Business Model: Freemium

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.

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 scale stage because it costs too much money to acquire free customers.

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 percent 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.

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 few years, 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.

Our prediction: She who builds the biggest most engaged user base wins. Therefore, freemium strategies will be deployed to strengthen overall competitive positioning.