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Summary:

The freemium business model propelled the phenomenal growth of Dropbox and Evernote, but it doesn’t work for everyone. Future Simple’s Uzi Shmilovici helps you decide if freemium is a good fit for your company and, if it is, how to make it work for you.

Free StuffFollowing the phenomenal growth of Dropbox and Evernote, many companies are now trying to figure out whether to implement the freemium business model and if so, how to do it successfully.

After studying this topic thoroughly and talking to many entrepreneurs, I found that there were two questions that people kept struggling with:

  • What happens to the customer acquisition cost in freemium?
  • What is the right free/premium segmentation?

Customer acquisition cost in freemium

Some people argue that freemium significantly increases the customer acquisition cost, and that the increase might in turn lead to disastrous results. The argument is that it costs money to acquire every new user, while only a sliver of them end up paying.

In order to understand what happens to the customer acquisition cost in freemium, let’s assume that your marketing investment is a given, so we’ll consider what happens to the total amount of premium users in the case of freemium.

The total amount of premium users depends on three factors:

  • the amount of people visiting your site (traffic)
  • how many of them sign up (signup conversion)
  • how many of those who signed up become paying members (premium conversion).

Traffic. People LOVE to talk about free products and recommend them to their friends. With a freemium model, you will most certainly see an increase in traffic for the same marketing spend, since people will spread the word via social media and other channels. You can further enhance this social media benefit by giving people easy ways to share their excitement and by implementing a smart referral program (which could easily be the subject of its own post).

Signup conversion. It’s highly likely that you’ll increase your conversion to users with a free offering, since users don’t need to enter the credit card details up front. Unlike the case of limited trial periods, your users don’t have to worry that their trial will end without them having a chance to try the product. Also, “Zero is a hot emotional button,” as Dan Ariely mentions in his book “Predictably Irrational, and there’s no reason to believe your users are emotionally different.

Premium conversion. Conversion to premium may drop since you might get a higher proportion of low-quality signups. However, this is not the only factor at work. With freemium, people have a chance to use the product long enough to see the value in upgrading. At the same time, while they are using the free product, they build up switching costs. Eventually, they might actually be more likely to pay.

I really like Evernote CEO Phil Libin’s approach to this subject: “We’ve got the rest of your life to make money off you.”

To sum it up, in order to succeed in freemium, you need the increases in traffic and sign-up conversion to compensate for the drop in premium conversion rate, if any.

In the case of successful freemium companies, the boost to traffic and adoption significantly reduced the customer acquisition cost, which in turn led to great results.

The free/premium segmentation

Another key factor in freemium success is making the right choice for the point of conversion. In other words, at what level of usage — or for what features — should you ask for money?

The two questions you’ll want to answer are:

  • What parts of the service you’ll use for the free/premium segmentation?
  • How much will you give away for free?

One successful tactic is to start with a very simple model in which you have only one segmentation parameter. The parameter you typically want to choose should:

  1. Be the best proxy for the value of your product.
  2. Increase with usage.

For Dropbox, the amount of storage you get makes the perfect segmentation parameter. It’s the best measurable proxy for your value from using Dropbox. Also, the more you use Dropbox, the more storage you are likely to consume, and eventually you will have to convert to a premium account.

After you choose the right parameter, you might augment it with one or two exclusive premium features, but keep it simple to avoid complexity and confusion.

The usage horizon and the NPO (nonprofit organization) zone

You want to give just enough in your free version to have people try your product and fall in love with it; but not too much, so eventually they’ll start paying.

Finding the right mix will affect both the signup conversion and the premium conversion.  If you don’t give enough away and people see themselves hitting the pay wall sooner rather than later, fewer people will sign up. You want to put the premium point beyond that “usage horizon” where users won’t expect to start paying within days. Using Dropbox again as an example, what would have happened if Dropbox offered 50MB instead of 2GB in its free version?

If you give too much, not enough people will convert to premium and you will find yourself in the “NPO Zone.” In this case, your users will be able to use your product for free for too long and you will risk your long-term profitability. What would have happened if Dropbox offered 100GB for free?

A quick visual representation of that:

Freemium

It’s very hard to get the mix right, and your first try will be an educated guess. That said, if you end up in the Freemium Success zone, even though you might be leaving money on the table, you will open the door to phenomenal growth.

A word of caution and an important reminder

Please note that the analysis in this article is based on a SaaS business. Different businesses have different markets, users and external factors, and might require a different approach.

The last thing I’d like to remind you is that the entry ticket for success in freemium is having an amazing product that creates value for people — one that people love and use. If you don’t have that, the smartest pricing model in the universe can’t help you.

Uzi Shmilovici is the CEO and founder of Future Simple, the company behind Base – a simple CRM for small businesses. This post was based on a study done with Professor Eric Budish, an economics professor at the University of Chicago.

Image courtesy of Flickr user frankh.

  1. The only fragment that is useful in the entire article is the next:
    “The last thing I’d like to remind you is that the entry ticket for success in freemium is having an amazing product that creates value for people…”

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  2. Marcos Sanchez Monday, January 30, 2012

    Yes, it’s a nice look at those two companies he drops names of, but he doesn’t address the larger and more important question. Who is you eventual end user, what use case are you going after? A company offering a freemium product for consumers, then trying to convert them is very different from say a company offering a freemium product for a small businesses or even medium sized businesses. Freemium may work great for facebook, where eventually the create a marketplace and have a huge audience to sell to, won’t work as well if you’re dropbox and perhaps going after business users, who eventually need to bring in their IT departments into the buying process. The key here may have to do with single user conversion, vs. organization conversion. Further, product to product, use case to use case, this can vary dramatically. One use case may attract low value, price sensitive users who are only out for a freebie and have no loyalty, another may attract a mixture of price sensitive and value based users, the latter of which is the customer you inevitably really want. Further convolute the waters in that some people may change their buying habits based on what the perceived value of the product is. Point being, this is a huge over-simplification of the “freemium conundrum” as I like to call it. converting a slim number of people, on a product with slim margins might work in the very short term, but it doesn’t make a good, sustainable business model.

    Marcos Sanchez

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    1. Cynthia Typaldos Sunday, February 5, 2012

      Very good points Marcos. Do you have any specific information about web apps where Freemium isn’t working despite having a large free user base?

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