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Musing on the On-Demand Economy

Even with the scale of many hundreds of millions of potential customers and low-wage workers, China's O2O startups are already struggling.

Nitrozac & Snaggy

A version of this essay was originally published at Tech.pinions, a website dedicated to informed opinions, insight and perspective on the tech industry.

Living here in Silicon Valley and working with as many venture capitalists as I do, I can’t escape discussions of the “on-demand economy.” If you aren’t familiar with this, it is an investment thesis of many investors and includes companies like Uber, Shyp, Luxe, Instacart and many more. The premise of these companies and this investment thesis is “anything on demand.” With a request from a mobile device, you can have almost any product or service delivered to you, anytime, anywhere. Basically, pizza delivery service for practically anything.

In case you haven’t been following this space closely, the trend started in China with what the locals call O2O, or online to offline. It is by far the biggest mobile Internet trend in China. You can request to have food, a car wash, a massage, your house cleaned, a vast array of gadgets and household items, fresh groceries — practically anything. The kicker, and the key to know about this trend in China, is the speed of O2O services. In nearly every case, you can have said goods or services delivered within an hour, and oftentimes within 30 minutes.

This Wall Street Journal article tells the tale of Car8, an on-demand car-wash service that ran out of cash. This is not the first tale of such a failure, and it won’t be the last from China, the U.S. or abroad. At a fundamental level, the business model requirement for many of these companies is scale. Many companies are operating at razor-thin margins, even at a loss, in order to make up for the low profits or negative customer acquisition cost in scale. These startups pour in millions of dollars to acquire customers, make nearly nothing on them, but hope they get enough of them to grow and be profitable someday. Sounds familiar to an era past and lessons learned. But there are several interesting points and observations to make when thinking about this incredibly hot category.

First, U.S.-based on-demand services lack two critical things which make many of these O2O services in China successful. They lack scale, and they lack low-wage workers. The reason these services have a chance in China is because, in a city like Beijing, there are more than 19 million people living in relatively close proximity; in Shanghai, there are more than 22 million people. Several large tier-1 (meaning more developed and wealthier) cities have populations between eight million and 11 million people. China has an estimated 700 million people in cities, many of them living in developed cities and considered part of the rising middle class, with higher disposable income.

Contrast this with the U.S., where only 10 cities have populations in excess of one million people. No. 1 is New York, with more than eight million; Los Angeles, with more than three million; and Chicago with just short of three million. I make these points because on-demand startups like the ones I mentioned will require scale of close-proximity urban living, and this is something China has at much greater numbers than the U.S.

Secondly, China has low-wage workers. This is probably the most salient point about the contrast of the two on-demand economy markets. In China, you can not only have goods or services delivered in an hour or less, but at costs only slightly above what it would be for you to go out and acquire the goods or services on your own. The economics work for not just the wealthy. Contrast this with the U.S., where I know of a CEO of a large startup in San Francisco who pays $25 once a week to have a burrito from his favorite burrito joint delivered to his office. He could have walked down the street and paid $8, but instead wanted to stay in his office and work.

Another example I’m fond of is Luxe, mostly because I use this service all the time when I go to San Francisco. With the touch of a button on the Luxe app, I set my location and someone will come to me and park my car. Luxe’s average hourly rate is $5; by contrast, parking in most places in San Francisco is $2 to $3 dollars for 15 minutes. Luxe is a great deal, and very convenient. The secret is it is parking the car in the same lot where I would have to pay much higher fees than $5 an hour.

While it is likely that Luxe has struck a deal with some parking-lot establishments, it is the low working-wage part that has me worried about their model. Luxe’s valets ride around on skateboards or scooters; most of the ones I have encountered look like college kids. They are likely making a decent-enough wage, but none of these kids are going to be full-time valets as a career. So churn will be high, and the economics of cost between parking, wages and other logistics means that Luxe likely has barely any to negative margins. Scale is its answer. Yet knowing there is a much lower total addressable market in the entire U.S. than in China, the question is, what number does Luxe need to hit to be profitable, and how big is the ceiling?

Now, parking may not be Luxe’s only model. It can offer to have your car washed, serviced, and maybe have the driver run errands for you. The bottom line is that the dynamics many on-demand startups are using in the U.S. are totally different than China, and thus will operate differently. The lack of low-wage workers in cities where these startups need scale is a huge challenge.

The China angle is important because, even with the scale of many hundreds of millions of potential customers and low-wage workers, these O2O startups are already struggling. I’ve spoken with many who describe the startup scene in China to me, and I observe a great many patterns happening which bear similarities to the dot-com bubble in the late ’90s in the U.S. While I know that many investors have learned from the first dot-com era, it is all new to China, and will likely see many public crash and burns. Investors in the U.S. are already guiding these startups to have more sustainable business models. But we will also see many case studies of on demand startups where failure is an important lesson.

Lastly, about Uber: It seems to be one of the companies that many investors don’t seem to criticize too heavily when they are sending warning signs to the on-demand economy. Part of this is because many are investors in Uber, but also because Uber seems like it can get global scale, and doesn’t necessarily depend on low-wage workers. While I’m not saying that Uber is immune to dynamics impacting many other startups in the on-demand economy, it seems to be more sheltered from them. Uber is absolutely burning cash, and its customer-acquisition cost is high, but its business model scales quite well. Being a taxi service is not Uber’s only way to employ people who are happy to drive around all day for a job.

Ben Bajarin is a principal analyst at Creative Strategies Inc., an industry analysis, market intelligence and research firm located in Silicon Valley. His primary focus is consumer technology and market trend research. He is a husband, father, gadget enthusiast, trend spotter, early adopter and hobby farmer. Reach him @BenBajarin.

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