By Michael Woloszynowicz

By Michael Woloszynowicz

Saturday, October 30, 2010

Freemium, Panacea or Parasite?

Based on my observations there is a huge dichotomy in the freemium camp, there are those that swear by it, and those that swear at it. Given this level of divisiveness, how do you decide if it is right for your business? I've been wrestling with this notion for some time now and would like to share some thoughts on the subject.

The evangelists will argue as follows:
  • By taking a freemium approach you can rapidly build up your user base which increases awareness of your product thus further driving growth
  • It allows people to get familiar with your product over a long period of time and as they get more entrenched they will need more features, thus compelling them to upgrade
  • You are less likely to loose customers to other companies as paying users will at worst downgrade to your free service
  • It makes life easy for sales as they have a large pool of users that they can upsell to
Sounds great, but what about the bad:
  • Your free customers may never convert (and most don't)
  • You have to support a large user base that pay's nothing and uses up the bulk of your computing resources
  • Conversion rates can be dismal, less than 1% for many companies and up to 5% if you're lucky, that means your 1% has to pay for the remaining 99%'s usage
  • You have no real gauge as to how valuable your service is since the bulk of your users have not attached a monetary figure to it
  • It can be easier for your customers to switch to another provider since they have no financial buy-in and are not locked into a multi-period contract
  • You could be leaving a ton of money on the table
First off, freemium is not a fad or new concept, it's been around quite some time. In fact it's not even unique to web based businesses. The best example of a freemium model outside of tech is a bookstore, let's pick on Barnes and Noble. Bookstores have a number of users that frequently come into the store, read the magazines, and never purchase anything. Those that wish to read the magazine in the comfort of their home pay the premium price, while those that don't care pay nothing. Nearly a decade ago, in an effort to bring in lots of foot traffic, Barnes and Noble tried to make the experience of reading in-store as pleasant as possible by providing ample comfortable seating. Over the years we've seen the amount of seats diminish to zero and it is clear that the company is trying to make in-store reading as uncomfortable as possible. The reason I bring up this example is because this is where many web companies are going with freemium as well. Many are either eliminating freemium outright (e.g. CrazyEgg) or they are burying their free plans in hard to find places with fewer and fewer features (e.g. 37 signals). That's not to say that freemium is wrong for all companies, there are many that have been extremely successful and happy using it (e.g. The important point however is that it's not for everyone and you need to determine which camp your product/business fall into. So let's begin looking at some critical considerations.

One of the most fundamental reasons for considering a freemium model is the presence of network effects. If the value of your product increases exponentially with the number of users (see Metcalfe's law) on the system  then freemium can be a good way to go. Similarly, if your product is a platform supporting a two-sided network, a freemium model can be applied on the subsidy side to generate added revenue through premium features. You can think of freemium on the subsidy side as a sort of bonus as these users typically pay nothing in an effort to grow the size and value of the network. If network effects are not a factor in your product you are almost always better off with a traditional pricing model and free trial. An exception to this is if your product has multiple revenue streams whereby non-paying users can engage in individual transactions. For example having a photo sharing site that also offers a printing and framing service, so although a user may not pay for a premium account, they may place periodic orders for prints. In this case it is clear that having a large user base is also beneficial. In the same vein we can think of multiple revenue streams as non-monetery currencies. Your free users can effectively pay you by submitting data and increasing the value of your offering. For example, free users tagging photos on Flickr creates value for the entire site. Ideally this value can be converted into a monetary figure to see if it justifies the cost of supporting your free users.

If you are considering switching from a paid model to a freemium model it is crucial to ensure that your websites architecture and infrastructure are scalable so they can support the rapid increase in users that will hopefully ensue. If it isn't you risk loosing your paying customers as well as the free ones that come in. You also have to ensure that you have enough cash on hand to support your freemium model. For example, if you're currently breaking even, or are only slightly cash flow positive and you introduce a freemium model, you will immediately go cash flow negative. Freemium not only increases your expenses (if you don't have excess computing capacity or are you're using cloud service such as Amazon S3) but also decreases revenue as certain paid clients may drop to a free plan. If you don't have enough cash on hand to ride out the dip then you may end up in flow-based insolvency. The important thing to note is that it may take a year or more to convert a free user so the cash-flow negative state may persist for some time. The same lessons applies to a new venture, if you are hoping to bootstrap your startup then freemium is not a good starting point. Due to the long conversion times it is also important to assess your retention rates. If users only use your product for a short period of time the it's unlikely to work under a freemium model. Simililary if your users are casual and only use the product on a sporatic basis, they are unlikely to become a paying customer.

Below is a table summarizing the factors that should weigh on your decision:

As a general rule of thumb, unless your product demonstrates a tremendous degree of network effects, you should charge for the product from day one and experiment with different price points, subscription levels, and free trial periods. Diligently track customer conversions with metrics, and monitor these metrics over a longer period of time to gauge the price sensitivity of your users. This will give you a good measure of the value of your product and how attractive your proposition is to your clients. Now that you have some financial information to work with you can use the above criteria to determine if freemium will increase the value of your product, or have long-term strategic effects that justify the added costs. Finally I will re-iterate that the decision to use freemium should be made very carefully as it can have a significant and lasting impact on your business. 

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