Pricing for SaaS Enabled Marketplaces - When to Go Free
SaaS Enabled Marketplaces employ elegant business models. They are verticalized SaaS companies that manage a marketplace to create winner-take-all market dynamics. SEMs can generate revenue in four ways: charge the buyer and/or supplier a software fee & charge the buyer and/or supplier a marketplace fee. In addition, a startup must determine what rake to charge.
At Redpoint, we’ve invested in more than 15 marketplaces and have evaluated dozens more, including more than 20 SEMs in the past year. Some of these are Free SEMs. So which type of pricing should SEMs pursue? These are the questions we use internally to hypothesize the best pricing models for SEMs.
SEM or FSEM? Does the sector lend itself to freemium software distribution? When should a startup remove the toll to access the marketplace? We recommend startups choose freemium strategies when they meet the following conditions.
- The potential users must number in the millions. The conversion rates of freemium product rarely top more than 5%, so the universe of users must be quite large to generate substantial revenue.
- The initial software user differs from the buyer. Free software becomes an education tool and lead generation to a second value proposition.
- The target user is difficult to acquire through traditional sales and marketing techniques because the unit economics aren’t profitable.
- The company possesses enough capital to sustain its development despite a long latency between product release and revenue.
- The company can generate meaningful transaction revenue (see transaction characteristics).
- There are important competitive considerations that compel the company to win as much marketshare as quickly as possible.
SEMs should ask themselves the first three questions for both the supplier and the customer to develop a point of view on each.
Transaction characteristics There are three dimensions that describe a transaction in a market place: frequency, transaction value, and supplier variability. Customers who frequently buy high value items from many different suppliers benefit the most from market places. Founders often consider the first and second. But, supplier variability is equally important.
If a customer varies little in suppliers, then the SEM should charge a substantial software subscription fee in addition to a one-time marketplace fee. In this scenario, both the customer and the supplier may use the marketplace to find each other (lead generation). But the initial introduct, the supplier and customer often negotiate a long-term business contract outside the marketplace to reduce costs - a concept we call breakage.
In such case, the marketplace cannot capture the ongoing value of the relationship between the buyer and seller through transaction fees alone. To maximize revenue, the startup should favor charging a substantial subscription fee for the software in addition to a fee on the first transaction.
Frequency and transaction value are often inversely correlated. From our research most SEMs charge between 5-15% of gross merchandise sales in rake. Among consumer marketplaces, there is quite a wide dispersion on rakes, which might foreshadow similar variance in the SEM world. Also, these fees tend to be higher when the marketplace manages the payments rather than providing leads.
Total Addressable Market Market places either shrink their market or expand the market. Marketplaces shrink the market when the total number of transactions remains constant, but the fee revenue in the sector compresses because the marketplace eliminates middlemen costs and so depresses total revenues. Other times, marketplaces increase the demand for a product by reducing friction, and new customers enter the market. An SEM’s pricing model should reflect the founder’s thesis on market size expansion or contraction. The more an SEM will compress a market, the greater the importance of software revenue, and the less attractive the FSEM option becomes.
SEMs should consider giving software away for free when they can generate substantial revenues from the marketplace alone with little breakage risk, without compressing the addressable market radically, and when the free distribution engenders a strong competitive advantage.