Jack Liu


A theory of the freemium model

I am having a hard time sleeping these past a couple of days. So after struggling to sleep for the last 6 hours, I decided to just get up and write them down. And one of the things I’ve being thinking is a theory about freemium pricing models.

First of all, I would like to clarify that I have no experience at all with using the freemium model. So everything written in this post are pure speculation. However, I am a frequent consumer of freemium products, and so I do believe I have some basis for my theory.
UPDATE: Our startup is now actually building a freemium Saas platform now, and I’m following a lot of the principles in this post that I made a year ago.

So here goes.

According to wikipedia,

Freemium is a pricing strategy by which a product or service (typically a digital offering or application such as software, media, games or web services) is provided free of charge, but money (premium) is charged for proprietary features, functionality, or virtual goods.”

This pricing strategy is interesting as it involves users who merely uses your product, and users who pays for your product(also known as customers). And as a result, you essentially have two targeted market. However, the problem lies in that the customers are a subset of users and they can easily be confused as one.

Let me demonstrate:

Product A with 10% paying customers
Product B with 2% paying customers

As you can see, both product A and product B have the same size for user base, but product A can be much more profitable as they can convert 5 times more users into paying customers. What is dangerous about this is that if you used total numbers of users as your metric for evaluating success, you’ll get the exact same numbers! In fact, if product B had twice the users, it’ll appear twice as successful even though it would only make less than 50% profit of product A. This is why we are seeing a lot of startups using freemium pricing model lose money even though they have a gigantic user base. So in this case, the best way to avoid this problem is to use revenue as the measurable metric rather than the user base.

Now would that mean it’s pointless to acquire a large user base? Not exactly. This is where we look in more depth on how to evaluate the worth of the user base (purely by revenue)

Different user conversion for different prices

In the above graph, say you had a million users. And you can convert a 80% into paying users if they all paid $1 (which I imagine is a ridiculously high conversion rate for freemium products), convert 60% if they paid $2, convert 35% if they paid $3, convert 15% if they paid $4 and only convert 5% if they paid $5. Then the value of this user base would be $1.2 million as having a premium price of $2 would give you the best returns. And with a 60% customer conversion rate from free users, you essentially get $6 for every 5 new users, which means an average revenue of $1.2 per user! So as long as you really dive deep into figuring out the right premium price, a large user base could really be quite profitable. And if you got viral user growth going, it is essentially a money making machine.

The problem, is when you have an user base that would not pay for anything at any price. This happens when the core value of your product is being “Free”. I personally feel this way for Dropbox. A couple years back, I got over 80 Gb of storage from Dropbox from all the promotions they were doing and was storing all my files on it. Dropbox isn’t a bad product and it is basically free storage for me. Last year, when my free space expired, I completely stopped using it. Why? There are other free alternatives! When I had 80+ Gb, it is great compared to others like OneDrive and Google Drive, which had much less, but now, Dropbox provides much less space compared to its competitors and why not just switch to a free one instead of paying for more?

The solution is to find the right feature from your product that some of your users would pay for. For example, buying extra life from Candy Crush, or new champion skin from League of Legends.

Even though freemium can be a dangerous pricing model to use if you aren’t aware of its risks, it does have a couple of significant benefits.

1. The user acquisition is just much easier. It’s a lot easier to get people to try a free product than getting people to pay for a paid product. People like free stuff.

2. You get a lot more control over how to develop your product. You are not as obligated to respond to user requests for a free product than for a paid product. People will be a lot more forgiving of free products over paid ones.

3. You are building your own market with a direct channel to everyone. The best example of this is Wave Accounting. Wave created an amazing free accounting SaaS that is very friendly to startups, freelancers and small business owners. And all its features are free forever (or at least according to their website). Where the “premium” comes from is their accompanying payroll services. I find this really clever because they are essentially doing targeted advertisement for themselves with a free product. And since the startup is doing all its bookkeeping with a free product, they’ll likely require a payroll service as well once they start hiring (or for freelancer and small businesses, they make money off of online payments). UPDATE: this is exactly what we did. We now use Wavesapp for payroll and it’s awesome! So what’s better than a payroll service that fully integrate with your bookkeeping platform? In my opinion, this is the biggest advantage of having a freemium model instead of straight out pay to use product.

So the best way to decide on what to charge as the premium is to treat it like a separate product, and the users of your free product as a sales channel. This way, you’ll be able to keep your users happy as well as generate revenue from the converted customers.

In summary, to efficiently use the freemium model there need to be careful selection of the premium features. Figure out what your users are willing to pay for and setting it at the right price instead of making a good free product and picking features you think the user will pay for. And lastly, don’t spend all your effort on user acquisition and falls in the trap of “massive user base”, and instead make your success metrics based on revenue. This way you can become profitable without needing to sustain yourself from investor money.

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