Freemium Model

How to run a freemium business.

This article was published on June 16, 2010.
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Because the idea of a freemium business model is fairly new, not too much has been written about how to approach it. We know what it is: You give your service away for free, acquire as many customers as you can, and then charge for premium features. Sounds simple. But the freemium business model is far from simple, and there's a lot to think about. I've compiled my thoughts about how you might go about implementing the freemium model for your startup.

Freemium

What Is Freemium?

Before I go any further, for those of you who don't know what the freemium business model is, let me explain. The more traditional profit generating business model for the Web is through advertising, but with advertising payouts being smaller than they once were, freemium has come along as a solid alternative.

Fred Wilson first articulated the idea of freemium on March 23rd, 2006 in a blog post entitled My Favorite Business Model. Here's a snippet: "Give your service away for free, possibly ad supported but maybe not, acquire a lot of customers very efficiently through word of mouth, referral networks, organic search marketing, etc., then offer premium priced value added services or an enhanced version of your service to your customer base."

A good example of that is Carbonmade. It is free to sign up for our "Meh" account, which comes with 5 projects and 35 images, but you can choose to pay $12/month for our "Whoo!" account, which gets you up to 50 projects, 500 images, and the ability to display video. Our free plan brings in the customers, and when they run out of space or find that they need video, they'll upgrade.

Freemium is different from the Software as a Service (SaaS) business model of free trials, which is also popular. Free trials are different in that you give away the fully featured product for a limited time (usually 30 days) and hope that by the end of the trial the customer is committed enough to pay from then on. Companies like 37signals and Squarespace are big proponents of this model over freemium. (Squarespace actually ditched the freemium model a few years back in favor of the free trial.)

Why Freemium?

There are three main reasons why using the freemium business model is good: (1) giving your product away for free indefinitely will give users time to think about upgrading; (2) there's a viral benefit; and (3) there's a network benefit because the more people you have using the product the more added value.

First, the added time that you wouldn't otherwise get with the free trial business model can give users time to decide whether or not they want to upgrade. They may be perfectly satisfied with the free plan for several months, or years, until one day they find themselves needing the extra space or expanded features. Carbonmade has been around for nearly five years, and every so often we find users upgrading to a payment schedule after having spent more than 1,000 days on the free plan. That's an upgrade — not to mention those after shorter extended periods — that we'd never have had if we'd followed the free trial model. We would have scared off the user who wasn't ready to commit to $12/month.

Second, the viral benefit stemming from a person using your free service can be substantial. They may not be interested in upgrading, but the friends they tell about your service may be. We track referrals that our current users bring in, and that category amounts to a large portion of our new users. On the bottom of every portfolio there's a Carbonmade button that can be clicked on by viewers. These people in turn may sign up.

Third, whereas the benefit of giving users extra time to decide and viral benefits are the most directly visible perks of freemium, the added network benefits are less obvious. Many people fail to realize the other verticals you can bring into your product when you have a large network of users. I wrote about this in an article back in December, 2009 entitled Building Blocks. New verticals can open as you bring more people into your network.

Can you Build a Significant Business?

Critics of the freemium business model say that you cannot build a significantly large business (think IPO or billion dollar acquisition) by employing it. That's clearly not the case if you look at successful companies such as Skype, Pandora, Dropbox, LinkedIn, and Flickr. All of these businesses use the freemium model and have hundreds of millions of dollars in revenue, with Skype rumored to be going IPO shortly.

It's true that these are all consumer-based businesses, which is important to note, because only consumer-based businesses can attract the millions of users needed for a 2-5% conversion rate to pay off. There just aren't enough businesses out there to sell your product to if you use the freemium model with the expectation of converting only 2-5% of them to a payment schedule.

Segmenting Free from Paid

The most difficult issue when setting up a freemium business is in figuring out the product segmentation. First, if you give too much away, there won't be any reason for your users to upgrade. An example of this is Feedburner, who only had two thousand paying customers out of 500,000 when they were sold to Google – far lower than the average 2-5% most freemium companies see. The standalone free product was good enough for most users, because all they cared about was how many subscribers they had and were gaining over time. Feedburner gave away too much.

Second, if you don't create compelling features that are aligned with how free users are using the product, then nobody will care to upgrade. Offering better support and expanded analytics are not compelling enough features for upgrading. At Carbonmade we give away more space (very compelling), but also video and domain binding support (everyone wants their own URL) with more paid-only features in the works. Running out of space is the most compelling of our motives to pay, and the easiest to segment. Dropbox is also very successful employing this model (2 GB for free and $9.99 for 50 GB). It's natural that users are going to run out of space and find themselves needing to upgrade.

Third, and one of the most important features to keep on the free side, is anything viral that will spread growth. You do not want to confine sharing or promotion of your product by your users to the paid plan. An example of this from Carbonmade is that everyone who signs up – free or paid – is given their own URL to promote their portfolio. Our competitors charge for a clean portfolio display, but our facilitation of personal URLs encourages our users to share their portfolio links with their friends, who in turn see a beautifully displayed portfolio and sign up by clicking the Carbonmade button at the bottom of every free portfolio.

Startup Metrics

At the launch of your startup, you want to be measuring all of your users' activity insofar as it's possible. Dave McClure, in a widely discussed series of slides entitled Startup Metrics for Pirates, goes into some good details on what to measure. If you're not tracking what your users are doing, then you're basically building blindly. You won't know where to take the product and how to price things going forward.

The most important number for you is your conversion rate. The vast majority of freemium products have a 2-5% conversion rate. You'll want to tweak what you offer until you're comfortably over 2%. The only way to successfully reach that rate is to track what's being used in your app, how long customers are on the free plan before upgrading, how long they then stay on the paid plan, what the churn rate is, where users are coming from, and so forth.

One thing to keep in mind when figuring out your conversion rate is to compare your overall paid users to a cohort consisting only of your active users. Taking every user that's ever signed up for your product is not a good indicator. A user who hasn't used your product in two years shouldn't factor into the equation. I like to compute conversion rates within cohorts of 30 day active users, 60 day active users, 90 day active users, and 180 day active users.

Freemium Business Pricing

Figuring out pricing is one of the issues entrepreneurs worry about most when employing the freemium business model. It doesn't have to be so worrisome. First of all, I suggest launching with a premium plan from the beginning. This establishes the understanding of your users from the beginning that you're segmenting the product. It'd cause a revolt if a year down the line you strip features away from the free plan to implement a paid plan.

When thinking up your pricing point, you should think about what you would pay for your own service. Most products are built by entrepreneurs who looked for a comparable product and didn't find anything good on the Web, so they built it themselves. What would you be willing to pay if you had been able to find the product?

Once you've arrived at a number, make sure that it's on the low end of what you'd be willing to pay, as it's much easier to raise prices than lower prices. The reason for this is that when you raise the price and protect all of your current customers from the new price by grandfathering, they feel as if they got a deal for being early adopters and will be really happy. If you were to lower prices on them, they'd feel as if you somehow cheated them. This may go against common sense, but it is the prevailing thinking when it comes to lowering or raising prices.

So you should start low and see how many people you can convert. If you are seeing a good conversion rate then you can begin to inch up prices and test to see how these new prices fare against the old ones. You want to really push the envelope as high as you can. Keep in mind that you need to factor in your competitors' price points and whether or not your users know they exist, but with all that said, don't be afraid to raise prices according to what the market will bear.

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