Live your life, Be free

I like getting stuff for free. I think most people also like free stuff. To paraphrase Professor Edelman, if you want people to use your product, make it look free. The internet has made it even easier to get stuff for free, as consumers. Some companies make money by giving away free products and services to customers and then charging some customers for add-on features, advanced functionality, virtual goods and/or premium services. This business model has been dubbed “freemium” – a term combining “free” and “premium” – by Fred Wilson, a notable venture capitalist and blogger in 2006. Many of us now associate this business model with companies like LinkedIn, which charges customers for premium accounts or additional features such as messaging un-connected contacts. Another notable example is dropbox, which gives users a limited amount of free storage and then charges for additional storage. While this business model has become very popular in the most recent generation of internet companies, it has been in use in the software industry since the 80’s, when “lite” software (limited feature) was given away on floppy disk (or preinstalled on computers) for free to promote advanced paid versions. This is not to be confused with free-to-try business model where full versions are given away for a limited period of time and then require payment to continue to use.

Freemium has been a successful business model for software for a number of key reasons. First, the marginal cost of serving an additional customer is equal to or near zero. Because infrastructure costs (storage, computing, bandwidth, etc.) have decreased significantly, once a product has been developed or new features released, there is very little marginal cost. Secondly, customers are fundamentally attracted to the idea of free and will try nearly anything because they have “nothing to lose”, which does not account for the value of time. Assuming the product is actually useful and creates value for the customer, adopting a freemium model can greatly accelerate user growth. Specifically in software applications, integrating data and being compatible / integrated with other applications increases switching costs for the customer, making the app even more sticky. For these reasons, many companies have successfully adopted the freemium model as a strategy for quick growth and user adoption. Dropbox grew from 0 to 50 million users in less than 3 years.

To the extent that the economics work out profitably varies dramatically across companies, products and customers. One thing is certain, to be sustainable, the free to paid conversion rate and lifetime value of the customer must be greater than the cost to serve all customers. On its surface, the relatively straightforward economic formula should be very clear for any entrepreneur, executive or investor to understand the sustainability of a freemium business. How one thinks about a few key questions will define whether freemium really works:

  1. Who is the buyer? It’s not uncommon for the person making the decision to pay or not to be a different person than the end user. For example, enterprise software where the buyers are IT professionals, but the users are other workers in the company.  Understanding both the user and the buyer is critical.
  2. What is features will be free and what will be paid for? Seems simple, but there’s a delicate balance between creating value for the user, the costs associated with developing and delivering each product / feature and providing significant value for the buyer.
  3. How much do you charge? Not to be confused with how much you can charge. Maximizing the value you create and capture depends greatly on how much value customers derive from the product and how sensitive they are to paying for it.

4 Comments

  1. Freemium model is risky but rewarding. Companies like dropbox are great examples.

    Freemium model is also a great way to test your idea. Learn how your customer behave by giving them the product for free. In fact, early version of products can be given for free and improved based upon your customer interaction.

  2. Joseph Coyne

    Another really great growth story, which was highlighted at the Freemium Conference NYC in 2011 is SurveyMonkey.com. Not only is SurveyMonkey a very simply platform that solves a very simple and ubiquitous problem, but also, it's clever and streamlined UI promotes repeat usage and virality through user experience prompts which seem helpful rather than like advertising ("create your own survey", etc). Furthermore, the beauty of this business model is that it straddles B2C and B2C usage in a way that uniquely addresses question #1, which Nate Leung poses above. Specifically, many users of SurveyMonkey adopt the product from within large corporations and spread and institutionalize usage, while disintermediating the typical SAAS company to IT professional sales process. As such, SurveyMonkey can attract and grow its user base from within large corporations and then as a second order monetization tool, address those consumers from a corporate sales standpoint, with a more B2B sales process (which is also more efficient).

  3. Miles Clements

    Great points Nate. Definitely agree that companies using the web for sales/distribution, and reaching end users directly rather than selling down through CIOs, are better positioned than the incumbents. I do wonder about the open source alternatives, though, particularly for products targeting a more IT-oriented user. Freemium is great, but is it better than products that are truly free, forever? I tend to believe the traditional TCO (total cost of ownership) argument- that the all-in cost of using open source, which might include a staffed employee doing customization work, is more expensive than freemium, and also more cumbersome. But I'm not sure 100% of the market has realized that yet.

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