June 25th 2018

The freemium business model is based on a service that the majority of users get for free, while a small percentage of users convert into paying customers. Those paying customers become the basis for the long-term financial success of the company. While the free users keep guaranteeing a viral growth, more effective branding and a fluid sales funnel that – in theory – allows the company to scale up without a complex salesforce.

Freemium business model origin story

On March 2006, venture capitalist Fred Wilson wrote an article entitled “My Favorite Business Model” which said:

Give your service away for free, possibly ad supported but maybe not, acquire a lot of customers very efficiently through word of mouth, referral networks, organic search marketing, etc, then offer premium priced value added services or an enhanced version of your service to your customer base.

He mentioned examples of this successful business model like Skype, Flickr, and a few others.

According to Fred Wilson, the advantages of a Freemium business model were multiples, but he made clear that it had to be as frictionless as possible:

A customer is only a click away and if you can convert them without forcing them into a price/value decision you can build a customer base fairly rapidly and efficiently. It is important that you require as little as possible in the initial customer acquisition process. Asking for a credit card even though you won’t charge anything to it is not a good idea. Even forced registration is a bad idea. You’ll want to do some of this sort of thing once you’ve acquired the customer but not in the initial interaction.

The main aim was to “eliminate all barriers to the initial customer acquisition.” He didn’t have yet a name for this kind of revenue model.

The Freemium business model started with a comment

At the end of his article, Fred Wilson had clear in mind what the Freemium business model looked like. However, he didn’t have a name for it.

That is why he invited people to comment and to come up with a proper name for this business model. A commenter, Jarid Lukin suggested the name Freemium model.

Thus, a service and product wholly free and frictionless, where most users don’t pay, and a small base of users pay for a product that has premium features.

Over the years Fred Wilson kept emphasizing the importance of free. Today the freemium business model has taken over also the gaming industry. But it has also become the most debated business model in the software industry.

On the power of free

Building a free product and make it available to anyone and then expect to make money isn’t the right strategy.

Instead, the “free” within the freemium, if appropriately used, can be a lever for quick success.

As Fred Wilson pointed out in October 2008 “freemium is far from dead, in fact, it may be the business model de rigueur.”

What did he mean? He recounted in a later article:

Facebook is a perfect example of freeconomics at work. A woman who works for a major media company was in my office recently. She quoted her CEO as saying “why doesn’t Facebook just charge a monthly subscription fee, they’d be making money hand over fist?”. Well I believe that if Facebook did that, they’d be vulnerable to other networks offering a free service. And certainly not every one of those 200mm+ users are going to cough up a monthly subscription. But by offering a friction free service, they have built a powerful and growing network that they are now starting to monetize in various ways and that they will monetize even further in additional ways. And they are super hard to compete with because they are free.

Freemium isn’t new

As pointed out on broadstuff.com:

The new Free! plan is in fact Freemium – where a small number of people subsidise the majority, who get it for free. But “Freemium” models have existed since antiquity, they work in some situations, don’t work in others. This is also likely to be true for Digital goods. The issue lies in the price sensitivity

This point is critical, as freemium is not a size fits all monetization strategy (yes the “free” in it is meant to make money).

In fact, that also depends on the cost structure of the company offering the service. Also, freemium seems to work well in conjunction with advertising spending.

Think of the most popular services and apps we use today, like Facebook and Google. Those are in fact freemium services.

In fact, as millions of users are accessing them for free and with the least friction possible. Thousands of businesses are paying and financing those services through advertising.

This is also the power of the hidden revenue business model. In other cases, free needs to be offset with different monetization strategy, just like the razor and blade monetizations strategy. Where you get something for free, but then a complementary service associated is costly.

Key metrics for the freemium

To make the freemium business model work it is critical to look closely at a few key metrics. Some of those metrics are matured from the gaming industry but are also used by traditional freemium business models:

The average cost of serving a free user
The rates at which free users convert to premium (paying) customers
DAU (Daily Active Users) is used to show the number of people who engage with the product, service on a daily basis. For other platforms, other metrics like monthly active users might be more appropriate
ARPU: Average Revenue Per User
ARPDAU: Average Revenue Per Daily Active Use
ARPPU: Average Revenue Per Paying User
LTV: Lifetime Value
Daily Sessions: The number of play sessions a user engages each day.
CPA: Cost Per Acquisition or Cost

Freemium is not a size fits all business model

In 2015 a SaaS company, Baremetrics, started to experiment with the Freemium business model. In short, they created a version of the product the was entirely free.

That product version allowed users to switch to the premium if they wanted to add specific features or capabilities.

As the story went, the conversion rates on the freemium business model turned out to be also quite good compared to the traditional subscription-based business model.

In fact, in 11 weeks over a thousand accounts were created. The math on those new accounts wasn’t exciting, but it worked. In fact, as explained on Baremetrics blog:

So, of the 1,000 accounts, 461 were actually eligible to even think about becoming a paying customer.

Of the 461 eligible paying customers, 53 actually upgraded.

53 as a % of 461 = 11.5%

Considering a 3-5% conversion rates on B2B the rates from the freemium seemed to be promising, until…

Beware of the cost structure

As pointed out by Baremetrics on the experiment they run with the freemium:

Quickly, we started coming up against a lot of performance and database issues. Within a few weeks our “free” customers were outnumbering our “paying” customers and the amount of data were both storing and processing had doubled.

This, in turn, created an adverse effect on the revenues:

Source: baremetrics.com

In short, the freemium resulted in higher server costs and the loss of active paying customers, rather than an increase in revenues.

Free isn’t free after all

With the advent of free services like Google, Facebook and many other tech giants that have become part of our daily routine the assumption that everything needs to be free has become pervasive.

In some cases, free isn’t free after all. In fact, the reason a company opts for the freemium it isn’t because it wants to benefit the public.

But rather because it expects higher revenue growth and scalability from it. Thus a free service has to generate higher revenues to make sense. That’s why it has to come with built-in “psychological traps” that make users become paying customers.

That doesn’t mean that other subscription-based products or services are “less evil.” But the nature of free is meant to create addiction and leverage on the lack of breaks.

For instance, the Facebook newsfeed is thought with the logic of a slot machine, where the more you get the more you want. For freemium models to work they need to bring in a continuous flow of users that keep using them indefinitely.

Also paid services leverage on the same psychological traps. Yet, those paid services have breaks based on the fact that those services aren’t free. Thus, the business can keep growing even though users aren’t necessarily trapped into it.

Is your one big enough to pay the bills?

On September 2009 MailChimp went freemium. Its user base went in one year to 450,000 users. Ever since MailChimp has grown into a successful company.

As pointed out one year after the experimentation with the freemium business model, a critical question to ask is “whether or not your “one” is big enough to pay your bills yet.”

In fact, MailChimp didn’t start as a freemium. When they launched the company back in 2001, they didn’t even have a free trial.

They didn’t have an idea of what the freemium was. They only started to consider that freemium business model as a viable option when they realized that that paying customer was able to keep them going with other nine unpaying customers.

As remarked by MailChimp:

We’d never consider freemium until our “1” was big enough. Enough to pay for 70+ employees, their health benefits, stash some cash for the future, etc.

Are you using the freemium just to get VC money?

In the Silicon Valley archetype “users” have become the most important asset a company seems to need to be eligible to get billion dollars of capital.

However, this system – I argue – is broken because it draws on the myth that once you have users then monetizing them is easy.

However, for anyone that has ever tried to grow a startup you know that monetization is the hardest part.

It might seem a trivial concept for small business owners that to build a sustainable business you need to balance things up so that your revenues will exceed your expenses.

Yet the so-called “profit” seems to be a thing of the past. Thus, they use a large users base to get VC money to keep growing revenues without focusing on profits.

Cases like ConvertKit are a great example of why generating profits is critical for your business. Many counterargue by mentioning cases like Google and Facebook.

Yet they forget that Google and Facebook were extremely profitable not long after they launched their services. At the time of this writing, companies like Snapchat are struggling just because they never managed to become profitable.

A final remark on how to do the Freemium right

I want to close this article with the extract from MailChimp Freemium business model. The reason being, MailChimp has been one of the most effective companies in applying the freemium, and this is the greatest lesson learned:

I think there are too many startups out there who are interested in going freemium because that big “10” number is so attractive. This is dangerous when they don’t even have the “1” yet. How will they pay their bills while they figure out how to “monetize?” Answer: they will need to borrow that money. Does your VC have the patience for the long term, while you try to figure out how to “monetize” and build up that measely “1” number? Answer: No — no they don’t. Build up that “1” before you chase the “10.” After you’ve got your “1” all set, use VCs to help you chase after that “10” (if you must). That’s my personal opinion. Disclaimer: I’m wrong about 99% of the time.

Key takeaways

Today the web has used us to think that everything needs to be free. This comes from the belief that the cost of products and services have gone down to almost zero. That might be true up to a certain extent.

In fact, for many software companies offering a free service means having unbearing operating expenses related to server costs. Thus, a free service that doesn’t convert enough free users into paying customers won’t succeed in the long run.

The Baremetrics case has shown it well. There is also another important aspect. For many companies, the freemium has become just a way to get money from VC. MailChimp case study has shown how to do the freemium right.

Until you don’t have the “one” paying customer big enough to pay your bills the freemium might not be the right strategy for you. Unless of course, you have VC money to burn!

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The post What Is a Freemium? The Freemium Business Model Explained appeared first on FourWeekMBA.

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