Last week, while speaking to 150+ mostly software focused product managers at the Startup Product Talks Meetup in San Francisco, I was surprised to hear negative comments about the freemium business model. Then I read in the Wall Street Journal two articles that were less than positive about freemiums: “When Freemium Fails” and “What Grubhub’s CEO Took From The Strategy“.
First, a definition. Freemium is the business model where a company (usually software) develops a functional and useful product and gives it away for free. The company also develops versions of the product with more features which it sells for money. Successful freemium companies typically convert 1-2% of their users to paying customers. Two common examples are LinkedIn and Skype. Both offer packages we can use for free, and both offer upgrade packages that give us more functionality at a price. Think about this. Around one percent of LinkedIn users pay so the other 99% of us can use it free.
Why does freemium work so well for companies like LinkedIn and Skype? The basic concept is that they offer a free product that millions of people want. It is much much easier to get a user for free than if you charge even a penny. This large free user base acts as word of mouth to attract even more free users. Then, you should find a very small proportion of your users (1-2%) that really want some additional features above and beyond the free product.
This works best when there are what economists call network effects. These are when the value to one user increases as more users sign on. Imagine how useless LinkedIn was to the first few users. However, now that they have millions of users, LinkedIn is extremely valuable to all of us who use it. However, LinkedIn is even more valuable to select users. HR people looking find new hires and salespeople looking for new clients readily come to mind. So LinkedIn created more features targeted specifically at those markets.
Freemiums don’t have to have network effects. For example, many free games on your iPhone or Android phone offer completely free versions up to a level and then sell the full version for even more levels. Although this is a freemium, it is much less sticky than businesses with network effects.
Now that we understand more about what it is and why it works, will it work for you? For freemium to work your business needs to have several characteristics:
- Low cost to serve – If 99% of your customers don’t pay, you had better be able to serve them relatively inexpensively. That’s why freemiums are most popular with software where there is close to zero marginal costs for another customer.
- Offer value for free – The free version of your product must have value to your customers. You want them to use your product. Otherwise you won’t get any network effects or word of mouth.
- Upgrades must be VALUABLE to a portion of your users – They must be willing to pay for these additional features.
- Network effects (ideal but not required) – The bigger your network becomes, the more valuable it is to your users.
Of course freemiums don’t work for every business. But don’t rule them out quickly. It may be true that companies and VCs have been overly zealous toward them. Maybe there is a backlash now. But if you have the right business and market conditions, the freemium business model can be extremely lucrative. Just ask LinkedIn.
Mark Stiving, Pricing expert, Speaker, Author
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Photo by Nan Palmero
Thank you to Cindy F. Solomon for hosting the Startup Product Talks Event