6 characteristics of successful Freemiums

The following is a guest post from Bocar Dia and was published earlier today on his blog Socialemon.

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Since venture capitalists Fred Wilson and Chris Anderson showed us the business opportunities of “free” on the Internet, Freemium has become one of the most popular business models for web companies. Freemium is based on the concept of providing a version of a service for free alongside one or several premium versions.

For a time, the default model for high-traffic but unprofitable websites was displaying ads, but companies such as Flickr, Linkedin, Youtube and Pandora did things differently and proved Freemium to be a very viable business model. Or is it?

Billing systerm provider Chargify launched a year ago with an attractive pricing model for Web 2.0 and SaaS companies including a free package for companies with less than 50 subscribers. But that model proved to be very ineffective in the long term so a few days ago they decided to switch things up with premium-only plans.  The company twitter account was responding to complains all day and a popular thread of negative publicity even made it to Hacker News. Other companies such as Ning, Phanfare or the now defunct LucidEra also failed using Freemium.

So what makes some companies succeed where others fail? What do successful Freemiums have in common?

1. Freemium is right for their business. Venture Capitalist Seth Levine of Foundry Group suggests that if your product offers value out of the gate, if your service is such that it doesn’t necessarily benefit by having a large volume of users – you may not be the right candidate for Freemium. A good rule of thumb is that the lifetime value of a paying customer needs to be greater than the cost it took to acquire them, plus, the cost of servicing all users: Lifetime value > Cost per acquisition + Cost of Service (paying and free). Typically the marginal cost of acquisition and service are very close to zero and the free version must generate a large customer base.

2. They treat users and customers as separate entities. According to “business model alchemist”  Alexander Osterwalder, all groups for which a company creates value through a product or a service are users. Customers are simply users who pay for the value that is created for them in the form of a revenue stream for the company. The keyword here is “value” – you need to understand where the value comes from. For example since Skype is based on Peer 2 Peer technology, free users are creating value for paying users by ensuring good calling quality. Flickr free users on the other hand generate costs that the company has to recuperate with its paying customers.

3. They have the right tiered model. Levine suggests that more pricing tiers mean more complication and confusion. Most companies overestimate their prospective customers’ ability to understand the features of their product. You also need to have a clear distinction between your pricing tiers. Andrew Chen notes that the key is to create the right mix of features to segment out the people who are willing to pay, but without alienating the users who make up your free audience. Do it right, and your conversion rates might be as high as 20%. Do it wrong and your long term value gets really close to zero.

4. They know their target conversion rate. From the get-go Phil Libin, CEO of Evernote, knew that he needed a 1% conversion rate. Right now, roughly 2% of all Evernoters are premium customers. 2% has largely been used by VCs from companies such as Google Venture as the “natural rate”. That said, conversion rates are different in each company – some are as high as 25%. The key is to know what rate you need to become profitable – looking at your Cost per Acquisition (CPA)  and Cost per service (CPS) is a good place to start.

5. They are not afraid to charge. Josh Kopelman of Fist Round Capital once tweeted that too many Freemium models have too much “free” and not enough “mium”. When you have a product that is valuable and that people love, you will be surprised how much they are willing to pay for it. Levine argues that many products have a lower price elasticity than their creators realize. If you get it wrong it’s a lot easier to lower prices than to raise them.

6. They maintain premium value. Management consultant Anders Sundelin suggests creating a strong control mechanism to ensure competitors do not offer free features to win over users until there is nothing premium left for the free-based version. Maintaining the value of your premium also means keeping an eye on dropout rates. Sales cycles can be very long in a Freemium model with subscriptions going for as long as a year. Keep an eye on the competition and revise your conversion rate targets based on you estimated dropout rates.