What is Freemium and how can it work for you?

Jun 19, 2013

Table of contents:

1. What is Freemium?
2. How does Freemium work?
3. Freemium is marketing
4. An example of how freemium works in real life
5. Getting business when they are young
6. Conclusion

Freemium is often an overhyped unicorn that is banded about by just about every wannabe hot dot com that doesn’t understand the fundamentals of online business models. I regularly hear deluded startup companies describing how they will be able to acquire millions of users to their product using a Freemium strategy.

Freemium is actually a very nuanced marketing strategy for customer acquisition, and not a get rich quick scheme for second-rate products. Using simple maths, you can calculate how effective freemium will be for your company and whether it is financially viable to pursue as a strategy over paid advertising.

Freemium is often thought of as an online only business model because it is just not possible to support the majority of people with the minority of paying customers in the real world.

However, when you reframe Freemium as a marketing expense, you begin to see how the strategy could work for any business, online or offline.

This post is a guide to Freemium, how the strategy works, how to calculate whether it is right for your company and how to reframe Freemium as a strategy for any company.

What is Freemium?

Freemium is a customer acquisition strategy that relies on giving away initial value to a potential customer in order to increase the conversion rate of becoming a paid customer at some point in the future. Freemium forms part of the marketing and customer acquisition strategy of a business model and should be thought of as an alternative to other paid customer acquisition techniques.

Freemium comes in all sorts of shapes and sizes. On the Internet, any subsidised service can be bucketed into the “freemium” tag. This could include advertisements or affiliate based content websites. However, I believe freemium to be a more accurate categorisation of a model when the intention is to attract and convert customers into paying customers as part of a sales funnel.

I’ve already written about freemium in the past, including Is freemium right for your product? and Convert more customers with product qualified leads.

How does Freemium work?

Freemium works best on the Internet when you have a product or service that is essentially self serve. With a Freemium strategy, you want to attract a huge number of potential customers at the top of your sales funnel. This means attracting new users to your website and convincing them to start using your product for free.

If you are giving away the value of your product for free initially, but you still can’t attract free-tier users, you have probably got bigger problems.

Once a user sees the value of your product she is far more likely to upgrade to becoming a paid user. Convincing potential customers to start paying for a new product when the value of it is still unknown can be difficult. Freemium promotes giving a full (but throttled) version of the product so potential customers can use it and become invested. Potential customers need to be reassured that your product will solve their problem. There’s no better way of doing this than allowing them to see it for themselves through real usage.

A freemium product’s customer base will be heavily weighted towards free users. The economies of a freemium business model mean that the smaller percentage of paying users must be able to support the entire customer base.

Freemium is marketing

Freemium is a marketing and acquisition strategy and should be clearly defined as an expense like you would with any other strategy. Giving away free access to your product might seem like you aren’t investing money into customer acquisition, when in fact attracting and supporting free users should be attributed towards a marketing expense. Freemium is purely an alternative to paid advertising through AdWords or marketing through any other means. With traditional marketing and advertising you are simply encouraging traffic to a signup form or to register as a new lead. Freemium is simply an alternative to this process, rather than just another facet of the model.

With a freemium business model, you obviously want to have a good conversion to premium percentage. If your users are languishing in the free-tier, even if they are active users, you aren’t going to make this model successful.

Freemium can be either better or worse than traditional paid customer acquisition depending on the product and the conversion rate. If you can acquire customers cheaper through freemium, then it is definitely what you should be doing, however, if it’s better for you to acquire customers through other channels then you shouldn’t have a freemium option.

Arguably, freemium is the better option even if comparable customer acquisition techniques cost relatively the same amount. Customers who are actually engaged with your product are more likely to convert at some point in the future, even if you have been supporting them as a free user for many months. Customer acquisition through just about any other means is a one time event, rather than an ongoing relationship like actual product usage.

An example of how freemium works in real life

I think freemium has been lost in the hype of new forms of online business models. As I mentioned above, you should always treat freemium as a marketing expense rather than just another option for customer acquisition. Freemium has real costs associated to it, as I will demonstrate below.

Say for example you have a Project Management SaaS application. You have a free tier which allows users to manage 3 projects and have a limited number of contributors and storage space. You also have a $50 a month tier which allows unlimited projects and unlimited storage space.

Your customer acquisition strategy is Adwords where you are spending $1,000 a month.

It costs you $4 a month to support a user. This includes hosting, bandwidth, customer support, developers etc.

You currently have 1,000 paying customers and you have 10,000 free users. You are earning $46,000 profit a month from your paying customers and you are spending $40,000 a month to support your free customers.

So in reality you are spending $40,000 a month to support your free users and $1,000 to acquire new users through AdWords. Your marketing and customer acquisition costs are $41,000 a month.

It’s important to think of freemium as a marketing expense because now you can very simply calculate your cost of customer acquisition.

If you are spending $40,000 a month on marketing and within that time period you converted 100 customers to the premium plan then your Cost of Acquisition is $400. You now need to keep that customer for 8+ months in order to break even on the cost of acquisition. If your churn rate is 5% then to calculate the number of months that the average customer will stick around you do:</p><p>1 / 0.05 = 20 months.

So now you know your cost of customer acquisition and you know how long the Life Time Value of your customer will be (20 months x $50 p/m = $1,000).

That was a very brief overview on the maths behind a Freemium strategy. There is much more to say on the topic, but hopefully you get the point that Freemium is a marketing and customer acquisition technique that can be directly attributed to cost of customer acquisition.

Freemium is a strategy that has deep roots in calculating the actual costs of acquiring and supporting customers, it isn’t a magical method for growing a really big online company like it has been made out to be.

Getting business when they are young

So what’s all this got to do with companies that aren’t a online SaaS product? Well, the same theory can be applied to just about any industry.

Now obviously, the economies of scale of the Internet allow the Freemium business model to work because there is a huge potential market of customers and the relative costs to acquire and support them are low. Not many businesses could really survive if the company relied on the minority of the paying customers to support the none paying customers.

But the same theory can be applied in the strategy of acquiring new young companies. You can convert free customers into paid customers once they have more of a reason to upgrade.

Business to Business

Every year, thousands of new companies are just starting out. These range from the self employed to more established groups and teams coming together to start a new business. At the outset of starting a new company, there are many services that are required such as legal, accountancy, insurance and recruitment. These are just some of the basic tasks that will eventually be required by just about every business at some point.

The freemium business model could be translated into this situation by offering free services to new companies. For example, a legal firm could prepare a set of boilerplate documents to new companies to handle their first couple of years of legal obligations. The new startup gets their requirements sorted and the legal firm pays a marketing cost to develop a relationship with the new company. When the startup has more nuanced legal requirements, they are much more likely to “convert” to paying customers of that legal firm because they already have a relationship and they have been relying on the “free usage” of the product up until this point.

So instead of the legal firm taking out radio or TV advertisements to attract new business, they could funnel that marketing expense into creating the boilerplate forms and supporting the new startups through their first legal requirements.

Business to Consumer

Again the same technique can be applied to any number of Business to Consumer companies. All you have to do is take the money you were going to spend on advertising and marketing and funnel that into free services that develop a relationship with the customer, which can lead to a conversion to a paid customer in the future.

Consumer marketing in particular is cut throat. Companies spend millions each year trying to acquire new customers. Instead of wasting that money with PR firms or media which provides no concrete Return on Investment, why not spend it on developing relationships with potential customers who could then become loyal and very lucrative customers in the future?

Conclusion

Hopefully that was a good overview of the fundamentals of what exactly Freemium is. I hear new startups claiming that their innovative new business is Freemium all the time. Freemium is a marketing expense that can be directly calculated using fundamental and easy accountancy maths, it’s not a get rich quick scheme.

However, Freemium is not just for online companies. Whilst the online sense of the word Freemium means having a small percentage of paying customers supporting the larger user base, it doesn’t necessarily have to be that way.

When you frame Freemium as simply a marketing expense, you can begin to see the real essence of the strategy and how it can be effective for user acquisition in just about every type of business.