To Freemium, or not to Freemium

Credits: DALL-E

I’ve spoken to several SaaS founders toying with the idea of adding a Freemium tier to their existing pricing. There are several reasons why this could be an interesting move, but they could primarily be bucketed into these 4 categories.

1. Create additional ToFu
2. Improve conversion on existing pipeline (greater/ faster conversion)
3. Increase ACV of new users
4. In response to competitor actions

Let’s deep-dive on each of these reasons and understand how we can analyze them. The quantitative parts of this discussion assume that companies have at least some reliable estimates of their key metrics like ACV, Gross Margin, CAC, cost-per-lead; and hence are more relevant for say, companies at Series A and beyond. However, the qualitative commentary holds for companies across stages.

Reason 1: Create additional ToFu

A big advantage of Freemium, is access to potential customer information which can be qualified and added to ToFu. Without such an easy (and free) call to trial, several relevant website hits might actually get lost. However, do consider the additional cost of performance marketing/SEO to build initial traffic even for Freemium sign-ups. If we need to invest in building this traffic, that needs to be a part of your analysis.

Further, Freemium for ToFu creation makes a lot of sense if the product has some inherent “virality” e.g. like for typeform: your free users will not just become potential leads, but they will also bring in more users. Most SaaS products don’t have this type of virality, and it is often difficult to build it. Freemium users could still get more customers through word-of-mouth, but that is often not as effective as inherent virality built into the product.

So effectively, the way to analyze this is:

Total cost of lead = (Cost of website hit) * (Conversion % to Freemium sign-up) * (% Sign-up from Target Customer Profile)

At scale, this cost should be within limits set by the LTV/ CAC profile of your business

This leads us to a few additional questions to answer:

• Will freemium product be useful enough standalone to be adopted?
• Will the user-persona of freemium users match the ICP for your product?

Reason 2: Improve conversion of existing pipeline

A Freemium model could be a powerful weapon for conversion: both in ensuring greater conversion, and also shrinking the effort involved in converting a lead.

• Data collected from Freemium users (usage pattern, requirements, # users) enables a sharper sales-pitch
• Delegating initial decision-making to the engineer (without involving commercial decision-markers) leads to faster trial; and also lower activation energy, since the product is already incorporated in existing workflow & basic assessment of “does this work for us” is positive
• Some of free-to-paid conversion could also be self-serve without involving salesforce at all.

However, this improved conversion could be very expensive as it materially alters the Gross Margin economics of the business.

Let us see the illustration below:

Cost-to-serve freemium customers, could very quickly erode all margin from paid customers gained through this model.

Effectively, freemium is not economically feasible unless at least the following conditions are met:

1. Gross Margin of paying users is >80%
2. Cost-to-serve freemium users (server, customer support, community management) can be maintained at <25% of cost-to-serve paid users
3. Freemium-to-paid conversion is at least at par with SaaS benchmarks of 8%

I have built a simple calculator to analyze this for your business: access it here

This is a crucial analysis, as this move effectively impacts “LTV” and not just “CAC”, since servicing free users is a recurring cost and not a one-time expenditure

Additional questions to answer:

• Can the same effect be achieved through a “Free Trial” instead of “Freemium”? Free trials help mitigate some concerns around Gross Margins by capping the duration during which the user gets free support & hosting. However, Free Trials might not be as effective in lowering the activation energy as Freemium, given the set-up effort involved.
• What will make the Freemium offering sticky enough to warrant conversion to paid?
• Will Freemium offering provide sufficient data on whom to target?

Reason 3: Increase ACV

Freemium usage and experience with the product might also help close at higher pricing. However, this is often difficult to assess without experimentation, and it’s recommended to not include any such assumptions into your analysis.

More importantly, it is critical to evaluate if the Freemium tier will negatively affect existing ACVs as you need to offer your existing contracts some refunds to maintain pricing parity.

Reason 4: In response to competitor actions

This could be a valid reason to introduce Freemium, even if economic arguments aren’t wildly positive (as long it is at least economically feasible).

However, before you invest significant resources into launching a Freemium tier, a few questions to answer:

• Is competitor Freemium product aimed at your target customer/ICP? Or does it affect a lower priority segment?
• Do we have evidence of effectiveness of competitor’s Freemium offering? (usually easy to determine based on win/loss data). Have we lost deals from ICP because they were already using competitor’s Freemium offering? Have we won deals from ICP despite them using competitor’s free offerings? Why did we win? Is this a sustainable advantage?
• Will our Freemium offering be strong enough to win against competitor Freemium offering? Or, does most of our value to users accrue from the premium features?

How to operationalize Freemium

If after this (hopefully quick and conclusive) analysis, it makes sense to introduce a Freemium tier, there are a few things to note:

Internal factors:

• Who will champion this internally? This will require a high-level overhaul of ways of working, and the champion will need influence & credibility across all functions (product, engg, sales, customer support) to make this work
• Can we spare the product/engg, and management bandwidth to make this work?
• Will we be able to ramp up on customer support resources to ensure a high-quality customer experience?
• Do we have a “community strategy” in place to ensure rapid feedback loops, basic customer support managed by community?

Managing existing customers:

• Proactive communication about new pricing tier, and how it affects them; and explain the incremental value of what they are paying for (e.g. prioritized customer support, unlimited access to some features, …)
• Ensure paying customers do not feel shortchanged; ensure that they also benefit from the Free tier within reason.

Monitoring & measurement:

What Metrics will you track? Monitoring a few metrics below will help continuously validate the assumptions on which Freemium was designed:

• Match % of Freemium users with ICP
• Support cost for Freemium users
• Lead conversion % for Freemium users
• Acquisition cost for Freemium users (performance marketing, SEO, …)

Remember, that this is an experiment: have a clear scenario for when you will press the kill-switch for Freemium, and revert to current pricing plans

Useful additional reading

• Christoph Janz on the three rules of Freemium
• Paddle on Freemium
• OpenView Partners on Successful Freemium examples
• Lighter Capital on things to consider while going Freemium