Plenty of startups out there want to do go for a “freemium” business model, but there’s a lot of confusion as to what “freemium” actually means. And more importantly, whether and how it works. So here’s a primer.
What Freemium Is (And Is Not)
Freemium means the vast majority of your users use your product for free and a minority pay.
Importantly, this means that freemium is NOT the same thing as “premium with a free sample.” Plenty of software as a service (SaaS) companies have some sort of free option, but the goal is to have the majority of users pay. A restaurant that offers free appetizers is not a freemium business, and neither is 37signals.
Why You Would Go Freemium
There are basically two reasons to go for a freemium business model:
- Marketing. By definition, having a free product makes it really easy to get customers. And internet economics make this very attractive, because the marginal cost of every new free users will be very low. Free users can also be good marketing because even though a free user might not convert, they can invite other free users who might.
- Network effects. A network effect is what happens when a product or service becomes more valuable the more people use it. A phone isn’t very useful if you can’t call anyone else with it. But once everyone you know has a phone, it becomes a pretty valuable thing to have. If you’re in a market that lends itself to network effects you’re going to want to have a free basic product because if you don’t someone else will and will use the network effects to crush you.
What Freemium Needs To Work
This is the part where there’s the most confusion. Not every product or service can work as freemium.
Plenty of startups like the idea of a freemium model, because they can have a free product and get lots of users really fast, but at the same time tell themselves they have a business model and can eventually make money.
One of the best experts on freemium business models is Evernote Founder/CEO Phil Libin, whose freemium company is very profitable and who has given several talks on how and why the freemium business model works for him. According to Phil Libin, here’s what you need to be able to do to make freemium work:
- Get lots and lots of free users. It seems obvious, but it’s important to keep in mind. Freemium is a numbers game: if only 1% of your users are going to pay you, then you need to have lots and lots of free users (millions, typically) to make that 1% enough money.
- Get all of these users to stick around. Also important, as we’ll see.
- HAVE A PRODUCT OR SERVICE WHOSE VALUE TO USERS INCREASES WITH TIME. This is the biggest thing that most people miss, hence the caps. The value of your service needs to increase the more people use it. A classic example is Spotify, where you create all your playlists and organise your music. Once you’ve done that, as investor Sean Parker says, “we’ve got you by the balls,” and you’re much more likely to pay up. The value of Spotify to you has gone up from being just music to music, your playlists and your friends’ playlists, so paying starts to make sense.
- Keep costs low. Also seemingly obvious but actually a big deal: freemium works because the marginal cost of each additional user is low, so you need to keep your operating costs correspondingly low. Again, internet economics, through things like open source and the cloud, help, but that’s not going to be true for everyone.
The Drawbacks Of Freemium
Freemium can sound like the perfect business model: the benefits of free users and the benefits of paying users. And sometimes it is. But not always. The main drawbacks are basically a function of the plusses seen above:
- You need lots and lots of users. Freemium will only work if your idea has the potential to reach millions of active users. If it’s more niche, you should go the premium route.
- You need lots and lots of returning users.Freemium works if your users stick around and start to love the product. If you can attract tons of users but they’re less sticky (if you have great search engine rankings for example), you might be better off monetizing through advertising.
- It takes a long time to be profitable.Because users take longer to convert as the value of the product to them increases over time, and because you keep adding (hopefully) new free users, freemium businesses take a long time to reach breakeven point. Once they do they can be very profitable, because your revenue per active user grows faster than your cost per active user, but it takes a while to reach breakeven. Equity financing (angels and VCs) or alternative sources of revenue can help you bridge the gap but not everyone has that opportunity or wants to do that.
Freemium can work for plenty of businesses and not others, so we’ve put together a list of startups that did (or didn’t) succeed with freemium, and why.
Evernote is an app that records and saves your notes and everything else you might want to remember. Its success as a freemium product is even more striking because the product isn't 'social' or 'viral' and yet it keeps growing via good old fashioned word of mouth.
But Evernote is a classic example of how important it is to have a service whose value increases over time. As CEO Phil Libin put it in a talk, if you have three weeks of recorded notes and memories, and someone offered you $50 bucks to delete them, you might say yes. If you have three years of recorded memories, that might be worth as much to you as your house.
The academic example of a 'network effect' is the phone network. Well, the 21st century version is Skype. Skype is so valuable because it has 600 million users who make calls for free over the internet. And only a small percentage of those pay to make calls to landlines. But that percentage is enough for a billion in revenue, and it would be impossible to make that revenue if it weren't for those hundreds of millions of free users who give the product its value.
Social networks are also classic network effects businesses, and because LinkedIn is a professional social network, it has no problems selling subscriptions to recruiters and sales people who are particularly heavy users of the site.
Dropbox is a cloud backup system that stands out in a crowded field because it's so easy to use.
Its free option is smart, because that gets people to use it. And it has a referral program that gives users free space for inviting space, which gives it viral growth.
It's obvious how it increases in value the more you use it: once you run out of free space and have all your documents in Dropbox, you're not going to move it all out. You're going to pay up.
And finally it keeps it costs low by being all in the cloud, where costs are always going lower thanks to Moore's Law.
In other words, it has a business model where almost by the laws of physics revenues are always going up and costs always going down. No wonder Y Combinator founder Paul Graham thinks it's one of the most valuable companies in the portfolio.
Most people don't realise how huge SurveyMonkey is. Even fewer realise how absurdly profitable it is. SurveyMonkey makes it easy to make online surveys, and charges a small fraction of users, most of them businesses for advanced features.
The company is private but most estimates put its revenues around $50 million and its profit margin around 50%.
Freemium doesn't always work. Ning is a pretty good example. When it was started, the goal was to out-Facebook Facebook (or, for 2004, out-Friendster Friendster and out-MySpace MySpace) by building a social network of social networks. Founder Marc Andreessen's idea was: if social networks have network effects, then a social network of social networks would have network effects squared!
It didn't work out that way. Turns out, people preferred a generic social network, and most people don't want to join a niche social network about their hobby on top of Facebook and LinkedIn (and Twitter, and Tumblr...).
But people who start and join social networks about hobbies are pretty passionate, so at some point Ning said: 'Hey, free ride's over. If you like the sites we've let you build so much, you're going to have to pay for them.' And most did.
The lesson? If your idea is smaller than you thought it would be, premium might be better than freemium.
MailChimp helps people manage and send out newsletters. It's a complicated business because you have to make sure people don't send out spam and talk to email and internet providers to make sure they don't think your newsletters are spam and so forth. And most people who send newsletters are small and medium businesses. Sounds like a classic premium business, right?
Wrong. At least for MailChimp.
They went freemium and with the help of some savvy marketing got tons of free users who led to even more paying users than they had before. One year after going freemium, paying customers increased over 150% and profit increased over 650%, founder Ben Chestnut wrote.
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