Freemium

Anyone with access to the internet has enjoyed the benefits of a freemium Freemium business models combine free services and premium services. Freemium is a term coined by Jarid Lukin, one of Fred Wilson’s commenters on his highly popular blog, A VC. Key features are made available to customers for free, and specific features and services are delivered for a fee.

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.

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.

Challenges to the Freemium Model 

Conversion from free to paid

Getting customers to upgrade is difficult, and many successful freemium companies rely on only a sliver if a percentage of users who convert to paid. For mobile gaming companies, often only 2-3{4b0c188ae8604bf014d8bc27c7c65bbf455b55139b6ec077c9ec57d60479b1a7} of customers drive the largest revenue for these companies. Successful freemium businesses pay careful attention to their engagement and conversion marketing funnel and regularly track what tactics work to move a customer over to the paid version.

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.

The business model mechanisms to test:

Mechanism to test Metrics to measure
Which combination of features to customers value at a premium? Does the customer understand the offer and why the paid service costs money? Conversion rate to paid: The rate at which free users convert to paid users
Which combination of features drive the network effect? Do users understand how and when to invite other users? Free user growth rate, referral rate
What is the value of each paid customer? Lifetime value, average revenue per user
What is the cost to acquire a customer? While free users drive the bulk of new users, paid forms of marketing can help to expand to new segments and smooth growth. Cost of Customer Acquisition

Emerging Trends: 

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: the in-app purchase. Customers download an app for free and pay to advance levels and get special powers for a micro-fee. If you haven’t played one of these games, go download Two Dots now. We’ll see you in a few hours.

Incumbent firms shifting to freemium 

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 year, however, Microsoft made its Office software free on smaller devices under 9 inches, and a subscription service for larger format devices. We expect the entire industry to follow suit. The freemium model is used as a defensive, rather than an offensive strategy to keep Microsoft relevant in mobile and cloud-based technology.

Deeper Dives on the Freemium Business Model 

The Freemium Business Model, by Fred Wilson at AVC.com, 2006.

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.

What do you think about the Freemium model? Do you work in a company that has tried this approach? Do you have other resources or company suggestions we should source? Share your comments or suggest another business model to add to our library.

 

Share this Post

Reason Street's Most Popular Business Models

Feb 11, 2016 - reasonstreet.co - 3324
Pay-Per-Use

In a pay-per-use business model, use of a product or service is metered, and customers are charged when they use the service. “Pay-per-view TV” and online journal publications, custom research firms, who sell access to high value content on a per use or per download basis.

Feb 11, 2016 - reasonstreet.co - 3580
Two-Sided Marketplace

A two-sided-marketplace business model is a platform for economic exchange between two distinct user groups that provide each other with the benefits of a large network.

Feb 11, 2016 - reasonstreet.co - 3136
Business Model: Subscriptions

The explosion of the “subscription economy” is upon us with everything from flowers to car sharing to data storage to beauty care products now being billed to us on a monthly basis.


Business Models in Use

Clash of Clans
Candy Crush
Survey Monkey
LinkedIn
Evernote
Box
DropBox
Hulu
Skype
Spotify
Slack

Share this Post