Considerations for “Freemium”

Freemium – the combination of “free” and “premium” – has become a mainstay business model for many technology companies.

The theory is simple. Users get access to basic features at no cost, while they also have the option to pay a subscription fee for more advanced capabilities. There are examples of prominent freemium companies across every sector. If you have listened to music on Spotify, networked on LinkedIn, or sent an email through MailChimp, you have experienced it firsthand. Slack, HubSpot, and Box come to mind in the B2B world as well.

For businesses the primary benefit of freemium is obvious, it’s an organic marketing tool. For a small company, freemium can seem like an attractive way to get market share fast. In theory, free users will use and share your product or service. Eventually, some of those free users will upgrade into revenue generating premium users.  Yet, as with most theories, freemium is not quite that simple. Before an entrepreneur makes the decision to go freemium they should ask themselves a few questions.

What market type are you entering?

Taking a page out of Steve Blank’s book, The Four Steps to the Epiphany, the first consideration you need to look at is market type.

Let’s assume you are entering the existing market of mobile music streaming. Since you are entering an existing market your goal in year 1 is to gain as much market share as possible. Freemium makes sense. Your free software should market itself and bring users to you. This does not mean you should overlook mature competitors who are offering similar products or services. Organic growth from free users may be stunted if your free feature set is not “good enough” to draw users from alternative free services. (Think about Peter Thiel’s “be a magnitude better” theory).

If you are not entering or re-segmenting a market you must be creating a new one. Your goal in year 1 is to educate your target market. Offering a free version of your product or service can be a cost effective way to do this. You may also mitigate expenses on traditional marketing and sales activities. Organic growth may be hard to come by because there is no community or industry to evangelize around your company yet. But, the benefits of empowering new users to learn on their own can provide meaningful long term benefits.

Freemium can work in any market type. Identify which you are entering to help clarify what potential pitfalls lay ahead.

What is free?

Imagine you are product manager of a new software with 15 distinct features. You decide 5 of the features are basic enough that any user can have access to them while the other 10 are only for those who pay. How do you know that you’ve made the right choice? What do you do if it turns out you were wrong?

Remember, the primary benefit of freemium is in attracting new users. That makes the “what is free” decision overwhelmingly important. A 2011 research paper written by Kim Joar Bekkelund, titled Succeeding with Freemium analyzes the thoughts of many academics focusing on this problem.

There are three main ways to differentiate your free and premium product.

  1. You can offer less functionality in the free version.
  2. You can offer less capacity in the free version.
  3. You can only offer the free version to some users. For example you let nonprofits use your service for free, but charge for-profit organizations.

These concepts are relatively straight-forward, the difficulty comes in executing one, or all effectively. One strategy to optimize your free vs. premium differentiation is to use beta tests as a crutch. Overtime you will be tweaking your free vs. paid differentiators based off of user feedback and the data you collect. Running many rounds of beta tests can be a cost effective way to learn what your users respond to.

Can you afford free users?

The freemium model is only profitable when the variable costs of free users are less than the profits generated by premium users. In the case of software products or services this concept is easy to grasp.

All expenses  that are not “one-time” are part of your variable costs. Money spent on servers, technology infrastructure and people must be less than the operating profit you realize from premium subscribers. If it costs you $1 a month for every free user you need to be realizing at least that much in revenue from every paid user.

By modelling future costs and watching expenses you can somewhat reliably predict if the freemium model is plausible for you.

More questions

This blog post touches on a few important considerations for freemium businesses. Below are more questions that you should pose yourself before deciding to go into the free/premium landscape.

  • Do users need the premium offer?
  • Are free users providing referrals?
  • Are you hitting your target conversion rate?
  • Do you have a large addressable market?

Related readings

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Published by

Zach Shefska

Entrepreneur, developer, blogger from Washington, DC.

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