Marketplace startups are challenging to run because sellers, buyers, and operators of a marketplace have conflicting goals. Sellers want to sell their goods for as much as possible. Buyers want to pay as little as possible. The operators of the marketplace want to reach liquidity as quickly as possible. Each group uses the platform for their own benefit.
Sharing the upside of a transaction is one way to build trust between two parties. For example, realtors typically get a percentage of the final sale price of a house. This incentivizes them to sell the house for a high price, and incentivizes the owner of the home to flexible with open house schedules. To increase profitability, marketplaces use fees and credits to incentivize or punish behaviors.
Managerial accounting of fees and credits in shared upside transactions isn’t as straightforward as I expected. The goal of managerial accounting is to interpret the financials of a company in a way that supports strategic decision making. Here’s an example based on my experience.
GizmoCorp is a hot new startup that buys gently used Gizmos from people in America and ships them overseas to China, where used Gizmos are in high demand because new Gizmos cost an exorbitant amount of money.
Jane, the founder of GizmoCorp, came up with the original idea in the shower and decided to try out the business model. That weekend, Jane convinced her childhood friend Dana to give her Gizmo-for-cash idea a try. When Jane arrived at Dana’s house in Oakland, she noticed that Dana’s Gizmo was rather dirty, and needed professional cleaning before it could be sold. Jane guaranteed Dana at least $15,000 for her Gizmo, and promised to split the difference if the Gizmo sold for anything more than that. Dana agreed, and Jane trucked the Gizmo to the port of Oakland, where it was cleaned, loaded onto a container ship, and sent off to China. Jane has a business partner in China that takes care of selling the Gizmos once they arrive in China. Her business partner charges a flat $1,000 fee per Gizmo sold. A few weeks later, the Gizmo sold for $20,000, and Jane received a wire transfer from her partner in China for $19,000. Thrilled, Jane sent Dana a cheque for $17,500, a thank you card for being GizmoCorp’s first customer, and this receipt:
| Dana | ||
| Guaranteed Price | $15,000 | |
| Actual Sale Price | $20,000 | |
| GizmoCorp Commission | -$2,500 | ($20,000-$15,000) x 50% |
| Final Payment | $17,500 | |
Jane Goes To Sand Hill Road
Fast forward a year, and Jane is selling tens of Gizmos a day. Jane goes to Capital Partners, a top venture capital firm, and pitches GizmoCorp to them. They decide to invest, but set very aggressive goals for Jane. Jane is only making an average of $2,000 per Gizmo sold right now. The investors are pushing her to make at least $3,000 per Gizmo. Jane is confident that she’ll hit that goal, and takes the money. Jane heads back to GizmoCorp with the good news, explains the new goal for the business, and takes the team out for a happy hour. As the bar is closing, Jane surprises the team by giving them the rest of the week off, and tells everyone to come back on Monday refreshed and ready to go.
The $500 Cleaning Fee
The GizmoCorp executive team gets together on Monday morning to figure out how to make more money per Gizmo. They analyze their past transactions and figure out that they’ve been spending about $500 per Gizmo on cleaning costs. Jane proposes that they pass the cleaning cost on to their customers: they’ll deduct $500 from the usual guaranteed price if a Gizmo needs cleaning. Everyone nods their heads in agreement. They call this the $500 Cleaning Fee.
That day, two customers with identical Gizmos contact GizmoCorp. Ariel’s Gizmo is in pristine condition, and doesn’t need any cleaning. Becky’s Gizmo has been sitting outside for years and needs to be professionally cleaned. Both Gizmos are sold for $20,000. Here are the receipts that were sent out.
| Ariel (Without Cleaning Fee) | ||
| Guaranteed Price | $15,000 | |
| Actual Sale Price | $20,000 | |
| GizmoCorp Commission | -$2,500 | ($20,000-$15,000) x 50% |
| Final Payment | $17,500 | |
| Becky (With Cleaning Fee) | ||
| Guaranteed Price | $14,500 | $15,000-$500 |
| Actual Sale Price | $20,000 | |
| GizmoCorp Commission | -$2,750 | ($20,000-$14,500) x 50% |
| Final Payment | $17,250 | |
Problems With The $500 Cleaning Fee
A month later, the executive team meets to discuss the results of the Cleaning Fee. Things are off to a good start! 60% of customers are opting to clean their Gizmos prior to pick-up themselves, up from 30% the previous month. However, there are two unexpected problems.
Firstly, GizmoCorp notices that they’ve had fewer customers than usual this month. The executive team theorizes that it’s because the Cleaning Fee sounds really bad in a pitch. People don’t like fees, because that sounds like money is being taken away from them.
Secondly, Jane pointed out that even though the Cleaning Fee is $500, GizmoCorp is only saving $250 whenever someone cleans their Gizmo themselves. The executives compare Ariel and Becky’s receipts and convince themselves that this is indeed true: their final payments only differ by $250.
The $500 Cleaning Credit
The executive team comes up with a brilliant solution: they’ll implement the Cleaning Fee as a credit instead. They’ll give everyone a guaranteed price that’s $500 lower than usual, but offer a $500 credit if they clean their Gizmos themselves.
That day, two customers with identical Gizmos contact GizmoCorp. Abby’s Gizmo is in pristine condition, and doesn’t need any cleaning. Bernie’s Gizmo has been sitting outside for years and needs to be professionally cleaned. Both Gizmos are sold for $20,000. Here are the receipts that were sent to Abby and Bernie:
| Abby (With Cleaning Credit) | ||
| Guaranteed Price | $14,500 | |
| Actual Sale Price | $20,000 | |
| GizmoCorp Commission | -$2,750 | ($20,000-$14,500) x 50% |
| Cleaning Credit | $500 | |
| Final Payment | $17,750 | |
| Bernie (Without Cleaning Credit) | ||
| Guaranteed Price | $14,500 | |
| Actual Sale Price | $20,000 | |
| GizmoCorp Commission | -$2,750 | ($20,000-$14,500) x 50% |
| Cleaning Credit | $0 | |
| Final Payment | $17,250 | |
Problems With The $500 Cleaning Credit
A month later, the executives meet up again to discuss the results of the Cleaning Credit. GizmoCorp’s monthly customer count is back to normal. It seems like positioning the fee as a credit has helped. 80% of customers are opting to clean their Gizmos themselves, up from 60% last month. The executives laid out all five receipts next to each other, and added new “breakdown” rows to figure out how much more money GizmoCorp made as a result of the Cleaning Fee and the Cleaning Credit. Here are the formulas they used:
Commission Revenue = (Actual Sale Price - Guaranteed Price) / 2
Cleaning Fee Revenue = IF clean THEN $0 ELSE $250
Cleaning Credit Revenue = IF clean THEN $0 ELSE $500
Comparing Abby’s and Bernie’s final payments, the executives are convinced that they’re now saving $500 whenever a customer cleans their Gizmos themselves.
| Jane (The Original Customer) |
Ariel (Without Cleaning Fee) |
Becky (With Cleaning Fee) |
Abby (With Cleaning Credit) |
Bernie (Without Cleaning Credit) |
|
| Guaranteed Price | $15,000 | $15,000 | $14,500 | $14,500 | $14,500 |
| Actual Sale Price | $20,000 | $20,000 | $20,000 | $20,000 | $20,000 |
| GizmoCorp Commission | -$2,500 | -$2,500 | -$2,750 | -$2,750 | -$2,750 |
| Cleaning Credit | N/A | N/A | N/A | $500 | $0 |
| Final Payment | $17,500 | $17,500 | $17,250 | $17,750 | $17,250 |
| Commission Revenue | $2,500 | $2,500 | $2,750 | $2,750 | $2,750 |
| Cleaning Fee Revenue | N/A | $0 | $250 | N/A | N/A |
| Cleaning Credit Revenue | N/A | N/A | N/A | $0 | $500 |
Jane notices that something is wrong. She adds two more rows.
| Dana (The Original Customer) |
Ariel (Without Cleaning Fee) |
Becky (With Cleaning Fee) |
Abby (With Cleaning Credit) |
Bernie (Without Cleaning Credit) |
|
| Guaranteed Price | $15,000 | $15,000 | $14,500 | $14,500 | $14,500 |
| Actual Sale Price | $20,000 | $20,000 | $20,000 | $20,000 | $20,000 |
| GizmoCorp Commission | -$2,500 | -$2,500 | -$2,750 | -$2,750 | -$2,750 |
| Cleaning Credit | N/A | N/A | N/A | $500 | $0 |
| Final Payment | $17,500 | $17,500 | $17,250 | $17,750 | $17,250 |
| Commission Revenue | $2,500 | $2,500 | $2,750 | $2,750 | $2,750 |
| Cleaning Fee Revenue | N/A | $0 | $250 | N/A | N/A |
| Cleaning Credit Revenue | N/A | N/A | N/A | $0 | $500 |
| Revenue Breakdown Total | $2,500 | $2,500 | $3,000 | $2,750 | $3,250 |
| Actual Revenue | $2,500 | $2,500 | $2,750 | $2,250 | $2,750 |
The breakdown rows can’t be correct because they don’t always sum up to the actual revenue for each deal! Jane thinks hard and realizes what the problem is: When a fee is implemented as a credit in a shared upside deal, the commission revenue is increased by a constant amount equal to half the value of the credit, regardless of whether it was applied or not. This constant amount will be double counted unless it is removed from the commission revenue.
Therefore, these are the correct formulas
For Cleaning Fee deals:
Commission Revenue =
IF clean
THEN (Actual Sale Price - Guaranteed Price) / 2
ELSE (Actual Sale Price - Guaranteed Price) / 2 - $250
Cleaning Fee Revenue = IF clean THEN $0 ELSE $250
For Cleaning Credit deals:
Commission Revenue = (Actual Sale Price - Guaranteed Price) / 2 - $250
Cleaning Credit Revenue = IF clean THEN -$250 ELSE $250
And they result in this table:
| Dana (The Original Customer) |
Ariel (Without Cleaning Fee) |
Becky (With Cleaning Fee) |
Abby (With Cleaning Credit) |
Bernie (Without Cleaning Credit) |
|
| Guaranteed Price | $15,000 | $15,000 | $14,500 | $14,500 | $14,500 |
| Actual Sale Price | $20,000 | $20,000 | $20,000 | $20,000 | $20,000 |
| GizmoCorp Commission | -$2,500 | -$2,500 | -$2,750 | -$2,750 | -$2,750 |
| Cleaning Credit | N/A | N/A | N/A | $500 | $0 |
| Final Payment | $17,500 | $17,500 | $17,250 | $17,750 | $17,250 |
| Commission Revenue | $2,500 | $2,500 | $2,500 | $2,500 | $2,500 |
| Cleaning Fee Revenue | N/A | $0 | $250 | N/A | N/A |
| Cleaning Credit Revenue | N/A | N/A | N/A | -$250 | $250 |
| Revenue Breakdown Total | $2,500 | $2,500 | $2,750 | $2,250 | $2,750 |
| Actual Revenue | $2,500 | $2,500 | $2,750 | $2,250 | $2,750 |
Much better! Now the revenue breakdown matches the actual revenue. The last thing to do is replace the now redundant “Revenue Breakdown Total” row with something more useful: Profit.
Profit = Revenue - Cleaning Cost - Chinese Partner's $1000 Fee
| Dana (The Original Customer) |
Ariel (Without Cleaning Fee) |
Becky (With Cleaning Fee) |
Abby (With Cleaning Credit) |
Bernie (Without Cleaning Credit) |
|
| Guaranteed Price | $15,000 | $15,000 | $14,500 | $14,500 | $14,500 |
| Actual Sale Price | $20,000 | $20,000 | $20,000 | $20,000 | $20,000 |
| GizmoCorp Commission | -$2,500 | -$2,500 | -$2,750 | -$2,750 | -$2,750 |
| Cleaning Credit | N/A | N/A | N/A | $500 | $0 |
| Final Payment | $17,500 | $17,500 | $17,250 | $17,750 | $17,250 |
| Commission Revenue | $2,500 | $2,500 | $2,500 | $2,500 | $2,500 |
| Cleaning Fee Revenue | N/A | $0 | $250 | N/A | N/A |
| Cleaning Credit Revenue | N/A | N/A | N/A | -$250 | $250 |
| Revenue | $2,500 | $2,500 | $2,750 | $2,250 | $2,750 |
| Cleaning Cost | -$500 | $0 | -$500 | $0 | -$500 |
| Chinese Partner’s Fee | -$1000 | -$1000 | -$1000 | -$1000 | -$1000 |
| Profit | $1,000 | $1,500 | $1,250 | $1,250 | $1,250 |
From this table, we immediately notice two things:
- GizmoCorp is making a constant amount of profit, equal to half the value of the Cleaning Credit, regardless of whether the customer decided to clean their Gizmo themselves or not.
- The Cleaning Fee, in the best case, actually led to more profit than the Cleaning Credit. In the worst case, it made just as much. The executives had intuitively expected to make more from the credit than the fee.
Going Negative
How about the case where the Gizmo unexpectedly sells for less than the guaranteed price, and there is no upside? Here’s the same table, except that the Actual Sale Price has been lowered to $10,000.
| Dana (The Original Customer) |
Ariel (Without Cleaning Fee) |
Becky (With Cleaning Fee) |
Abby (With Cleaning Credit) |
Bernie (Without Cleaning Credit) |
|
| Guaranteed Price | $15,000 | $15,000 | $14,500 | $14,500 | $14,500 |
| Actual Sale Price | $10,000 | $10,000 | $10,000 | $10,000 | $10,000 |
| GizmoCorp Commission | $0 | $0 | $0 | $0 | $0 |
| Cleaning Credit | N/A | N/A | N/A | $500 | $0 |
| Final Payment | $15,000 | $15,000 | $14,500 | $15,000 | $14,500 |
| Commission Revenue | -$5000 | -$5000 | -$5000 | -$5000 | -$5000 |
| Cleaning Fee Revenue | N/A | $0 | $500 | N/A | N/A |
| Cleaning Credit Revenue | N/A | N/A | N/A | $0 | $500 |
| Revenue | -$5000 | -$5000 | -$4500 | -$5000 | -$4500 |
| Cleaning Cost | -$500 | $0 | -$500 | $0 | -$500 |
| Chinese Partner’s Fee | -$1000 | -$1000 | -$1000 | -$1000 | -$1000 |
| Profit | -$6,500 | -$6,000 | -$6,000 | -$6,000 | -$6,000 |
Like the earlier examples we hold Commission Revenue constant in order to make apples-to-apples comparisons. Here we see that Cleaning Fee Revenue and Cleaning Credit Revenue are identical, and when not zero, are equal to the full amount of the credit or fee: $500. Not only that, but Profit is identical across both the Cleaning Fee and Cleaning Credit. The conclusion: in the case where a Gizmo sells for less than the guaranteed price, the Cleaning Fee or Cleaning Credit will reduce losses by $500 regardless of whether the Gizmo was clean.
The Twilight Zone
How about the case where the Gizmo sells for somewhere between the highest and lowest guaranteed price (between $15,000 and $14,500)? Here’s the same table with the actual sale price set to $14,750.
| Dana (The Original Customer) |
Ariel (Without Cleaning Fee) |
Becky (With Cleaning Fee) |
Abby (With Cleaning Credit) |
Bernie (Without Cleaning Credit) |
|
| Guaranteed Price | $15,000 | $15,000 | $14,500 | $14,500 | $14,500 |
| Actual Sale Price | $14,750 | $14,750 | $14,750 | $14,750 | $14,750 |
| GizmoCorp Commission | $0 | $0 | $125 | $125 | $125 |
| Cleaning Credit | N/A | N/A | N/A | $500 | $0 |
| Final Payment | $15,000 | $15,000 | $14,625 | $15,125 | $14,625 |
| Commission Revenue | -$250 | -$250 | -$250 | -$250 | -$250 |
| Cleaning Fee Revenue | N/A | $0 | $375 | N/A | N/A |
| Cleaning Credit Revenue | N/A | N/A | N/A | -$125 | $375 |
| Revenue | -$250 | -$250 | $125 | -$375 | $125 |
| Cleaning Cost | -$500 | $0 | -$500 | $0 | -$500 |
| Chinese Partner’s Fee | -$1000 | -$1000 | -$1000 | -$1000 | -$1000 |
| Profit | -$1,750 | -$1,250 | -$1,375 | -$1,375 | -$1,375 |
Like the earlier examples we hold Commission Revenue constant in order to make apples-to-apples comparisons, but it’s definitely harder to intuitively explain what’s going on here. Here is what seems to be happening:
Cleaning Fee Revenue = IF clean THEN $0 ELSE $250 + GizmoCorp Commission
Cleaning Credit Revenue = IF clean THEN GizmoCorp Commission - $250 ELSE GizmoCorp Commission + $250
A Counterintuitive Result
GizmoCorp leadership made these changes because they wanted to increase profit by encouraging customers to clean their Gizmos themselves. The executives were celebrating increases in the percentage of customers who cleaned their Gizmos, because they intuitively thought it was correlated with cost savings. After performing this analysis, it was clear that GizmoCorp was getting extra profit from every customer regardless of whether they clean their Gizmos themselves or not. They didn’t have to wait to know how much extra profit they were going to make from the credit: if we ignored the rare case where a Gizmo sells at a “twilight zone” price, it is simply:
$250 x expected Gizmos sold above guaranteed price + $500 x expected Gizmos sold below guaranteed price
Cleaning Credit 2
This issue can be avoided by lowering the guaranteed price by $1000 instead of $500. We’ll call this “Cleaning Credit 2”. Cleaning Credit 2 Revenue is indeed $500 when cleaning is required, and $0 when cleaning is not required. Here’s how Cleaning Credit 2 compares to Cleaning Credit 1:
| Abby (With Cleaning Credit) |
Bernie (Without Cleaning Credit) |
Angela (With Cleaning Credit 2) |
Beatrice (Without Cleaning Credit 2) |
|
| Guaranteed Price | $14,500 | $14,500 | $14,000 | $14,000 |
| Actual Sale Price | $20,000 | $20,000 | $20,000 | $20,000 |
| GizmoCorp Commission | -$2,750 | -$2,750 | -$3,000 | -$3,000 |
| Cleaning Credit | $500 | $0 | $500 | $0 |
| Final Payment | $17,750 | $17,250 | $17,500 | $17,000 |
| Commission Revenue | $2,500 | $2,500 | $2,500 | $2,500 |
| Cleaning Fee Revenue | N/A | N/A | N/A | N/A |
| Cleaning Credit Revenue | -$250 | $250 | N/A | N/A |
| Cleaning Credit 2 Revenue | N/A | N/A | $0 | $500 |
| Revenue | $2,250 | $2,750 | $2,500 | $3,000 |
| Cleaning Cost | $0 | -$500 | $0 | -$500 |
| Chinese Partner’s Fee | -$1000 | -$1000 | -$1000 | -$1000 |
| Profit | $1,250 | $1,250 | $1,500 | $1,500 |
Now, GizmoCorp is making $1,500 in profit in either scenario, and the amount of revenue that can be attributed to Cleaning Credit 2 is either $0 or $500. The “Twilight Zone” problem still persists, but it should happen with low enough frequency that we can safely ignore it.
