How To Avoid The Traps and Make a ‘Freemium’ Business Model Pay
By Anna Johnson on June 14th, 2010Pandora, Dropbox and Evernote are three Internet companies using a ‘freemium’ business model. As intuitive as the freemium model may seem, however, their experiences are instructive for anyone planning to employ a freemium model in their Internet business. It’s crucial to avoid the traps to make the freemium model pay.
Firstly, a quick refresher on what is the freemium business model: it’s basically where your business provides a free version of your paid product or service. The free version may be a free trial of your paid product, a limited-feature version of the product, a version with ads, or it may be something else. Ideally, it gives people a taste of your product, which in turn whets their appetite for the paid or premium version.
At the 2010 Freemium Summit in San Francisco in March, Pandora, Dropbox and Evernote were among a group of Internet companies that shared their experiences developing a freemium business model, including the metrics they’ve used to judge its success. As you’ll see, arriving at a profitable freemium model isn’t necessarily easy or straightforward.
When it launched in 2005, Internet radio station Pandora began by offering a free trial – 10 hours of free online radio – before requiring users to pay $36 per year for unlimited online radio. Whilst Pandora signed up 100,000 people for the free trial, hardly anyone was willing to pay the $36 annual fee.
Pandora subsequently adopted an ad-supported option whereby free users could maintain a basic Pandora subscription in return for experiencing ads – much like listeners to a typical terrestrial radio station are exposed to ads in return for free music and/or talk.
This strategy led Pandora to attract 20 million unique visitors and $50 million in revenue in 2009. Nowadays, Pandora’s premium offering is Pandora One which offers higher quality streams, a desktop app and fewer usage limits. Pandora One has 300,000 subscribers, who account for 1.6 or 1.7 percent of monthly uniques, and are expected to bring in 15 percent of 2010 revenue.
Pandora’s experience shows that merely offering a free trial and a paid upgrade are no guarantees of a successful freemium model – at least, not in online radio. Had Pandora not revamped its business model and introduced ads it may well have gone out of business (just to add to the difficulties Pandora has faced in its rocky 10 year 5 year history).
Dropbox, which offers an online back-up service, has a freemium model where it offers a free cut-down version of its otherwise paid service.
Interestingly, Dropbox found that its biggest initial trap to avoid was paying too much to attract free users. The company’s foray into search marketing generated too many free users who didn’t convert into paid subscribers. This led to the company having, according to Dropbox CEO Drew Houston, a “cost per effective acquisition per paid user (that) was thousands of dollars for a hundred-dollar product.”
Not only was Dropbox’s search engine marketing strategy unprofitable, but the company also discovered that one of its free features was responsible for a huge and growing percentage of its costs.
Fortunately, Dropbox dumped its unprofitable paid search activities – discovering that an incentive-based referral program was much more cost-effective to generate leads – but few customers used the costly free feature and Dropbox was able to eliminate it without too much trouble.
Nevertheless, both experiences underscore the need to intimately understand the economics of your freemium model. Is your free offering costing you so much that it’s impeding your profitability?
Personal note-taking service Evernote launched in June 2008, and now has 2.7 million users, with 7,000 new users signing up each day (mostly through word of mouth).
Just 1.85 percent of Evernote’s users (around 50,000) pay for the premium version of the service (which lets them use Evernote on multiple platforms, among other things). But that 1.85 percent is responsible for the company growing its revenues by 18 percent each month.
In Evernote’s case, the instinctive user behavior of its subscribers drives the success of its freemium model: according to Evernote CEO Phil Libin, inactive users tend to drop off whilst active users begin paying.
While a mere 0.5 percent of those signing up for the free version upgrade to the paid service in a given month, around 2 percent of those who sign up for free end up being paid users a year later.
In terms of measuring the effectiveness of its freemium business model, Evernote’s key metrics are its average revenue per active user and average variable expense per active user. Right now, Evernote makes $0.25 per month per active user, and its average variable expense per active user is $0.09, making the freemium model profitable in this regard.
In fact, Evernote’s Phil Libin essentially sums up the factors likely to make a freemium business model pay off.
As you can see, there is no clear-cut strategy for success when it comes to adopting a freemium based business model. Phil Libin, however, provides some helpful advice when he says that a freemium model can work for a business where it has three key characteristics:
- A great long-term retention rate;
- A product that increases in value over time; and
- Variable costs.
