Business Model Breakdown is a blog series where we break down a great business model into its most elementary components, so that we can see how the model is changing the value paradigm in its respective industry

The development of the online economy has lead to a whole new class of business model called freemium. The freemium business model has spurred the growth of many of today’s hottest web-based companies – Skype, SalesForce, Flickr and a slew of others. Today we will break down the freemium business model and look at the critical success factors to making it work.

The term “freemium” was coined by Jarid Lukin and made popular by Fred Wilson in the mid 2000’s. The freemium business model offers users access to basic services for free and then charges for access to premium services.

The freemium model was created to sidestep the major problem that many online businesses have, getting users. Giving users no-strings attached access to a basic level of services helps them become acquainted with the benefits that the application can offer them. Many technology companies get into trouble when they overwhelm users with feature-rich applications. Providing free access to a basic level of services makes it simpler to market the product and train new users because the application is stripped down to its simplest components.

As users become more familiar with the application through usage, they see the opportunities that the more advanced features can provide them with and are happy to pay for it. Companies can offer users one premium tier (ex. Skype offering users the ability to pay for phone calls) or multiple tiers (ex. Basecamp offering four different premium accounts). Providing users with multiple premium tiers gives them the ability to grow within the application, but there is a fine line between giving options and over-complicating things.

The whole key to the freemium model is to attract a large user base. Generally speaking, the highest percentage of conversion from free to paying users that a business could hope to achieve is 10 percent. The average, however, generally ranges from 2-5% according to experts. To build a profitable business using the freemium model requires rapid scalability and successful conversion of non-paying to paying users.

When building a freemium model, two metrics are of great importance:

  1. the cost to serve free users
  2. the rates at which users convert from non-paying to paying

To ensure that the business model will work, it is necessary to take out an Excel Spreadsheet and crunch some numbers. If for example, you believe that you can convert 5% of your user base from free to paying, then the revenues derived from those paying users would have to be at least 20x the cost of servicing and acquiring a free user. Since users typically pay on a monthly basis, it is essential to map out the projected lifetime, or annual revenues that each paying user will generate.

Skype, for example, has over 500 million registered users on the website with 124 million active users per month, but only about 8 million of those users pay for the services. Paying users spend only about $96 per year on average, which is why Skype only turned an accounting profit of only $13.2 million for the first six months of 2010 despite healthy gross margins (51%). Clearly there is big potential for Skype, but when you map out the numbers it becomes apparent how challenging it can be to build a freemium business from the ground up.

Since gaining notoriety, the freemium business model has become increasingly popular in the online world, as many companies have found success. To develop a freemium model from the ground up requires a good understanding of the costs associated with building a large, scalable platform to service a large user base. However, as we have seen with a number of companies in recent memory, the payoff can be extremely lucrative.


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