Freemium Business Model: Why It Works and How to Do It Right

This report defines the freemium model, the reasons for its widespread acceptance and some key concerns as well as strategies for entrepreneurs to apply this business model successfully.

Introduction

The application of the freemium model is very prominent in industries such as games, entertainment, online news, and software as a service (SAAS). This report will cover its definition, reasons for its widespread acceptance and some key concerns as well as strategies for entrepreneurs to apply this business model successfully.

Definition and Examples

The table below includes names of some freemium companies or brands, along with their free and premium tiers. Information on this table was collected on November 24th, 2018.

What make the Freemium model works

By using a 360 Degree Business Model Framework, Rayna and Striukova analyzed the innovation of the freemium model via the case of Spotify. What makes Spotify different from other companies is the way it modified the Value Proposition and Value Capture elements (4). Spotify’s pricing model gives away the right to access its content for free with some limitations and charges the users a monthly fee to enjoy all of its music (along with some advanced features). Besides subscription fee, its revenue model also includes advertising on the free tier.

Figure 1- Business Model Framework (Rayna and Striukova 2016)

Moreover, we can also consider the way in which the freemium model innovates its Value Communication element an innovation. By offering free content and features, firms can attract a large number of users, making it a powerful marketing strategy (2). This approach is better than spending a significant amount of money on online advertising, especially when there is a high inflation rate in the term of Cost per Click (CPC), which increased from $0.92 in 2013 to $2.14 in 2017 (4).

The research of Shapiro and Varian showed that users could not understand the values of a software until they experienced it (5). The same statement can also hold true for other digital goods and services. The freemium model has lower friction to generate new users (6) because they can evaluate the experience and have less uncertainty (7).

The network effect is also a critical success factor for the freemium model (7). After experiencing the products and services for free, users can share their evaluation with other people and invite them to join. Most of the firms understand the power of this word-of-mouth marketing and design promotions with attractive incentives for users who help them expand their network.

For companies which apply the freemium business model, a large portion of revenue comes from a small percentage of users (8). But they can still maintain their operation with less than 5% of paid users (9). Also, the revenue stream from monthly subscription fee is more sustainable than the advertising method, which was the dominant model in the early 2000s (2).

Key Concerns and Strategies

Firms need to find an optimal balance between the free and paid tiers (7). If they cannot generate new users effectively, then their free features are not attractive enough and need to have more values. However, giving away too much can harm the companies. Many users can be satisfied with the features and content which they can have without paying and become accustomed to the free version. The situation in which the free tier lowers the demand for the paid features is called cannibalization. And it can reduce the firms’ conversion rate as well as their profit.

The average conversion rate from free to premium users is from 2% to 5%. If the rate is low, companies need to reduce the values offered for free and communicate premium values better. However, in case the conversion rate is high, there is a chance that companies are not growing as fast as they can be.

2. Not all efforts can lead to a higher revenue

Contrary to popular belief, user satisfaction might not always be what freemium companies need. High satisfaction level can lead to a higher intention to continue using, but not purchasing. Some users are already happy with what they can have for free and don’t want to upgrade. Worse, some of them might develop a free mentality and take for granted the rights to use digital goods and services without paying (10). After using the free version for too long, users can become adapted to it and do not want more.

Switching cost affects positively both the intention to keep on using and to pay (10). If users are familiar with a software, store a large amount of data on it, and their network is also using the program, they can still pay for its premium features, even though they do not have a high satisfaction level.

And finally, relative advantage, the gap between free and paid features, has a strong influence on paying intention (10). Firms can increase their revenue by cutting back the free features. This is the reason why the New York Times decreased the number of free articles which a reader can consume per month from 10 to 5 (11). Many other online magazines have also been building and enhancing their paywall to make more money from subscription instead of advertising (12).

Hence, companies need to have clear goals and take appropriate courses of action. If they want more users and longer usage, they can enhance satisfaction level. But if firms want to have higher revenue, they should widen the gap between free tier and premium tier. And enhancing switching cost is something all companies must do to increase both continuance and conversion ratios.

3. Prepare for the dip

Freemium companies cannot develop their forecast based solely on their initial success (2). People who use their products and services first are early adopters. They are heavier users (13) and are less price-sensitive than the others (14). Companies need to spend more efforts to attract and convert users who come later. Hence, firms need to prepare themselves mentally and be ready for the dip after launching (2).

4. Predict customers lifetime value

Customers are not equally important. Some users pay more than the others and become more critical to firms’ businesses. Hence, it is very crucial for companies to identify users who could contribute more and have strategies to manage them better. Voigt and Hinz showed that freemium customers would have higher lifetime values if their initial payment is a large amount of money, which is made early after registration and is paid with a credit card. Companies can make use of this research to recognize and improve their relationship with principal customers, especially via a good Customer Relationship Management (CRM) system.

5. Don’t ignore the free users

It is true that freemium companies can sustain their business because of revenue from paid users. However, free users also play an essential role in the success of those firms. Research showed that a free user’s worth is 15% to 25% of the value of a premium user (2).

Free users introduce new users to the companies, and thus enhance the firms’ network. They are also an essential factor for attracting investment. A large user base can lead to a higher valuation for the company (15). Moreover, free users can provide valuable feedback to improve products and services. And finally, firms can make additional money by advertising on the free tier (10).

It is not free to serve free users because they still consume server power and require customer services (2). However, freemium firms should not treat them as an operational cost, but rather as a crucial factor for growth.

Conclusion

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This is one of my assignments during the Master in Management Program at Trinity College Dublin.

You can download the full paper here to read it later.

REFERENCES

(2)Kumar, V. 2014. Making ‘Freemium’ Work: Many Start-ups Fail to Recognize the Challenges of This Popular Business Model. Harvard Business Review, 92(5), pp.27–29.

(3) Zhang, Z., Nan, G., Li, M. and Tan, Y. 2016. Duopoly Pricing Strategy for Information Products with Premium Service: Free Product or Bundling? Journal of Management Information Systems, 33(1), pp.260–295.

(4) Rayna, T. and Striukova, L. 2016. 360° Business Model Innovation: Toward an Integrated View of Business Model Innovation. Research-Technology Management, 59(3).

(5) Shapiro, C. and Varian, H. 1998. Information Rules: A Strategic Guide to the Network Economy. Harvard Business Press.

(6) Wagner, T., Benlian, A. and Hess, T. 2014. Converting freemium customers from free to premium — the role of the perceived premium fit in the case of music as a service. Electronic Markets, 24, pp.259–268.

(7) Chen, W., Hua, Z., Zhang, Z.G. and Bi, W. 2018. Analysis of Freemium Business Model Considering Network Externalities and Consumer Uncertainty. Journal of Systems Science and Systems Engineering, 27(1), pp.78–105.

(8) Voigt, S. and Hinz, O. 2016. Making Digital Freemium Business Models a Success: Predicting Customers’ Lifetime Value via Initial Purchase Information. Business & Information Systems Engineering, 58(2), pp.107–118.

(9) Lyons, K., Messinger, P.R., Niu, R.H. and Stroulia, E. 2012. A tale of two pricing systems for services. Information Systems and e-Business Management, 10(1), pp.19–42.

(10) Kim, J., Lee, J. and Zo, H. 2018. Toward sustainable freemium software: The roles of user satisfaction and use context. Journal of Electronic Commerce Research, 19(3).

(11) Garun, N. 2017. The New York Times cuts the free articles limit from 10 to five per month. The Verge. Available from: https://www.theverge.com/2017/12/1/16724620/new-york-times-cuts-five-free-articles-paywall/ [Accessed November 25, 2018].

(12) Madrigal, A.C. 2017. Prepare for the New Paywall Era. The Atlantic. Available from: https://www.theatlantic.com/technology/archive/2017/11/the-big-unanswered-questions-about-paywalls/547091/ [Accessed November 25, 2018].

(13) Taylor, J.W. 1977. A Striking Characteristic of Innovators. Journal of Marketing Research, 14(1), pp.104–107.

(14) Goldsmith, R.E. and Newell, S.J. 1997. Innovativeness and price sensitivity: managerial, theoretical and methodological issues. Journal of Product & Brand Management, 6(3), pp.163–174.

(15) Holm, A.B. and Günzel-Jensen, F. 2017. Succeeding with freemium: strategies for implementation. Journal of Business Strategy, 38(2), pp.16–24.

CEO of IMP, a mentor, a marathoner, the author of quanvm.com. His key areas of expertise are Marketing, Business, and Technology.