Freemium Revisited

With the economy in a tailspin and a gloomy outlook, there is a renewed focus on sustainable business models for startups.  One model that has come in for particular scrutiny is “freemium” with posts such as Is Freemium Really the Way to Go? and Freemium is Not a Business Model.  But not everyone has given up on it.  I just had a conversation with Dave McClure where he said that he has been thinking a lot about where to draw the line between free and paid features in the freemium model. A while back I wrote a post that also raised this issue and argued that it was a very fine line with problems on both sides.  Since my conversation with Dave, I have been thinking more about it and have concluded that it is maybe not the best question to start with.  Instead, anyone considering a freemium model should first try to answer the question: what do I want to accomplish by offering part of my service for free?

There seem to me two possible justifications for offering part of the service for free.  First, it can be a form of marketing.  You have or are planning to have a paid version (pro, premium, whatever you may call it) of the service and the free offering will attract users.  If that is the case, then you need to be disciplined about calculating how much it costs to support a free user, figure out what the conversion rate is and turn this into a CPA equivalent.  In other words, how much could you afford to pay someone per signed up user?  You can then take that CPA number and back into how much you could spend on CPC or even CPM campaigns under varying assumptions about conversion from those campaigns.  For instance, if you have a service that costs you (net of any advertising revenues) $2 per free user per year to support and only 1 in 50 free users converts to paying, then you could afford to pay $100 in a CPA model (this of course assumes that the lifetime value of a paying customer is at least $100 otherwise you definitely do not have a business).  This is not just a hypothetical alternative.  Anthony Casalena built SquareSpace into a very profitable business solely on the basis of keyword marketing and never offered a free version of the service.

The second possible justification for offering a free version is that users of the free version make the service more compelling for everyone.  For instance, LinkedIn has a massive network because it is possible to be on LinkedIn without paying.  That network is critical to LinkedIn’s value proposition.  In this case, there is no obvious alternative to offering a free version and it is therefore a stronger reason for offering a free version than marketing.  If such a network effect or data asset is the reason for offering a free version it is absolutely critical for the free version to offer enough value that it can become dominant in its field.  This is clearly the case for LinkedIn.  It is also true for Craigslist.  The free portions of Craigslist have created such massive liquidity in the marketplace that they can easily charge in those cities and categories where they have decided to do so.  In both examples it is easy to see that if the services had charged more aggressively they would be a fraction of the size and would not have achieved their dominant positions.

There may be other justifications for offering a free version, but these are the two that I can think of right now.  It seems to me that once you have answered this question about why you are offering a free version in the first place, you will be much better positioned to answer the question about the demarcation between the free and paid offering.