How does the freemium business model work?
The term freemium merges the words “Free” + “Premium”, which also adequately describes the business model. The concept is based on offering one level of service free of charge and the other for a premium fee. The main objective behind the free version is to attract more clients to test the service provided and hopefully convert them to paying customers. Freemium products offer a basic level of service, which already creates value for the client.
A good example is Spotify. With the free version, Spotify enables you to listen to music, but you have to listen to ads as well, with certain services unavailable. However, if you upgrade to a premium version, you can enjoy music without ads and access a wider range of services.
Freemium is not to be mistaken with a free trial period. In a trial period, one gets access to the full range of services for a certain period of time. Upon the end of the trial period, a customer losses access to the service. The freemium model, however, enables users to use the basic services for free, independent of any subscription.
For what services/products does a freemium business model work?
With the free product, we aim to build a large user base, which we then can convert to paying customers. In general, users are willing to test free products. Therefore, if the freemium service already creates some value (solves a problem, generates joy, increases efficiency), the user will likely keep using the service, giving us a chance to convert them into customers.
Freemium products need to be ready to use within a few minutes. The following products/services could work for freemium:
- Chat / Video Calls / Conference calls
- Streaming
- Efficiency tools (Todo Lists, Notebooks, Calendars, Project Planners)
- Games
- Content editing tools
- File storage / Exchange
The main characteristics of a good freemium product are:
- Standalone products, no integration or complex setup required
- Easy to use, no explanation or training needed
- Low operating cost per additional user
- Product with a lot of upscale features
- The basic functions need to create value
What are the challenges of a freemium model?
The main challenge is keeping the customer acquisition cost low. For a freemium to work, it is necessary to gain a lot of users at a very low marketing cost. That means advertising cannot include fancy online ads campaigns, lead funnel and personal customer acquisition. The main idea is that satisfied clients will promote the product themselves. Offering a product for free reduces the signup hurdles. Successful promotion would require using organic content and social media to raise awareness and focus on user satisfaction and a good net promoter score.
The second challenge is becoming profitable with the premium user. Depending on the conversion success, it can be that one premium user needs to cover the variable cost of 20 Freemium users and generate profit for the overall company. This part is particularly challenging for cost-sensitive markets.
The right mix of the value proposition
In a freemium model, we need to have two good value propositions. The value proposition for the free service needs to be attractive since it is what the business growth depends on. However, it needs to leave the customer wanting additional features. The premium product then needs to address the additional desires which customers are willing to pay for.
Examples:
Free vs Premium
5gb Webspace vs Unlimited Webspace
Limited to 1 Project vs Unlimited Projects
With Advertising vs Ads free
No Download vs Share & Download
Limited by time vs Unlimited time
It is important that the free version itself is bug-free and creates value. If the version does not work well, the user may leave a bad rating. Some companies had to relaunch/rebrand to eliminate the initial bad reputation.
The financial model of a freemium business
When building the financial model in a spreadsheet, building a small model to simulate the user growth and churn (user loss) over the time period is mandatory. There are different approaches to the buildup of the user matrix. The simplest approach would be to manually add the free and premium users at a particular time. Another way would be to simulate some level of growth rate and churn over the timeframe.
The freemium model has a few key assumptions:
User Growth rate – How many new users are there at the given time frame
Active User – How many free users actively use the service
Conversion rate – How many users convert to the premium service
Churn rate – How many users cancel their premium service
User acquisition cost – How much does it cost to generate one premium user
User lifetime value – How much revenue can we generate with one premium user
Valuation of a freemium model
For a freemium startup without revenue, it is only possible to evaluate the market and validate the team’s value proposition and execution capabilities.
When the company is able to generate some user base, it’s important to evaluate the number of active users. Getting someone to sign up is easy, but giving them a valuable product is challenging. A useful KPI for early freemium business would be “Activity Ratio after months joining.” It is acceptable when half of the users are inactive after a month of signing up. Getting an activity ratio of 20% after 3 months is a good accomplishment for any new business.
The following KPI is the customer acquisition cost. If users only sign up after spending money, that is not a good sign. In addition, users need to promote the product, so the net promoter score would be useful to track. Also, offering a referral program can help track the product’s attractiveness.
Once the product is more mature but still has challenges to generate revenue, the value proposition of the premium service should be evaluated. For example, is there an untouched revenue potential by changing the offering? Or are there some product features missing?
The next aspect may sound strange, but is the free product too attractive? Perhaps reducing some features would force the user to switch to the premium model? In that case, there is a potential of losing 50% of the user base, but even if only 10% convert to the premium model, there is a gain for the company.
Summary
The freemium model can be attractive for companies with services that are easy to use and can be implemented within minutes. The balance between “Free” and “Premium” will be a continuous challenge, but if well handled, the free offering will generate a huge user base. Companies such as Spotify, Mailchimp and various Email providers have proven that freemium can be a powerful business model. However, there is also a long list of unsuccessful attempts.