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Scarface and Freemium Business Models

June 8, 2012
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LaunchPad is currently working through pricing strategies for two projects and we have found ourselves wading through the ins & outs  of the freemium pricing model.   We wanted share an interim conclusion:  You need to think like a drug dealer if you want to succeed at freemium. (… Not that we have any personal experience, but we did see a late-night replay of Scarface recently.  Maybe that explains this conclusion. )   More below.

For those of you unfamiliar with the term, let’s take a look at wikipedia:

Freemium is a business model by which a product or service (typically a digital offering such as software, media, games or web services) is provided free of charge, but a premium is charged for advanced features, functionality, or virtual goods.[1][2] The word “freemium” is a portmanteau combining the two aspects of the business model: “free” and “premium”.

Portmanteau?  Who knew!  And you thought you were going to be reading about freemium-drug dealer stuff…

It’s easy to confuse freemium for free trial.  But they are very different.  A free trial is designed to become obsolete.  The free-ness goes away in a short time.  Either one purchases or one loses the privilege of using the free product or service.  Whereas under freemium pricing models, the free use of the product or service endures for as long as the user is interested and the supplier is able to supply.   And here’s the rub–  how can a company endure if it’s not getting paid for its product?

Thankfully, we are not going to suggest your business model needs to include an expense line item for guns or other related ‘machinery for persuasion’.

Back in the days of the first internet bubble we saw the emergence of the first wave of freemium.  Only it wasn’t called freemium.  Rather, the concept then as is often the case now:  Get Big Fast.  To get big fast companies raised gobs of capital in a frothy market and bought users by advertising and a variety of other methods to bring people in.  In most cases the price to users was zero.  The hope:  aggregate eyeballs and sell to advertisers.   Of course, this is going on today as well.  And some openly wonder whether it will end as messy as the first time around.

But there’s something different at work today that makes freemium both more possible and more appealing.   First, the cost to provide an offering (code and host) is a fraction of what it once was.   What used to consume millions and millions of dollars can now be done for tens of thousands or even less if you are fortunate enough to have coding skills.   Second, thanks to social media, the cost to tell the world that your shiny new offering is available and free is also quite low if you are fortunate enough to understand how to market on the social web and while also able to build social-viral-functionality  into your product DNA (as we have discussed here).   Because it costs a lot less to put something out there and promote it, New Market Entrepreneurs usually have a higher tolerance for delaying revenue if they feel it’s going to pay off.

Let’s take a closer look at the key elements of a freemium strategy and the business model / market opportunity characteristics that  best support freemium.   Here’s the generally agreed list that covers the spectrum of freemium strategies – many drug-dealer inspired for sure:

  1. True Freemium – Give a basic version of the product for free and charge a fee for the other versions.   Prime example:  free comes with insufferable ads.  Pay and you remove the ads.   This approach is often used in mobile apps.  And it’s still widespread in desktop web apps.
  2. Value based – Perhaps the most successful type of Freemium strategy,  this approach is perhaps closest to the drug dealer’s strategy.  Give the product away at first and get them hooked.  Of course, the offering has to be good.  The more a customer uses the product, the more value she derives, the higher the switching costs are, and at some point she’ll hit a usage limit (that’s fully disclosed up front but never paid attention to) and convert to a paying customer.  Evernote and Dropbox are today’s celebrated examples of this.
  3. User based – In this approach, often used in B2B SaaS (Software as a Service) collaborative apps, a small number of users in a work-team can use all features for free.  However, the nth user and every additional after that must pay.   The typical break point is 3 or 5.   I’m a big fan of Zoho, a freemium low-cost competitor to salesforce.com.  They employ this model.  As your company or project grow in complexity, you eventually trip over the user wire and have no choice but to pay up due to the sunk costs of time and data build-out (and switching costs).
  4. Free Product in expectation of future-upsell cross-subsidies  – Give one product for free and charge for complementary products.  Perhaps the best example of this is Apple’s iTunes or Android’s App store.
  5. Time Based Free Trial – As mentioned, we don’t technically consider this true freemium because the offer of free is fleeting.     On the other hand, we choose to list it because it is a viable tactic to get users to try your offering that results in delayed revenue recognition.

Dropbox’s founder once said, “The fact was that Dropbox was offering a product that people didn’t know they needed until they tried.”  Drew Houston had to give it away to get them hooked and hooked they did get.  Luckily no brain cells or lives have been damaged in the process!  Rather files are seamlessly shared across devices and collaborators via Drobox’s ingenious hard-drive in the cloud.

But freemium strategies are not for the faint of heart.   There is no guarantee your conversion method will actually work.   In fact, while we can’t locate any credible research to support this claim, our anecdotal experience is that most freemium strategies will fail.  This is easy and safe to say because most startups fail.  That is a fact we’ve discussed and backed with published stats here.

So what are the business model / market opportunity characteristics that  best support freemium?  We believe there’s a simple answer that’s actually quite difficult to gauge.  The optimal scenario is the following two characteristics:

  1. Your product is showing potential to be addictive – your product offering has been proven in your beta test phase to be delighting its users and quickly earning a regular-use must have status.   Products like Dropbox, Evernote, Zite and most of google’s offerings have earned this with me.  While I am not paying currently, I would if policies changed.  I simply cannot do without them at this point.  The drug pushers have hooked me.   Gauging your product’s addictive qualities will be near impossible until it’s out in the wild… and a bit too late since you will already have had to make your freemium pricing decisions!  But you can cheat by working hard during your beta to watch and listen to your beta customers.    If you see your beta users are not coming back as frequently as you thought and not engaging with all you have offered, it’s time to consider refining your product and delaying your launch.
  2. Your ability to support free users will not break you – you will need to do your homework to understand your cost structure through your user acquisition and freemium-to-paying life cycle.  To truly get your head around this will involve building complex, assumption-driven customer acquisition models that take into account the gestation period from acquire-to-pay which must be staged to recognize the fact that each day/week/month or quarter (depending on the granularity of your model) brings a different generation of your acquire-to-pays.  The longer the gestation, the more complicated this is to model.  Then you must tie your cost structure to the userbase and do so in a manner that allows the cost structure to variably adjust as you model different assumptions in your customer acquisition and freemium-to-pay gestation assumptions.  This stuff can be tedious and complex.  You will get a headache, for sure.  But in the end you will have a reasonable tool to help you define how much you can offer in your freemium model before such time that you run out of money.
We are still thinking this through ourselves.  So, of course, this post does not have all the answers.  But we thought it would be helpful to pass along what we’ve picked up along the way.  Drug dealers who use methods like the ones described above are hurting people.  Not good.  However, we hope you understand our rationale for comparing the strategies.
In closing, we thought we’d pass along this interesting set of case studies done back in 2010 on the freemium-model approaches as described by their own executives at Pandora, Dropbox, Evernote, Automattic, and Mailchimp.
What has your experience been?  Please let us know!
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