Startup Pattern: The Freemium Business Model

Summary:

Freemium is a business model where usage of the product is free for a basic version. Once the customer wants to use a lot of the product or use more feature dimensions, the customer starts paying for it. Different than a Free Trial where a customer uses a fully-featured product for a limited amount of time, in Freemium, the company starts charging based on a dimension besides time. Therefore, it is possible for a significant portion of users to never pay for the product.

Description and Background:

Giving stuff away online for free without any plan for how to make money is a stereotypical Silicon Valley trope. But there is a way to be thoughtful and build value with a free version of your product.

For example, at SeeClickFix, we use a freemium model and have tried different dimensions for value or charging. Anyone including citizens and government officials can use the web application and mobile app for free indefinitely. Key features that are part of paid versions include dashboards, control over form fields, different interfaces, routing and assignment, reports, and also importantly branding. People can use the product for free and then make the decision to buy informed by experience.

As my friend Yannick talks about it, Freemium fits into a larger philosophy of creating a“frictionless” business that allows customers to discover and use the product without barriers or challenges. Look at anywhere your funnel losses people as an opportunity to reduce friction. In a signup flow, for example, the fewer questions you ask before someone feels like they are using the product perhaps the better. That can include payment questions. Particularly when you are offering a new category that the customer doesn’t know they need, being frictionless can be helpful.

You may wonder, how different is it from a good old-fashioned Free Sample? With Free Samples, you give away some of your fully-featured physical product but in limited quantity. The hope is that once the customer experiences the product, they will be willing to pay for an additional quantity of your product. And in a Free Trial is basically the Free Sample strategy for intangibles like service or software.

Also, Freemium is different than Loss Leader where you sell an unrelated product for below marginal cost in order to attract and develop new customer relationships. The hope is that once the customer buys one product, they will be more likely to buy other products that generate profit.

Virality is great to combine with freemium as user growth can be even faster.

Some examples of the Freemium business model include:

Checking accounts are often freemium although we don’t typically think of them that way. We had some products priced that way at Higher One
In B2B SaaS, famous examples include G Suite, Hubspot, and Slack.
One of the earliest examples of Freemium in software was Shareware. In that model, people would distribute downloadable software for users to run locally. Sometimes it was time-limited and some times the full feature set was not unlocked without a license code that you had to purchase.

How to Use It:

Check Your Unit Economics. What will it cost you to support lots more users of your product? Even if you have low marginal cost, the cost of supporting non-paying users may really add up. Examine the components of your marginal cost and see if that can be reduced to create a free version of the product. If you have significant marginal costs, consider instead a Free Trial or Free Sample approach.
Review Your Positioning. If your positioning is luxury or exclusive at a higher price point, then offering a free version could potentially undermine the value and be counterproductive. Consider Razors and Blades more than Freemium, although it won’t fit for every case. If high-touch service is a key part of your value proposition, it may also be counter-productive to offer a stripped-down, free version of the product.
Assess Your Market. Freemium works best for markets with large numbers of buyers, as only a fraction of non-paying users will convert to paying customers. If you have fewer buyers consider Free Trial (or Unpaid Pilot). Also, some categories may require user education before they would accept a free version. For example, customers may be more skeptical of a free version if a product category has traditionally been highly personalized or high cost.
Pick Your Dimension of Value. Consider the dimensions of value that customers will pay for when they convert from a free version. Is it features, usage volume, collaboration (including a number of users in a group), branding, removal of ads, control, compliance, or support? If you handicap the product by choosing the wrong dimension, then you can hurt conversion as customers may not understand the full value proposition. It can be elegant if the dimension pricing dimensions are the same as the cost dimension that creates marginal cost for you. But if your marginal cost is low enough, you do not have to be constrained to only this dimension.
Fight for Retention. Do your best to keep the non-paying customer engaged and happy. By keeping retention high, you have the opportunity to continue to make the pitch to them why they should start paying.
Iterate Carefully. When it is early and the customer base is small, take the chance to iterate on your dimension of value. I’ve been told that web-hosting company Wix tried over two dozen different pricing configurations before focusing in on branding as a key upgrade trigger. As your customer base grows, it can be more complicated to iterate on the pricing model. If you give away too much and customers get used to it, it can be painful to switch back to charging for that value (for example see Evernote’s history). If instead, you are perceived as adding new features to the paid plan and making that increasingly worth buying, customers often understand that better.
Always Be Converting. Similar to Bottom-Up Sales, your sales/marketing funnel does not stop at product usage. Continually communicate with customers about the value of upgrading. Be thoughtful about how to introduce the idea of paying. For example, if you choose any quantity or usage dimension for your pricing mechanism, consider how to prepare the user and position the value of paying. Sometimes it may make sense to have a soft limit rather than reaching a hard limit which prevents the user from going forward. Don’t be discouraged if a small percentage of customers decide to pay. One rule of thumb is that you can build a great business with the conversion of users to paying customers of 2% to 5%. (Dropbox for example!) Truly standout conversion rates from Free Trial can be ~93% if you are Netflix, but you don’t have to get that high.
Free Bonus: Use The Word FREE. Free is a magical word in marketing that attracts attention and can drive action. If you have a free offering, make sure to use the word! ‘Nothing beats free!’

Benefits:

You gather a lot of users, you can get a lot of market feedback quickly.
Some are able to get lots of users quickly with a free offering.
If your free version is popular you may be able to save money on an expensive sales force at first.

Trade-Offs:

Hard to have luxury positioning if you have any free usage.
Hard to do if you have real marginal cost.
Once you have built up a user base, it can be painful to switch away, decrease what’s included in a free version, or raise prices. Although, having no users may be more painful.

Related Venture Patterns:

Free Trial (or Unpaid Pilot)
Free Samples
Bottom-Up Sales
Virality
Razors and Blades
Loss Leader
Opposite: Insurance