Business Model: Freemium

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

Challenges

Key Performance Indicators

Valuable to Business Offering Freemium

Benefits

Challenges

Key Performance Indicators

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.