What do Dropbox, Spotify, YouTube, and Fortnite all have in common? They are what people refer to as a freemium model.

Freemium is such a big part of our lives that even SouthPark took the courtesy to make fun of it in its ‘Freemium Isn’t Free’ Episode.

But how did it become such a wide-spread business model? What are its pros and cons? And which companies utilize it to its fullest potential?

Definition

The freemium business model is a product or service, which can be used free of charge. If a customer wants to use additional features, he or she needs to pay for it (i.e. premium).

Freemium is thereby a portmanteau of the words free and premium. Freemium models are offered within categories such as media, software, or (web) applications.

Freemium models originated in the late 1980’s within the software industry and the free version was used to promote a paid application.

Nonetheless, the term was coined only much later in 2006 in a blog post by venture capitalist Fred Wilson. Ironically, this were his last words in that very same post: “So from here on in, I will refer to this business model as the freemium business model.  I hope the name sticks because I love it.”

Freemium Business Model Examples

In 2009, Lincoln Murphy first published his list of the seven different types of freemium models.

Traditional Freemium

In the traditional model, the freemium product remains free forever. Normally, either the usage or amount of features is prone to a limitation. This model often suffers from the so-called penny gap, in that the freemium portion of the product is so good that customers are not incentivized to switch. The companies operating under such a model often expect that only a small number of their customers convert.

Examples include the Dropbox ‘Basic Account’ plan or Apple’s free iCloud subscription.

Land & Expand

In the Land & Expand approach, users can sign up for free. Once a critical mass is reached for users of the same organization, that very same organization is then being monetized. The underlying thinking behind this approach is allow for more signups since users don’t have to apply for company budgets. As network effects creep in, that product will then become essential to the daily work of those users – and therefore easier to get the required budget.

The most recent example of that approach is messaging platform Slack. It’s basic product is free to use, but limited to a certain amount of users and content being shared. If users want to go past those walls, they have to pay a monthly fee based on the features they select.

Unlimited “Free Trial”

The Unlimited Free Trial is a mixture of the Traditional Freemium model coupled with a free trial. It offers snippets of features so that users can test out the product, but makes it essentially unusable if not upgraded to premium.  Nonetheless, this version is somehow risky to implement because users expect the freemium features to last forever and often disregard the limited trial aspect of it.

Lincoln Murphy mentions Echosign and Basecamp as examples, which implemented this approach.

Freeware 2.0

Freeware 2.0 refers to fully functional products that remain free forever. That product is often part of an array of other products offered by a particular organization. Monetization occurs through additional (but not critical) features or special add-ons.

A great example of this approach is Fortnite. The game is fully playable for anyone and monetization occurs through add-ons such as outfits or dance moves.

Alternative Product Strategy

Alternative products are often used by companies, which already offer a set of premium services. These companies aim to branch out into other markets or industries and use the freemium product as a means to attract customers. The intention is then to cross-sell once the users are on the freemium platform.

Amazon is one of the great examples following this strategy. They utilize freemium-based services such as Twitch or Audible to cross-sell into their core platform.

Ecosystem

In the ecosystem model, the base product remains free forever. Therefore, users have complete access to all features on that platform. Monetization then occurs through a revenue-sharing model in which the parent companies takes a slice of the pie from each sale.

Examples include the Apple and Google Play Store respectively. The store is free to use, and if users chose to purchase a product, part of that revenue then goes to the storeowner. In Apple’s case, developers take home 70 percent from a sale while the iPhone maker obtains the rest.

Network Effect

The network model monetizes its user base through the collection and selling of data. These companies are extremely good at grabbing and monetizing your attention through the usage of sponsored ads. And the more data they collect about you, the better they get. Just as the saying goes, “if you’re not paying for the product, you are the product.”

Obvious examples include the likes of Facebook, Google, or Twitter.

Freemium Business Model – Pros And Cons

As seen in those examples, freemium models are here to stay. But despite very successful examples, they are not without flaws. Let’s dive into both advantages and disadvantages of the freemium business model.

Freemium Business Model – Advantages

Viral Growth. Since your product is free to use, it is a lot easier to acquire customers. And if these customers become advocates for your product, you can experience exponential growth. Take, for instance, online Battle Royale game Fortnite. The game grew to over 250 million players worldwide, mainly through influencers streaming and playing the game.

Decreased Customer Acquisition Cost. Since the users are already in your ecosystem (and hopefully engaging with it), it can become easier to monetize them. You don’t have to pay for any ads or sales personnel as you can advertise premium features on the platform.

More Feedback. Another advantage of having the customers in your ecosystem is the fact that you can collect feedback from them. Thereby, you can get to know their motivations for you using the platform and potential features they’d pay for. Freemium games often utilize this by sending their users feedback polls and reward them upon completion.

Beta Testing. Lastly, having freemium users on the platform can allow you to test new features on them. As such, you don’t run into the threat of angering your premium users, who then might end up leaving.

Advertising Income. While your users won’t pay, advertisers will happily take over. Freemium users are then shown ads within the application, for instance on parts of the screen or between audios. The challenge is to not put too many ads in to keep the freemium users around and eventually convert them to premium ones. Just for reference: Spotify generated over $500 million in ad-supported revenue for the fiscal year of 2018.

Freemium Business Model – Disadvantages  

Difficult monetization. The biggest challenge in freemium is to find a way to make customers pay for your premium features. Oftentimes, freemium users lack the financial resources to pay for premium features. This is especially the case when they are already subscribed to other services or even competitors. Therefore, some of your freemium users might never convert to paying ones.

Balance between free and paid. You want to make your freemium product engaging and fun to use, but not so good that people would never need to pay. Finding the right balance is one of the biggest challenges in freemium. Oftentimes, you want to keep your freemium customers in the loop as long as possible because that increases the likelihood of them switching to premium.  

Expensive operations. Large freemium platforms such as SoundCloud only have a small percentage of their users pay for their services.  These can be quite taxing on a company’s balance sheet as the company has to invest heavily in storage, marketing, and product development without seeing a financial return.

High customer churn. Some people just want to try out your service without any intentions of paying. They are a sunk cost as they possibly won’t advocate for your brand nor sign up to pay. Nevertheless, you still have to invest in them in order to avoid any negative feedback.

Essential Metrics & KPIs

Your goal as a freemium business is to maximize advertising revenue (on freemium users) as well as converting as many freemium customers to premium ones.

In order to do that, you will have to track a set of key metrics to fully understand your user base and implement the right features. These include:

  1. Daily and/ or Monthly Active Users (DAU/MAU)
  2. Conversion Rate (CR)
  3. Customer Acquisition Cost (CAC)
  4. Churn Rate

Daily / Monthly Active Users

Daily and/or monthly active users tell you how many people use your product in a given period (day or month). It serves as an indication towards the engagement users have with your product.

A user is counted as active if he or she logs into the service and utilizes at least one feature of your product. Some companies stick to only the logins (as this number tends to be higher) in order to impress investors and the general public.

Therefore, counting your active user base does not replace a deep dive into their respective user behavior and how they interact with the product itself. Otherwise, DAU and MAU can easily become vanity metrics.

Conversion Rate

In almost any freemium model, converting users to a paid model is far more lucrative. Estimates show that companies, on average, tend to generate four times more income per paid user compared to free ones.  

Therefore, you have to measure the rate at which you convert free users to premium ones. Conversion rates are calculated by dividing the amount of newly converted users by the total amount of free users you have.

CR = Converted Users ÷ Free Users Total

A short example: in any given month, you count 100 free users to your platform. Over that month, 10 of those convert to be paying users. That would yield a conversion rate of 10 percent.

Conversion rates can be optimized in a multitude of ways. Examples include lowering prices, adding more premium features, or free premium trials.

Customer Acquisition Cost

Similar to the subscription model, freemium based businesses have to keep an eye on the cost of acquiring a customer.

Customers can be acquired through different channels. Examples include app store promotions, social media or Google ads, or through more traditional means such as TV or banners.

CAC is calculated by dividing your total acquisition (i.e. marketing and sales) cost by the number of customers you acquired over a given timespan.

CAC = Acquisition Costs ÷ New Customers

Let’s say, for example, you spent 200$ on Facebook ads, which yielded you 20 new customers. That’d give you a CAC of 10$ per customer.

For a freemium business, you should measure your CAC both on the freemium and premium level. Dropbox, for instance, offers a free, paid, and enterprise (B2B) plan. They potentially use different marketing and sales channels to acquire those customers.

Your goal is hereby to minimize CAC preferably to zero. In their book Hacking Growth, Sean Ellis and Morgan Brown provide several tactics for virality (and thus minimizing CAC):

  • Customers receive rewards for sharing your product with others.
  • Making your product fun and engaging to use so customers automatically show them to their friends and family.
  • Have a noble mission so that the greater good benefits from using your product.
  • Include community related features that incentivize your users to invite others.

Churn Rate

So your business converted new customers and you want to know if they stick with your product? One of the most essential metrics to track how loyal your customers are is your churn rate.

Customer churn indicates at which rate your users cancel their subscription or leave the freemium service. It is calculated by subtracting the amount of users at the end of a period by the amount of users at the beginning. That result is then divided again by the user count at the beginning of a given period.

Churn Rate = (Users At Beginning Of Period – Users At End Of Period) ÷ Users At Beginning Of Period

For instance, if you have 2000 users at the end of the month and 2200 in the beginning, your monthly churn rate is (2200 – 2000) ÷ 2000 = 10 percent.

The objective, similar to CAC, is to minimize customer churn. This can be achieved in various ways, such as:

  • Engaging and rewarding product, which is made for long-term use.
  • Constantly evolving product. Part of a long-term usage of products is that they keep changing and adding new features to avoid becoming mundane and boring.
  • Listening to your users. Make sure to get to know both your freemium and premium users to understand which parts of the product experience can be improved upon.
  • High customer lock-in. For instance, users wouldn’t just switch from Spotify to Apple Music because of the amount of playlists and podcasts they have saved up (unless a far superior product comes along).
  • Keeping your prices stable. As many customers are on multiple subscriptions, they wouldn’t be able to bare continuous price increases.

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Hi folks, my name is Matthew! During the day, I lead a tech team of 10 folks for an e-commerce startup. At night, I work on expressing my weird thoughts through this blog. And if there's time, I cuddle my cat..