The Best and Worst Uses Of The Freemium Business Model

Updated: January 25, 2011

Many new start-ups planning to launch a web-based service contemplate adopting a freemium model. For those unaware, freemium means that the company offers a limited version of its product for free, and a paid upgrade that comes with more features and added value. Such a model has worked for many big name start-ups, some of which you may use on a daily basis. Conversely, this model has also been shown to be damaging to other companies who find that it actually decreases the number of paid users they convert. So when is freemium done right, when does is not work, and what are companies doing to entice free users to convert? Today we explore the freemium business model and explore conversion figures, weaknesses, and strengths from some of the Internets hottest start-ups.

Pandora

The secret to Pandora's success using the freemium business model may stem from the fact that they didn't start out as a freemium company. Instead, Pandora dedicated itself to creating the best free Internet radio they possibly could, and their efforts paid off in the form of a feverishly loyal userbase that, according to TechCrunch, "actually [asked] for ways to pay the company, to make sure it stays alive."

With it's main free product dominating the industry, Pandora set to work on adding further value and features to a paid service it later named Pandora One. Benefits include a downloadable desktop application, no ads, higher quality audio, and custom skins. Launched in March of 2009 for just $36.00/year, TechCrunch predicted a $40 million haul for that year and forecast that they would go profitable in 2010. Such a titanic conversion of free users to paid accounts and profitability in around 4 quarters represents one of the best implementations of freemium ever undertaken.

Flickr

Photo sharing giant Flickr has been a shining example of what the freemium model can do for several years now. Flickr has developed a clever way of enticing users to upgrade to a paid account. Free members can upload 300 MB worth of files to Flickr every month, but can only see their last 200 uploads. If you're an avid hobbiyist photographer (let alone a professional) who uses the service with regularity, time very quickly comes when you lose access to your old uploads. They're still there waiting to be retrieved when you upgrade, you just can't access them as a basic user.

In addition, paid Flickr accounts allow unlimited uploading, HD video playback, ad-free browsing, and more. TheLongTail reports that this strategy seems to be working very well for Flickr. As of late 2008, the company converts between 5% - 10% of its free users into paid accounts. Thanks to such strong conversion rates, Flickr is now worth $67.39 million, and continues to pull in over $90,000/day according to TeqPad.

Google AdWords

When most people think of freemium, they picture a business that offers a free version of their software, and another version that costs money. This is not always how freemium is done however, and Google has mastered an alternative model known as "Free As Inventory." Start Up Lessons Learned describes this method as a company selling access to free users, which is exactly what the AdWords platform allows. Using AdWords, advertisers can display ads to searchers for free, but only pay when a searcher clicks one of them.

In this way, Google cultivated a super-massive userbase of largely intelligent and hungry searchers, and charges advertisers only when they express interest in buying from them. As Start Up Lessons Learned notes, this is a similar set-up that many dating sites employ - allowing you to create a profile, post your pictures and description of yourself, and only pay when you want to email and get in touch with other users. Often, this is the whole point of the site, and the essential feature of messaging cannot be resisted for long.

Skype

Earlier this year, CNET reported that VOIP (internet telephone) company Skype filed with the SEC for a $100 million dollar IPO, proving that its freemium business model has served it well over the years. Skype offers a free account that allows users to do voice and video chat with other other Skype members - a cool alternative to traditional instant messaging - but it is the paid version that is the real difference-maker. Skype has two paid versions that challenge phone companies by allowing users to call regular phone numbers (they don't need to be Skype users) for less than standard telephone rates.

For between 1.2 and 2.3 cents a minute (depending on the plan you select) you can use Skype to call anyone anywhere in the world. Apparently, quite a few users have seen the benefit this service provides. According to noteworthy tech blogger Todd Caroters, Skype claims to have 124 million connected users, 8.1 million of which are paying customers. This represents a 6% conversion rate to paid accounts, a true victory for a freemium business.

BidSketch

All the companies listed above successfully used various models of freemium to convert over 5% of free users to paying customers, building substantial revenue streams needed to establish their business. Unfortunately, freemium doesn't always work out so smoothly. Ruben Gamez, owner of design proposal software company BidSketch, reported on their failure to make a freemium model perform for them. When BidSketch launched, Gamez decided to include both a free and paid version, a decision which he called a "no-brainer."

Initially, he launched to his high-converting, expertly cultivated mailing list, and received a 54% conversion rate. Unfortunately, that number dropped down to a mere 1% once the site was receiving primarily organic search traffic only six weeks later. BidSketch responded by tweaking the paid version to look far more enticing, but to no avail. Desperate to increase revenue, they decided to delete the free version.

That month, BidSketch reports that conversions increased 10X, or 1000%, representing a meteoric rise in revenue. Gamez concludes that the freemium model is just not right for all online services. "Obviously free plans have worked well for companies..." he writes, "But the problem is that we're not them. We need to stop blindly copying them and start thinking about ways to bring in revenue."

Support Could Become A Burden

Another consideration to make for start-ups considering a freemium model is the cost of support. Any company worth its weight in salt offers support to all members - paid or not. Unfortunately, from a financial standpoint, this doesn't always make sense. Consider the example of BidSketch converting only 1% of its monthly traffic. Essentially this means that on the strength of those 1%, the company will have to pay for support for the other 99% of free users who, based on their statistics, will likely never convert. Such a cost represents a serious drain on resources, perhaps even enough to take the start-up under if left unaddressed.

Does Dropping The Free Version Always Work?

Reading that above bit about BidSketch increasing user conversion to paid accounts by 1000% in one month simply by dropping the free account makes some people wonder whether such a decision could work for everyone. Of course, no one solution is right for every company, but a surprising number of small start-ups have been finding that doing away with the free version is a terrific strategy for increasing revenue. Technology blogger and investor Seth Levine quotes Jason Fried from 37Signals in finding that "…the majority of people who are on pay started on pay... most people who start on free stayed on free."

They aren't the only ones. Website analytics company CrazyEgg reports doubling their monthly revenue by dropping their free plan. This is not to say the same results would be had by the Flickrs and Pandoras of the world if they suddenly ditched their free programs, but it is food for thought to all new companies who aren't experiencing strong results from a freemium model.

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