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Understand the "Freemium" Business Model

Posted by: Today's Tip Contributor on September 24, 2010

The "Freemium" business model is based on companies offering their basic services for free while charging a premium for advanced features. With a lack of available comparison sets, Freemium startups often do not know how they’re really performing, and they sometimes aren’t sure how to measure their performance. Metrics differ, depending on the industry and offering. For example, some industry experts say businesses need a 10 percent conversion rate from free to paid to be viable. Some Freemium service companies, however—such as publicly traded LogMeIn—are successful with conversion rates of barely 1 percent. Skype’s recent filing reveals a 6 percent to 7 percent conversion rate of active free users. Below are a few tips on running your Freemium business successfully and measuring its success:

1. Don’t get bogged down in the numbers. If your business has 15 million registered users, does that really help you monetize better? Not necessarily. And who’s to say what the best conversion rate is? Public companies do well with a 1 percent conversion rate, whereas others need a much higher rate to survive.

When you sign up your first customers, you need to think about what it will cost to serve them, the costs of acquisition, and what you must do to keep them engaged. If it costs you $50 to acquire a customer who only pays you $2—something’s wrong. Make sure you can quantify these things as early as possible.

2. Consider the full picture. To measure the success of your Freemium business model, ensure you’re taking everything into consideration, even the little things. For example, cost-to-serve goes beyond storage and bandwidth costs. At YouSendIt, we take into account everything from credit-card fees to depreciation when calculating a true cost-to-serve.

3. Square pegs and round holes. Not every business is built to survive the Freemium business model, and learning if it will work for you is crucial. First, if free customer acquisition is not in your DNA, it’s likely you’ll end up as roadkill; it takes experimentation to figure out all the levers in your conversion funnel (acquisition costs, price sensitivity, churn rate, etc.), and constant optimization is a must. The most successful Freemium companies serve very large and very horizontal markets and are masters of filling the top of the funnel.

4. Take your time, do it right: Keeping free users engaged is essential to converting them to paying customers down the road. Many businesses try to extract value within the first 30 days and then bail out without realizing that they’re carrying a huge potential of lifetime value they will realize only by creating value over multiple engagements. You need to give the right offers to the right customers at the right times to be successful.

Once you have some basics squared away, you have a better shot at running a successful Freemium business, and measuring its success will become second nature.

Ranjith Kumaran
Founder and chief technology officer
Campbell, Calif.

Reader Comments

AJ Leon

September 27, 2010 9:21 AM

Great post, Ranjith. Thanks for the tips. :)

Bobbie Garner

September 27, 2010 3:01 PM

Nice post. Applies to small fry consultants like myself - where free advice backs up and helps build future paying relationships.

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