Freemium
Freemium is a term coined by Jarid Lukin, one of Fred Wilson’s commenters on his blog, A VC. Key features are made available to customers for free, and specific features and services are delivered for a fee.
Freemium isn't Free
While in the era of cheap credit running up through 2021 a number of companies would offer their software or digital experiences for free in order to build an audience, freemium is a different tactic, involving a deliberate design of a free “front porch” experience, a gate or paywall, and higher value experiences beyond the gate.
Freemium Evaluator
Valuable to Customer
Benefits
- Try before you buy
- No costly “per seat” software licenses that may go unused due to lack of interest
- Less IT infrastructure and support needed
Challenges
- Risk of banning the software when IT department learns about adoption inside the company they do not control
- Risk managing security in cloud-based data, particularly in free version
- Integration across multiple SaaS and on-prem solutions
Key Performance Indicators
- Cost of ownership vs. usage
- Risk vs. reward analysis (when IT learns of use)
Valuable to Business Offering Freemium
Benefits
- Faster potential growth and likelihood of word-of-mouth
- Low friction shorter sales cycle move to departmental buyers, avoid the IT department
- Opportunity to learn from free users and identify emerging behavior
Challenges
- Requires rigorous focus and discipline on the right balance between free and premium
- Often need a two-step value proposition: 1 for free user, 1 for paying user
- Freemium does not sell itself – sales departments are still required
- At risk of being cancelled during a downturn when customer CFOs evaluate total spend
Key Performance Indicators
- MRR: monthly recurring revenue
- Retention of paid users
- The ratio of CAC (cost of customer acquisition) to LTV (lifetime value)
When it Works Well
Incremental Costs Approach Zero
In software-based services that are stored in the cloud and delivered over the internet, incremental costs for producing a new unit (marginal costs) decrease over time, never reaching zero but approaching low cost the larger the user base grows.
Services designed to attract a network effect
The free version of the service in a freemium model works well when it is designed to attract network effect, a service that becomes more valuable as more and more people use it. LinkedIn and other social networks operate on network effects. When LinkedIn started, it was used primarily by technology professionals who were already active on the internet. As the use and adoption grew to represent the majority of people wanting to connect professionally, the value increased exponentially.
Less Cost to Acquire Customers
Specifically, in internet services, a network effect can be designed into the service, by building in sharing and collaboration features as part of the free service offering. The resulting benefit: less money needed for paid marketing and advertising, as awareness is driven through referrals.
Product-Led Growth
An emerging competency: product-led-growth, can shape a successful freemium model: emphasizing the design of initial onboarding and upgrade from freemium to paid vs. only spending money on marketing to acquire customers.
Challenges to the Freemium Model
Cost of Acquiring Free Users
If you build it, they don’t always come. Measure the cost to acquire free and paid users. When you tally up your costs of customer acquisition (CAC), make sure you are including marketing costs for users and paid customers in your calculations. Many freemium models fail at the scale stage because it costs too much money to acquire free customers.
Competitors Attack with Free
Startup disruptors often approach an incumbent with an aggressive freemium strategy, serving up features for free that a competitor may currently be offering for a fee. Hotmail was one of the first companies to adopt a freemium model, dismantling the business models of established email service providers and internet service providers of its time. Build scenarios when mapping out the paid part of your current product service model to understand competitive responses to your offer.
Cost of Acquiring Free Users
If you build it, they don’t always come. Measure the cost to acquire free and paid users. When you tally up your costs of customer acquisition (CAC), make sure you are including marketing costs for users and paid customers in your calculations. Many freemium models fail at the scale stage because it costs too much money to acquire free customers.
Competitors Attack with Free
Startup disruptors often approach an incumbent with an aggressive freemium strategy, serving up features for free that a competitor may currently be offering for a fee. Hotmail was one of the first companies to adopt a freemium model, dismantling the business models of established email service providers and internet service providers of its time. Build scenarios when mapping out the paid part of your current product service model to understand competitive responses to your offer.
Trends in the Freemium Model
In App Purchases
As far back as 2010, game apps made most of their revenue from app downloads, but now the highest-grossing apps make their money from a freemium model. The most popular method is the in-app purchase. Customers download an app for free and pay to advance levels and get special powers for a micro-fee. Game companies like Epic have sued Apple to contest these fees, and other apps encourage you to use web browsers rather than grant in-app purchases.
Incumbent Firms Respond with Bundling
It’s been hard for companies that charged in a fee for services and software to acknowledge the power and strength of the freemium model. For years, Microsoft’s three biggest product lines—Office, Windows, and Windows Server—drove the firm’s revenues, profits, and mountains of cash reserves in a straight-up software licensing model. Within the past few years, however, Microsoft made its Office software bundled in for on smaller devices under 9 inches, and a subscription service for larger format devices, and in response to freemium chat software Slack, they have bundled in equivalent Teams for free. The bundling model is used as a defensive strategy to keep Microsoft relevant in mobile and cloud-based technology.
Key Freemium Mechanisms to Test
Freemium is all about testing the ratios, time, and combination of features and offerings to convert free to paid. You are better off testing freemium pricing as soon as possible so that you can understand how people value your features and services. KPIs depend on your unique business attributes and business model combinations. However, there are heuristics when investors evaluate a freemium model:
Before You Consider Freemium
- How do you go about purchasing and using this solution today?
- Even free costs time: Test for jobs to be done, level of pain on the pain scale. How much of a priority is (defined problem or pain)?
How would users adopt the free version? - How would they share the use of the free version to invite new users?
- What is your target customer’s stance on freemium software? (Does IT immediately shut you down)
Testing the Model
- What is the total cost of ownership of comparable solutions? Are you still disrupting that cost with your premium offer
- Arrange features, services, and benefits into key elements of your offer, and have the potential customer arrange the elements of the larger solution in order of willingness to pay. (minimum viable paywall).
- Can you design an MVP that has high usage, engagement, and user referral in the free version?
More on Freemium
The Freemium Business Model, by Fred Wilson at AVC.com, 2006.
How Companies Can Get the Most Out of a Freemium Business Model, Harvard Business Review, 2019. (limited access)
Making Freemium Work, by Vineet Kumar, Harvard Business Review, 2015. (limited access)
The Rise of the Freemium Business Model, by Tren Griffin, at 25iq, 2017.
How to Create a Profitable Freemium Startup (spreadsheet model included), by Andrew Chen at AndrewChen.co,
Marginal Costs at Khan Academy, by Khan Academy, 2012.
Network Effects and Network Externalities, by Arun Sundararajan at Stern NYU, 0z.stern.nyu.edu.
Moving Customers from Freemium to Premium: The Art of Monetizing Virtual Products, by Ava Seave at Forbes, 2015.
Reality Check: No, Microsoft Isn’t Going Freemium, by Darian Graham Smith at Alphr, 2015.
10 SaaS Companies that Rocked the Freemium Model, by Ross Starkey, Digital Media Sream, 2017.
Music Superstars like The Weeknd are Using a Classic Tech Startup Strategy to Rule the Future, by Nathan MacAlone, Business Insider, 2017.
