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Building marketplaces is hard, just ask Bill Gurley of Benchmark about the complexity of identifying good opportunities for marketplaces in the Internet economy.  This was further evidenced today when I received a little email hand grenade from the CEO of Upwork, a leading online marketplace for freelancing.

In the wake of the ODesk-Elance merger, Upwork is inflicting a higher “Upwork tax” on customers and freelancers for the overwhelming majority of  jobs, and is also levying a new financial processing fee.   At the same time, Upwork is also lowering fees on higher dollar transactions, and introducing a processing fee.

Here is how Upwork CEO Stephane Kasriel’s explained these changes:

We help you build your business by acquiring clients, helping you connect with the right opportunities, and providing services like payment protection. On small projects, the costs we incur outweigh the fees charged; because they aren’t profitable, we haven’t been investing in growing the number of these projects. At the same time, client relationships that result in larger, repeat projects incur fewer of these costs because of the trust that’s been developed, and we want to pass those cost savings back to our users. – Upwork CEO Stephane Kasriel

I did have a good laugh at that.  For those of you who not well versed in deciphering the charismatic double speak of startup CEOs, please allow me to translate:  You need us.  We see no reason whatsoever why Fiverr should be allowed to make 20% of client money while we make only 10% for same size transactions.  Therefore we are increasing our prices because, frankly, we can.   We are under pressure to make more money.   This is a carefully calculated risk we think we can take because the market for freelance work is growing faster than we can count dollar bills.

What I found interesting is that this change highlights the fragility and complexity of marketplace revenue models.  Marketplaces like Upwork are fundamentally middlemen.  Middlemen exist in markets where they lower transaction costs for buyers and sellers.  More specifically, middlemen exist when their fees are lower than the corresponding costs of buyers and sellers who transact with one another directly.  These models begin to break down when their fees approach direct transaction costs.  If you are a middleman, determining the true direct transaction costs between buyers and sellers is pretty important, since it determines in part whether or not buyers and sellers transact business with you instead of each other.

So what are the direct costs to freelancers and their clients, and how does Upwork know that the low end market will bear these higher fees?  I am sure there is one hell of an Excel model at Upwork HQ, but one clue is the pricing of competitors.  Upwork must believe it can charge as much as its competitors in the low end of the market. That might be a dubious assumption.  Competitors like Fiverr have optimized the user experience for the low end transactions.  These jobs are just harder to do on Upwork, period.  By raising its prices in the low end of the market, Upwork opened itself to any competitor willing to step in and deliver a slightly better experience at Upwork’s old price.  Why lower any barrier to entry at this stage of the game?

Which brings us to the really big strategic play.  Upwork is betting that its future is to be the premier marketplace for large freelance projects.  Obviously, the cries from larger clients that Upwork’s 10% fee was already too expensive did not fall on deaf ears. By lowering its fees to 5%, it believes that it can further disrupt traditional suppliers of short term talent. These include recruiters, temp agencies, and small consulting firms.  Temp agencies have profit margins ranging from 1.4% to 8.8%, with the industry average being 5% according to the latest report from Barclays.  Upwork is betting that it can disintermediate these existing middlemen by further reducing friction for buyers and sellers.  If this strategy is successful, then Upwork probably secures its exit through one of these suffering middlemen.  Pretty smart, and pretty risky.   I like it.

I am a big fan of freelance marketplaces, having sourced many thousands of dollars of work on projects ranging from software development, writing, advertising, and even illustration for a children’s book.  Given the usability friction for low end jobs on Upwork, I’ll probably just use something else for these jobs from now on.  However, now I see no reason not to float much bigger contracts to Upwork in the near future now that the fee is 5%.  I get the feeling that this is exactly what Stephane Kasriel would want me to do.