The Freemium Road to Revenue: How to Grow by Giving Away Your Service

By offering premium upgrades and valuable extras, developers and content providers can convert freemium users into subscribers or micro-payers.

Source: Bigstock

In its very beginnings, the Internet was free. And that created the problem of users who expect online stuff to still be free.

We are now in an age of slowly educating users that in actuality there ain’t no such thing as a free lunch. One way to spread that ethos is with a freemium business model.

The Freemium Business Model

In a freemium setting, a product or service is available for free, generally without time or usage limits, without a meter, without barriers. However, you get advantages if you pay for a premium or paid/upgraded mode of usage. Maybe you get greater efficiency, more storage space, access to more or better content, new features, fewer ads, and so on. Many users — in fact, generally a large majority — will never pay to upgrade, but the ones who do pay enough to keep the lights on. Even the ones who don’t pay can have value, as we’ll see.

One option for buying upgrades is through a recurring payment, or subscription. The other common alternative is to buy upgrades a la carte, through micropayments.

The freemium/micropayment model has revolutionized video gaming. Today, the vast majority of games, especially mobile games, use it. Per the Instabug blog, about three-quarters of mobile games use a freemium model:

  • Freemium games are free games to download and play that offer paid in-app purchases that give you some sort of advantage in the game. The freemium model is the most widely used in mobile game monetization and in-app purchases account for about 70-80% of the $10 billion or more in iOS revenue alone each year.

On the flip side, many other kinds of online services use a freemium model, from professional social platform LinkedIn to online storage service DropBox to messaging service Slack to news site Talking Points Memo. All offer valuable but limited services for free, and offer upgraded offerings to subscribers. Look at this analysis of the top 100 media and entertainment non-gaming apps:

(Source: Activate; App Annie Tech and Media Outlook 2017 via Statista)

That’s for non-gaming apps. Overall, app developers favor freemium revenue models over all others. Here’s a survey of app developers who were asked for their preferences:

(Source: Clutch)

Clearly, a freemium model is not for everyone, but there are compelling advantages that go beyond “teaching users that it is OK to pay for stuff online.” At the University of Pennsylvania’s Wharton School, Professor Ravi Bapna offers a good summary of reasons to go  freemium:

  • Freemium services such as Spotify, Linked and OkCupid do the delicate dance between giving something away for free and charging premium essentially for a similar, but somewhat enhanced, service at the same time. Free is powerful to build an installed base, complete with network effects, market thickness (no one wants to go to a dating platform where there are few others) and targeted, advertising based monetization.

Take these real-world examples of established brands using a freemium model:

Barrons reports that DropBox has used its freemium model to save a lot of marketing money:

  • Along with that growth through “viral” word of mouth that comes with having a freemium business, writes Jaluria, the company has managed to achieve a very low cost of sales and marketing – it doesn’t have the traditional enterprise model that’s heavy on direct sales commission. The result is sales and marketing that’s just 25% of revenue

Gadgets 360 reports that Microsoft is rolling out a freemium version of its Teams product in an effort to grab market share:

  • The launch of a freemium version of Teams will allow Microsoft to directly compete with Slack, which starts off free and offers tiered upgrades on a subscription basis.

Thurrott reports that Spotify recently made its free version even better:

  • Spotify announced an update to its mobile app that emphasizes a key advantage over Apple Music. … Recommended music … On-demand music … Low-data mode. … The free tier will continue to be ad-supported, of course, and the goal, as before, is to upsell as many customers as possible to a paid subscription. Indeed, Spotify notes that 60 percent of its Premium subscriptions started out as free users. So the freemium model appears to be working.

THE VALUE OF “FREELOADERS”

Research shows that the percentage of users of a freemium service who do upgrade can be very low, even as low as 5%. When the vast bulk — even 95% — of your users are non-paying, what good are they? As it turns out, even users who do not pay are valuable.

A team of researchers set out to determine the actual value of these non-payers. They are Clarence Lee, Vineet Kumar, and Sunil Gupta, at Cornell, Yale, and Harvard; their paper is Designing Freemium: Strategic Balancing of Growth and Monetization. They studied a cloud-data-storage firm. They do not name the firm, but think of DropBox and you’ll have the gist. The service let people expand their base free storage space by (1) paying for more space or (2) by recruiting other users. The researchers created algorithmic models for another version of the service that did not use referrals. With these two scenarios, one with referrals, one without, they found:

  • The number of organic premium consumers is 38% lower in the referral scenario than the no-referral scenario. This makes sense, since with the referral program, customers can gain space from sending out referrals, therefore reducing part of the need to upgrade. … while the referral program reduces the number of premium customers in the organic batch, it more than makes up for this loss by bringing in more than three times the number of customers through referrals, indicating the significant value in the referral program.

One of the researchers, quoted in Forbes, explains it this way:

  • “We have found that a free user is typically worth 15% to 25% as much as a premium subscriber, with significant value stemming from referrals,” reports Kumar. “We have also found that firms can increase the value of referrals by carefully managing referral incentives and communications. If you’re considering a freemium model, pay close attention to why and how satisfied users might help your product go viral.”

In other words, the value of non-paying customers lies in their ability to tell others about the service, especially if you incentivize them to do so. Many app developers have figured this out, and are exploring different incentives. For example, when you play a game and achieve a goal or reach a success, the game app helps you to easily boast about it on social media. Your reward is that you get to recruit your friends to play!

PIRACY

Some advocates of the freemium business model claim that it helps reduce piracy. The idea here is that since the app or software or service is being given away for free, illegal copies are actually just, well, copies. Within the app or service, the same upgrade options are available to all users, whether they got the app from an app store or from a torrent download site.

Take a look at this data from a 2015 survey, reported at the Radio and Internet News site, of those using freemium music services:

  • Availability of free music services decreased the likelihood of pirating music for 41% of the 503 freemium users surveyed. The rate was higher – 54% – among the respondents aged 18-34.

Others make similar claims that freemium video game makers are less likely to see revenue losses from pirates. Per an old BBC article, Video games embrace China’s freemium model to beat piracy. Years later, a report in TechNode suggests that freemium apps and games are getting Chinese consumers into the habit of paying for content, or at least, premium content.

The piracy issues get complex (actually, the topic looks like good fodder for a future column), but it seems that freemium models at least have forced pirates to change their ways to some degree.

DOWNSIDES AND PITFALLS

The freemium business model gets a deservedly bad rap in some cases. Games using the micropayments model are the primary offenders, with the “loot box” practice of random rewards being criticised as too much like gambling — and underage gambling at that. In April 2018, loot boxes were outlawed in Belgium and the Netherlands. In 2014, comedy show South Park devoted an entire episode to condemning micropayments in games as addictive tools used by greedy developers to ensnare kids; the episode was titled “Freemium Isn’t Free.”

Closer to home, even the freemium-plus-subscription model has potential pitfalls. Interviewed in Forbes, Brian DeChesare sees four hurdles:

  • Jumping into a market that has NO portion willing to pay for your service.
  • Striking the wrong balance between making your free offerings too skimpy or too rich.
  • Ignoring the right metrics.
  • Failing to shepherd users toward the paid upgrade path.

The BMT Micro Blog has a few more. These two focus on the value proposition of giving away your base service. Or maybe we should call it the “devalued proposition”:

  • Higher churn rate – users can easily adopt a throwaway mentality. This means users intend to use a product only for a short time, and then “throw away”
  • Lowered Value – freemium users are not financially invested in using your product

The freemium model is not a good fit for all online services who seek paying subscribers. A large majority of newspaper websites, as I recently discussed, are opting for metered gates, as an example of an alternative. But for those who can make it work, freemium can create a stable option that includes both paying users and non-paying users who offer other kinds of value.

Insider Take

In a competitive environment, offering a base portion of your service for free can be an effective way to build awareness and audience. A portion of that audience will upgrade to a paid premium version of the service, and the rest can be useful as word-of-mouth ambassadors, or as eyeballs looking at ads, or as a high-value certified audience that marketers will pay to reach.

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