The last few years the freemium business model has been talked about and used extensively, but lately companies such as Ning, 37signals, Get Satisfaction and others have started to play down — or even remove — their free offering. At the same time there have been little academic research on this business model.
Let’s work through some of the basics, what’s going on, and why I want to write a master thesis about the freemium business model.
Fred Wilson of Union Square Ventures popularized the term freemium in 2006 with this definition:
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.
What Wilson focused on was eliminating all barriers to the initial customer acquisition, and then converting them to paying users because they love your service and see the value that comes with the paid service.
One of the core problems with the freemium model is the balance between what to offer for free and what to charge for. The free version needs enough functionality to get traffic and usage, but most importantly needs to incentivize an upgrade to the paid plans. Chris Anderson, Wired Editor-in-Chief, spoke at Y Combinator’s Startup School about freemium business models, and outlined some of the models he’s seen:
The pricing of the premium product is a science in itself, and investor Seth Levin thinks that many initally price their product to low:
[The] reality is that if you have a good product, many users who will pay “something” will pay more than you think for your product. […] I’ve watched many companies spend untold cycles trying to raise the price of their product after initially setting prices so low that they essentially commoditized what they do.
For freemium an often discussed element is the conversion rate. Tayloy Buley of Forbes define a conversion rate as follows:
[You give] away some services in hopes of getting users interested in ones that cost money. This upsell is called a conversion and most freemium businesses pay attention to the number of conversions relative to overall users, or at least active users, called a conversion rate.
Before Ning shut down its freemium offering they had 300,000 free communities, but these only brought in 20% of revenue and 25% of traffic. Ning converted just under 5% of its total user base into paying customers. Skype, on the other hand, have 560 million registered users, of which 124 million use the service each month, and of which 8 million are paying customers. This means that Skype has a 7% conversion rate. Looking at Pandora, Dropbox and Evernote we see conversion rates in the range 0.5% to 4%.
One of the drivers of the freemium business model has been 37signals, but recently their CEO Jason Fried talked about their free plans in an interview with Mixergy:
The majority of the revenues for our products come from people who sign up for the paid versions upfront. So we definitely have people upgrading from free to paid, but the majority of people who are on pay started on pay.
Rob Walling has written a great blog post on what happened when he launched his product Bidsketch. It started out great, but:
While the numbers looked good I knew they wouldn’t last because I was relying on a limited time offer. I just didn’t realize how much worse things would get: For the next month only 1% of users would choose the paid option. My user base was growing fast but the money was barely trickling in.
Walling decided to drop the free plan, and it resulted in an 8x — 800% — increase in paid conversions.
From the Freemium Summit in San Francisco this year, Liz Gannes of Giga OM collected these success criteria when using a freemium model:
Don’t spend money on marketing, do offer flexibility and data exporting to eliminate buyers’ regret, make sure to capitalize on and value goodwill, and only charge for things that are hard to do.
Even though we have seen a lot of examples of bad conversion rates and companies that are dropping their free plans, several companies are using the freemium model with great success. Tom Tunguz summarizes after the Freemium Summit that “free users build network effects and user mindshare that are useful for later upselling and refer a friend incentive program”. As an example Dropbox increased conversion rates by 60% by offering a two-sided incentive to encourage referrals.
Commenting on Gannes’s article, Andrew Nadeau says that “Freemium’s place in the world of business is for products that people don’t know they need, until they start using it.”
This has been somewhat fragmented, but it’s easy to see that there are still a lot of unsolved questions. Even though the business model is extensively used — New York Times states that freemium is becoming the “most popular business model among Web start-ups” — there is still little research regarding the model. Sachin Rechi wrote something a few months ago that really triggered my interest:
I believe we are still early in our understanding of [freemium] models and to date most of the available analysis has been limited to anecdotal evidence, one-off case studies, tips & tricks, and a few early overviews of what’s been tried.
I haven’t specifically pinpointed my hypothesis or, generally, what I want to answer in the thesis, but as you see there are many interesting aspects of the freemium business model that can be looked in to. One possibility is to look at the levers that are required for the model to succeed, e.g. conversion rates, functionality and market/product fit. Another is performing a qualitative analysis of some of the companies that successfully and unsuccessfully have used the model, and try to create a framework for when a freemium model is a good fit.
If you are still with me, you might have some ideas or thoughts as to what I could write about, things I should check out, of generally just want to discuss freemium. If so, don’t hesitate to contact me at mail@kimjoar.net or at the Hacker News post on my master thesis.