value moves from Party A to Party B. And this arrangement has its benefits.

For one, you’re first in line to get paid: Party A pays you, you take a cut, then you pass the rest on to Party B.  Record labels and book publishers are a common example.  They pair a creator with an audience.  All of the business deals for that creator’s work run through the middleman, who collects the revenue from sales and takes their share along the way.

(The music biz is littered with stories of artists getting a raw deal—making a small percentage of revenue from their albums, while the label takes the lion’s share—but that’s another story.)

Then there’s the opportunity for recurring revenue, if Party A and Party B have an ongoing relationship.  Companies often turn to tech staffing agencies to find staff-augmentation contractors.  Those agencies typically take a cut for the entire duration of the project or engagement, which can run anywhere from a few weeks to more than a decade.  The staffing agency makes one hell of a return on their efforts when placing such a long-term contractor. Nice work, if you can get it.

Staffing agencies may have to refund a customer’s money if a contractor performs poorly.  Some middlemen, however, make money no matter how the deal ultimately turns out.  Did I foolishly believe my friend’s hot stock tip, in his drunken reverie, and pour my savings into a bad investment? Well, NYSE isn’t going to refund my money, which means they aren’t about to lose their cut.

A middleman also gets a bird’s-eye view of the relationships it enables.  It sees who interacts with whom, and how that all happens.  Middlemen that run online platforms have the opportunity to double-dip on their revenue model: first by taking their cut from an interaction, then by collecting and analyzing data around each interaction.  Everything from an end-user’s contact or demographic details, to exploring patterns of how they communicate with other users, can be packaged up and resold.  (This is, admittedly, a little shady. We’ll get to middlemen’s abuse of privilege shortly.)

Saddling Some Burdens, Too

Before you rush out to build your own middleman company, recognize that it isn’t all easy revenue.  You first need to breathe the platform into existence, so the parties can interact.  Depending on the field, this can involve a significant outlay of capital, time, and effort.  Then you need to market the platform so that everyone knows where to go to find the Party B to their Party A.

Once it’s up and running, maintenance costs can be low if you keep things simple.  (Consider the rideshare companies that own the technology platform, but not the vehicles in which passengers ride.) But until you reach that cruising altitude, you’re crossing your fingers that things pan out in your favor.  That can mean a lot of sleepless nights and stressful investor calls.

The middleman’s other big challenge is that they need to keep all of those N sides of the N-sided market happy.  The market only exists because all of the parties want to come together, and your service persists only because they want to come together through you.  If one side gets mad and leaves, the other side(s) will soon follow.  Keeping the peace can be a touchy balancing act.

Consider Airbnb.  Early in the pandemic they earned praise from guests by allowing them to cancel certain bookings without penalty.  It then passed those “savings” on to hosts, who weren’t too happy about the lost revenue.  (Airbnb later created a fund to support hosts, but some say it still fell short.)  The action sent a clear—though, likely, unintentional and incorrect—message that Airbnb valued guests more than hosts.  A modern-day version of robbing Peter to pay Paul.

Keeping all sides happy is a tough line for a middleman to walk.  Mohambir Sawhney, from Northwestern University’s McCormick Foundation, summed this up well: “In any two-sided market, you always have to figure out who you’re going to subsidize more, and who you’re going to actually screw more.” It’s easy for outsiders to say that Airbnb should have just eaten the losses—refunded guests’ money while letting hosts keep their take—but that sounds much easier said than done.  In the end, the company still has to subsidize itself, right?

The subsidize versus screw decision calculus gets even more complicated when one side only wants you but doesn’t need you.  In the Airbnb case, the company effectively serves as a marketing arm and payments processor for property owners.  Any sufficiently motivated owner is just one step away from handling that on their own, so even a small negative nudge can send them packing.  (In economics terms, we say that those owners’ switching costs are low.)

The same holds for the tech sector, where independent contractors can bypass staffing firms to hang their own shingle.  Even rideshare drivers have a choice.  While it would be tougher for them to get their own taxi medallion, they can switch from Uber to Lyft.  Or, as many do, they can sign up with both services so that switching costs are effectively zero: “delete Uber app, keep the Lyft app running, done.”

Making Enemies

Even with those challenges, delivering on the middleman’s raison d’être—”keep all parties happy”—should be a straightforward affair.  (I don’t say “easy,” just “straightforward.” There’s a difference.) Parties A and B clearly want to be together, you’re helping them be together, so the experience should be a win all around.

Why, then, do middlemen have such a terrible reputation?  It mostly boils down to greed.

Once a middleman becomes a sufficiently large and/or established player, they become the de facto place for the parties to meet.  This is a near-monopoly status. The middleman no longer needs to care about keeping one or even both parties happy, they figure, because those groups either interact through the middleman or they don’t interact at all. (This also holds true for the near-cartel status of a group of equally unpleasant middlemen.)

Maybe the middleman suddenly raises fees, or sets onerous terms of service, or simply mistreats one side of the pairing.  This raises the dollar, effort, and emotional cost to the parties since they don’t have many options to leave.

Consider food-delivery apps, which consumers love but can take as much as a 30% cut of an order’s revenue.  That’s a large bite, but easier to swallow when a restaurant has a modest take-away business alongside a much larger dine-in experience. It’s quite another story when take-away is suddenly your entire business and you’re still paying rent on the empty dining room space. Most restaurants found themselves in just this position early in the COVID-19 pandemic. Some hung signs in their windows, asking customers to call them directly instead of using the delivery apps.

Involving a middleman in a relationship can also lead to weird principal-agent problems.  Tech staffing agencies (even those that paint themselves as “consultancies”) have earned a special place here.  Big companies hand such “preferred vendors” a strong moat by requiring contractors to pass through them in lieu of establishing a direct relationship. Since the middlemen can play this Work Through Us, or Don’t Work at All card, it’s no surprise that they’ve been known to take as much as 50% of the money as it passes from client to contractor.  The client companies don’t always know this, so they are happy that the staffing agency has helped them find software developers and DBAs. The contractors, many of whom are aware of the large cuts, aren’t so keen on the arrangement.

This is on top of limiting a tech contractor’s ability to work through a competing agency.  I’ve seen everything from thinly-veiled threats (“if the client sees your resume from more than one agency, they’ll just throw it out”) to written agreements (“this contract says you won’t go through another agency to work with this client”).   What if you’ve found a different agency that will take a smaller cut, so you get more money?  Or what if Agency 1 has done a poor job of representing you, while you know that Agency 2 will get it right?  In both cases, the answer is: tough luck.

A middleman can also resort to more subtle ways to mistreat the parties.  Uber has reportedly used a variety of techniques from behavioral science—such as the gamification of male managers pretending to be women—to encourage drivers to work more.  They’ve also been accused of showing drivers and passengers different routes, charging the passenger for the longer way and paying the driver for the shorter way.

It’s Not All Easy Money

To be fair, middlemen do earn some of their cut. They provide value in that they reduce friction for both the buy and sell sides of an interaction.

This goes above and beyond building the technology for a platform.  Part of how the Deliveroos and Doordashes of the world connect diners to restaurants is by coordinating fleets of delivery drivers.  It would be expensive for a restaurant to do this on their own: hiring multiple drivers, managing the schedule, accounting for demand … and hoping business stays hot so that the drivers aren’t paid to sit idle. Similarly, tech staffing firms don’t just introduce you to contract talent. They also handle time-tracking, invoicing, and legal agreements. The client company cuts one large check to the staffing firm, which cuts lots of smaller checks to the individual contractors.

Don’t forget that handling contracts and processing payments come with extra regulatory requirements. Rules often vary by locale, and the middleman has to spend money to keep track of those rules.  So it’s not all profit.

(They can also build tools to avoid rules, such as Uber’s infamous “greyball” system … but that’s another story.)

That said, a middleman’s benefit varies by the industry vertical and even by the client.  Some argue that their revenue cut far exceeds the value they provide. In the case of tech staffing firms, I’ve heard plenty of complaints that recruiters take far too much money for  just “having a phone number” (having a client relationship) and cutting a check, when it’s the contractor who does the actual work of building software or managing systems for the client.

A Win-Win-Win Triangle

Running a middleman has its challenges and risks.  It can also be tempting to misuse the role’s power.  Still, I say that there’s a way to build an N-sided marketplace where everyone can be happy.  I’ll explore that in the next article in this series.

(Many thanks to Chris Butler for his thoughtful and insightful feedback on early drafts of this article.  I’d also like to thank Mike Loukides for shepherding this piece into its final form.)