Freemium Business Model

Ever scratch your head and wonder why you can use your favorite application for free? How can a business actually make money (and stay in business) when they offer their product for free? This article looks at the freemium business model, to see when it makes sense for a company to offer it. The freemium model is one where the company offers two (or more) versions of a product. The basic version is free to use. You have to pay for the premium version. The goal of this article is to answer the product management question, “Should you create a freemium business model?”

Economics of a Freemium Business Model

One way to look at the freemium business model is to look at it per user. A user will either use the free (basic) version, or for-a-fee (premium) version.

By definition, a freemium model is where one user is faced with a choice – do I use it for free, or do I use it for a fee?

We will look at how to encourage users to move from the free version to the for-a-fee version later. For now, we’ll just look at the impact of that choice.

Billing Peter to Pay for Paul (Freemium)

Every free user gets benefits, for free. Every for-a-fee user pays for the benefits of the product. The customers who pay for your product also cover the costs you incur when providing the service for free to other customers.

As a company, you have to look at your aggregate user base to analyze the economics. Some percentage of your users pay for a product (premium), and another percentage do not (free). What makes this interesting is asking the question – “What percentage of your users will pay when a free version is available?” Basecamp, from 37signals just celebrated its 5th anniversary, and serves as a good illustrative example. Note that 37signals expressly does not share this information, so we have to speculate.

• In a 2006 interview with Ryan Carson for ThinkVitamin; Jason Fried, owner of 37signals, indicated that it was “more than 0.87%” – we’ll call that 1%.
• In a 2009 interview with Brad Spirrison for MidWestBusiness.com; Fried indicated that 90% of revenue comes from subscriptions to web applications. Spirrison points out that 37signals earns $40,000 monthly from their job board – so we’ll estimate $360,000 per month from subscriptions. We can sanity-check our 1% estimate. Fees for 37signals products range from $24 to $149 per month. If the average paying user pays $36 per month, then there would be 10,000 paying customers – 1% of a million. We could tweak the numbers (the average might be lower, there may be more than a million users, etc). But this data is consistent with a 1% conversion rate.
• Jed Christiansen did an analysis about a year ago where he estimated ~ $5,000,000 per year, with numbers very consistent with the Spirrison interview. Jed built his estimates up from the usage stats that 37signals reported (links at Jed’s article), and some assumptions for converting from usage to number-of-users. His estimates would put conversion somewhere around 0.5% to 1%. He provides a spreadsheet of the model too, if you want to tinker with it.

This feels reasonable – 100 free users for every paying user. Even if that number is wrong, the rest of this article holds true, but it sometimes helps to have a number to think about.

The Left Hand Doesn’t Know What the Right Hand is Paying (Not Freemium)

This is the situation where a user gets a product or service for free, and a different user gets a different product or service for free. Technically, this is not a freemium model – the same user does not choose between the two options. User A chooses between free-product-A and not using anything. User B chooses between for-a-fee-product-B and not purchasing anything. User A has no interest in product B and vice-versa. A company may offer a free product or service using this business model, and it may make sense – but it is not freemium, because the same user is not choosing between the two different products. A company may also use a freemium business model, but augment it with this business model. The following examples are examples of this model, listed here to avoid miscommunication:

• A company can offer a product for free to (primary) users, then charge advertisers (secondary users) to display ads to the primary users.
• A conference may offer the opportunity to speak/present (for free) to lecturers, then charge attendees to listen to the lectures.
• A government may offer waivers on corporate or property taxes to a company to build a new facility, then levee payroll taxes against the employees for the priveledge of working there.
• A shopping mall may host free events (like christmas pageants) to the general public, then charge the retailers for rental space in the mall.

In each of these scenarios, the users who get the free product or service are not choosing it relative to the paid product or service. Different users are targeted for each. The first model (advertizing supported products) is easy for everyone to identify, but all of the examples share a commonality.

Freemium Product Costs and Prices

Isolating the freemium business model from other revenue-generating opportunities, you can see that finding a profitable model can be tough – you have to control costs and set prices correctly. Assuming our data from above is representative (and I don’t know if it is), if 1% of customers are paying customers, then each paying customer has to cover the costs of 100 customers to have the possibility of being profitable.

Quick Cost-Model Refresher

From a management accounting standpoint, for a given product, there are two types of costs.

• Fixed Costs – these costs are the same for the company, no matter how many users there are – additional (incremental) users add no incremental costs.
• Variable Costs – these costs are the same per user – incremental users add incremental costs.
• Total Costs – the sum of fixed and variable costs.

There are also two important ways to look at profitability – overall, and per product sale.

• Total Profit – The sum of all product sales minus the total costs to make and sell the product (including overhead).
• Contribution Margin – The difference between product (or service) revenue and the variable costs to make and sell the product.

When the total revenue from product sales exceeds the total costs to make and sell that product, the product is profitable. From a decision-making standpoint, the contribution margin needs to be positive. The number of products that need to be sold for the company to be profitable is the fixed costs divided by the contribution margin. Here’s an example (using a software as a service pricing model):

• Your business has $10,000 per month in fixed costs.
• Your product has a variable cost of $0.10 per month per user.
• 1% of your subscribers pay for their subscription, 99% subscribe to the free version.
• You price your product at $20 per month per user (per unit subscribed).

That looks like a hell of profitable product – some people will pay $20 for something that costs you a dime. But looks are deceiving. You have to cover the costs of the free subscribers, and you have to cover the fixed costs of making and selling your product.

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You have to get to 100,000 subscribers (1,000 paying customers) just to break even. This takes much longer than you would expect when selling dimes for $20! Even a 25% per month growth rate can’t help you early on.

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The exponential growth does start to compound, but it delays break-even.

The reason this happens is that you have to pay for 100 free-account subscribers with the revenue from each paying customer. The contribution margin is the key here, and three things have to be true or you shouldn’t have a freemium business model.

1. You have to have a contribution margin that is positive, when taking into account the ratio of free users to for-a-fee users.
2. You have to have a sufficiently large user base (number of users – more precisely, paying customers) to cover your fixed costs.
3. You have to lower your costs (if (1) is not positive or high enough) and grow your user base (if (2) is not large enough) fast enough to get profitable before you run out of funding.

Growing Your Customer Base

There are a two ways to grow your customer base – traditional marketing to grow your customer base, or word of mouth marketing to grow your customer base. If you’re relying on word of mouth marketing, there are two different dynamics that drive word of mouth [thanks to Jonathan Berkowitz of Thinktiv.com for this insight!] – altruistic and selfish.

Altruistic – This product helps me, it will help you too. You should use it.

Selfish – It helps me if you start using this product. You should use it.

Discussion of the two different word-of-mouth patterns will have to wait for the next article. I’ll update this one with a link to that one when it is written.

[Update: Viral Product Management is now posted! Thanks all for the great attention to this one so far.]