Start-up Entrepreneurs' Blog

The Freemium Business Model – What Can A Startup Expect?

May 20, 2010

What is a Freemium business model? A Freemium business model offers basic services for free and then offers additional features or enhanced services as an upgrade to those that pay.  The premium users pay for all of the users who use the service or product for free.  It is one of the more widely used business models in the Internet and software business.  Most everyone on the Internet has used a Freemium model product or service at sometime. There is a big difference between being a consumer of such a product and being an entrepreneur considering a Freemium model for your start-up. While everyone knows what the Freemium model is, there are few who know how to implement it effectively and get the results needed to sustain a business.  When does the Freemium make sense and what can an entrepreneur expect from offering a Freemium model?

Conversion Rates Are Very Low

The first case study is software-as-a-service startup whose product allows users to organize and file away all things digital in their lives – a modern day version of the filing cabinet, junk drawer, and moleskin notebook rolled into one. Two years after launching the product, the startup has 3 million users of which 60,000 users have purchased a premium subscription. That’s 2% of the users becoming paying customers and 77% of the paying users choosing the annual subscription fee of $45 over a $5 monthly charge. The company break-even point is at the 1% conversion.

Dropout Rates Are High

What did their ramp up in traffic look like? After two years, they are signing up 8,000 new customers per day. The drop out and retention rates have remained consistent since the product’s launch. In the first month after signing-up for the free version, 50% to 60% of the users abandon the service and never return.  In the second month, another 5% to 10% of users abandon the service.  Afterwards, the dropout rates dwindle to very small numbers and almost all customers stay thereafter.

The Sales Cycle Can Be Long

The number of users converting from a free user to a paying subscriber is nil in the first month of usage.  After twelve months, the conversion rate between free and paying customers is 2% and after 24 months the conversion rate is 8%.  The startup attributes the increased conversion rate to the fact that the more information a user enters into the database, the less likely a user will leave and recreate their database on a competitor’s tool – this is the traditional lock-in scheme that makes the amount of effort required to change or transfer greater as usage continues.  In essence, customers use the service for free for quite awhile before paying.  It took 15 months to get the first one million users and 9 months to get the first 10,000 premium subscribers.

Revenue Per Customer Can Be Only Pennies

While more than 80% of the start-up’s revenue comes from premium subscriptions, they are licensing their technology to other companies which accounts for 10% of the revenue, advertising contributes another 4%, and the rest is miscellaneous.  Initially licensing was a much greater portion of their revenue, but licensing growth has slowed as premium subscriptions are growing at a much faster pace. The company revenue is $0.25 per user per month and there operating expenses are $0.09 per user per month.  In comparison, Wal-mart is known for offering rock bottom low prices to the multitudes collects about $46 per transaction per month.

Volumes Are Needed

The startup has concluded there are four keys that allow the Freemium business model to work for them:

(1)    Good long term retention rate

(2)    Customers perceived value of the service increases as they use the tool more and become more entrenched in its usage.

(3)    Low cost and non-variable subscription rates

(4)    Expenses only require them to need to capture single digit percentages of subscribers, who are willing to pay a small amount for the service.

Does this hold true for other companies? A popular social gaming start-up also uses the Freemium model.  It has been 4 years since their product launch, they have more than 8 million users with only 5% of the users paying for premium access and the remaining 95% are free users. This startup uses micro-payments approach for revenue and only a small percentage of the paying customers spending $500 a year of the online gaming site.  Another startup targeted at the online dating services is in the early stages of developing traffic, and they have 10% of their users converting to paying customers. Adobe Acrobat for PDF’s is an earlier version of the Freemium model.  Users can obtain free PDF readers and premium users must buy the software in order to create PDF documents.

Many investors dislike the Freemium business model. They view it as an indication of the lack of a marketing strategy, and too often it is just a way for the entrepreneur to postpone figuring out how to sell the product.  The Freemium business model works, but like most things, it works under a select set of conditions. The Freemium model is a volumes game and a large number of users is needed. What can be concluded is it works when the product is a widespread technology whose use is desired by the masses. While we have all heard that the world has become one of niches, these small, specialized markets cannot support a viable business when only pennies of revenue per customer can be generated. A revenue mix is needed to create a sustainable business – subscriptions, advertising, technology licensing, merchandise, and other related services.

Filed under: Marketing & Sales

Tags: business model, business strategy, freemium, revenue mix, startup