The freemium business model was born out of a blog post created by venture capitalist Fred Wilson.
In his article, he wrote advised startups to give away their service for free.
At the time of writing the article, the concept of freemium was new and many new startups were Software As A Service (SaaS) startups looking to rapidly grow.
According to Fred Wilson, the advantages of offering a free option was the ability to rapidly acquire customers. The goal of using it was to “eliminate all barriers to the initial customer acquisition“.
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The Birth of the Freemium Business Model
Fred Wilson didn’t have a name for the concept of using a free level to acquire customers, and so he asked his audience to come up with a name.
A commenter, Jarid Lukin, then suggested the name Freemium model. The Freemium model then evolved and became known as the Freemium business model.
In a nutshell, the freemium business model involves providing a basic version of a product or service for free, with the intention of persuading sufﬁcient numbers of customers to pay for a more advanced version.
Services like Dropbox, Skype, LinkedIn or Spotify have successfully implemented the freemium business model and offer both free and premium-priced versions.
But, A large number of other online digital companies have experienced freemium as a costly trap.
However, entrepreneurs and senior managers in organizations still have a limited understanding of why some freemium business models become successful and sustainable while others do not.
The Power of Free
Free can mean many things, and that meaning has changed over the years. It raises suspicions, yet has the power to grab attention like almost nothing else. It is almost never as simple as it seems, yet it is the most natural transaction of all.” – Chris Anderson in his book Free, The future of radical priceChris Anderson
The Freemium business model isn’t new. It started in the 1980s as a strategy to get customers to try software.
Back then it was more commonly known as shareware. The free (limited) version of the product was offered out to people with the hope that they would then upgrade to the paid version.
Fast-forward to today and companies like Linkedin use it as a core part of their business model. Another example is the Spotify business model, where users can listen to music for free, in exchange though they are exposed to adverts.
For Spotify, these adverts are a way of offsetting the costs, but also providing a significant value difference and reason to upgrade (listen to music ad free).
Why A Freemium Model Is Not a Business Model
A business model is a systematic way of designing how a business works and involves defining its activities, resources and how these go onto to create value for customers.
A revenue model is a method of capturing value from how you market and sell your products – in other words how you make money.
A freemium pricing strategy is often used as a startup financial model to accelerate growth, particularly for software businesses.
A customer is only a click away and if you can convert them without forcing them into a price/value decision you can build a customer base fairly rapidly and efficiently. It is important that you require as little as possible in the initial customer acquisition process. Asking for a credit card even though you won’t charge anything to it is not a good idea. Even forced registration is a bad idea. You’ll want to do some of this sort of thing once you’ve acquired the customer but not in the initial interaction.Fred Wilson
Freemium vs Free Business Models Using Advertising
Many digital platforms such as YouTube, Netflix, Tencent Video, and Qiyi, to name a few, generate profits from advertisers. These are two-sided platforms. This is not the same and not to be confused with a Freemium model.
A platform is often a two-sided that facilitates transactions between the participants on both sides. In a classic two-sided market, the agents on one side of a platform can obtain value from interacting with agents on the other side. This is termed network effects.
In order to attract online users to a website, freemium services are often introduced, such as online auctions (e.g. eBay), eCommerce (e.g. Amazon), social networks (e.g. Facebook), online video (e.g. YouTube), online job bank, online games, etc.
In these models, they offer free services to load one side of the two-sided market, a platform. In turn, this attracts advertisers, firms, stores, and buyers (another sided market) that are willing to pay.
Conversely, a freemium model offers a set of features for free and then provides a paid upgrade path.
What are the problems with the Freemium Model?
Giving your product or service away for free doesn’t guarantee customers will then convert to premium.
If the value proposition isn’t strong and customers do not see the added value in moving to premium services a startup might acquire a lot of customers but will rapidly run out of cash.
Offering free, even with digital business models, still requires a lot of resources to service the product and the associated overheads. An example of this is Ahrefs, an SEO platform that allows people to search for keywords, analyse a site for traffic, keywords and much more.
Ahrefs doesn’t offer a free version for a good reason. The cost, increase in bandwidth and the sheer volume of queries would outweigh any benefits in terms of conversions. Also, Ahrefs is a high priced service. This premium pricing allows it to reinvest in the development of its platform. Essentially, Ahrefs business model relies on the revenue of long terms subscriptions from SEO professionals.
A further consideration is how a freemium offer affects your overall pricing strategy. Pricing and value are inevitably intertwined and need to be carefully considered. Low-cost items are often not perceived as being low value.
Ratios, Costs And Financials Of Freemium Users
According to Anderson (2009), many websites using the freemium models work on a ratio of premium cstomers to freemium customers.
He called this the “5% principle,” meaning that providing one out of 20 people pay for value-added service, it can cover the cost of free use of the remaining 19 people. Of course this ratio is not a fixed one and depends on the service/product being offered.
However, the ratio affects many other parts of the business and ultimately optimizing the ratio has implicit implications for the profit and cash flow of the business.
- The average cost of serving a free user.
- Free to Premium Ratio for customers.
- DAU (Daily Active Users) is used to show the number of people who engage with the product, service on a daily basis. For some platforms, monthly active users (MAU) might be more appropriate.
- ARPU: Average Revenue Per User.
- ARPDAU: Average Revenue Per Daily Active Use.
- ARPPU: Average Revenue Per Paying User.
- LTV: Lifetime Value.
- Daily Sessions: The number of play sessions a user engages each day.
- CPA: Cost Per Acquisition or Cost.
The Perfect Marriage Subscriptions and Freemium
Examples of this can be seen with Spotify, Linkedin, Dropbox and many others.
However, despite its immediate appeal, it isn’t a one-size-fits-all approach. Where Freemium works well is when it is supported by other revenue models e.g. Spotify where the cost (and pain to be relieved) is advertising.
The concept also works well when the first level of any premium plan offers a significant benefit but at a lower cost. The crucial and more comprehensive premium features are then locked out for much higher prices.
It is this balance of understanding which features to offer for free and which to offer as a premium that is the difference between success and failure.
Freemium Business Model Examples
Google Drive offers a fixed level of cloud storage for free and then incrementally larger amounts of storage based on a subscription.
Dropbox offers 2 GB of free storage capacity in the cloud, which is generally adequate for text documents. However, if users exceed that storage limit, they have the option to upgrade to 1 TB (i.e., 1,000 GB) by paying a monthly subscription fee of $9.99 or an annual subscription fee of $99.
LinkedIn Inc. was founded in 2002. It runs a professional networking site allowing the members to create business connections and search for jobs and potential clients. As of 2019, the network had more than 310 Monthly Active Users (MAU)’s in over 200 countries and territories.
Linkedin provides a free service for people to upload their details and create a digital cv. However, if they want to improve visibility with recruiters and gain access to insights about jobs they need to upgrade to a premium version.
Free for as many as six users; however Skype charges for out-of-Skype connectivity.
Mailchimp is an email marketing platform that offers limited service for free up to when a user acquires a 1000 subscribers. The more advanced features such as automation and tag-based triggers are part of the premium pricing.
Spotify AB was founded in 2006. It is a digital music service providing users with access to millions of songs. Spotify is available on computers, smartphones and other devices. Users can listen to music for free but are exposed to regular adverts. The premium version offers listeners an ad-free experience and the ability to download the music and listen offline.
Eventbrite Inc. was founded in 2006. It runs a self-service ticketing platform. The technology allows anyone to create, share, find and attend new events. The online service is used in 187 countries by over 60,000 event organizers. It books over 3 million tickets per week.
Eventbrite allows people to set up events for events that do not charge for tickets. If users want to charge for tickets Eventbrite then charges different levels of commission based on the level of features you need.
How To Create and Sustain A Freemium Model
- Sustain the high value of free and premium offerings. To succeed with freemium, companies need to sustain the value offer relative to other offers in the market. Also, the free and premium value offer needs to refined and improved to reinforce the value proposition, e.g. a better user interface, additional new features, further compatibility with other systems and solutions and more free space.
- Optimize the balance between free and premium offerings. Reaching the right balance between free and premium offerings is crucial for a freemium business. There is a danger of offering too much for free, thus eliminating the incentive for users to upgrade to the paid version.
- Extract value from free users. Free users should be treated as a valuable resource and as a marketing tool rather than as operational costs. They provide opportunities for testing and ideating the freemium portfolio and provide invaluable feedback when it comes to product usability and features. In companies, free users can also serve as a gateway to potentially lucrative cooperation as they can suggest the product to their employers, as well as peers and co-workers.
- Learn continuously from user behaviour. Understanding the users’ behaviour is a key competitive advantage for a freemium business. Successful companies spend a lot of resources in building their data analytics capacity. They harness this knowledge to optimize user-management and tailor their premium offers.
- Targeting using product bundling and integration. To reach a broader scope of potential users, it is useful to test product bundling and expand integration with other market players. As an example, to expand the distribution of its service and mobile app, Spotify signed partnership agreements with mobile operators.
- Minimise costs of free-user management. Costs are an important aspect for any company, yet are an especially important aspect for freemium companies since free users generate costs related to service and maintenance, data usage and cloud computing, but no direct income is earned from them. Therefore, successful freemium businesses work hard on reducing user-servicing costs by implementing automated and mass-customised customer relationship platforms.
- Aggressively internationalize. Once the freemium company is established in the local market, it should consider internationalisation. For instance, LinkedIn focused on growing its presence in China, which in 2015 became the company’s second-largest market for new signups behind the USA.
- Access new technologies and users through mergers and acquisitions. Freemium managers should consider mergers and acquisitions to add new technologies or to reach new users and customers. The successful freemium companies are constantly searching for complementary and supplementary capabilities that are aligned with their strategic orientation.
Summary – Advantages and Disadvantages of Freemium Business Model
Choosing the freemium business model for online digital business means choosing to compete in a particular way.
Offering a service for free does not guarantee success.
First of all, the free offer must appeal to the target market, and it must satisfy an existing or a latent need of potential users. More importantly, this target market must include individual users with buying potential.
Before choosing to compete on a freemium business model basis, evaluate if your business can pursue the innovation and growth strategies needed. If this strategy is not an option in the long run, then it is worth considering other business model conﬁgurations.
The logic of the freemium business model requires not only a constant new user acquisition, but also persistent user retention. The perceived customer value should inherently increase to keep users loyal and increase their switching costs.
Running the freemium business model in online markets requires a deeper knowledge of users and consumers that goes beyond traditional market research.
Big data and web analytics are relevant and necessary capabilities needed.
Carefully testing and identifying the most effective cut-off between free and premium offerings is crucial for profits.
Altogether, the business strategy, the business model conﬁguration and the Freemium business model require strategic choices need to be aligned and continuously reviewed to build a sustainable business.