Is Freemium the Right Model for your Startup?

From Dropbox and Evernote to MailChimp and HootSuite, the freemium business model has zoomed to prominence as a popular revenue model for startups. But is it right for your startup?

Freemium is a popular customer acquisition strategy that is seen in many of the most-used services today, including Slack, Notion, and Canva. The idea is to offer a few basic services at no cost to attract a huge number of customers. Out of this big customer base, only a few people convert into paid users. The freemium model allows new users to use and acquaint themselves with the service in the hope that some of them will like it enough to begin paying for the advanced features.

In part, the reason for the popularity of this model is that a lot of basic services today are available for free, like Gmail and YouTube, making ‘free’ a basic standard nowadays. Customers have started not only wanting services for free, but to some extent even expecting it. For instance, customers expect free shipping on ecommerce purchases, or free WiFi during hotel stays.

Freemium models are great for launching a new product where you want to gain customers quickly. After all, if you are offering some part of your service for free, chances are that customers will be interested in trying it out. This way, you get to beta test your product with a large user base as well.

There are a few different variations of the freemium model. The most common one is the classic freemium model where companies offer their basic features for free and customers can upgrade to a paid offering to gain access to advanced features or higher usage capacity. The basic offering in this model remains free forever and is usable without paying for a subscription.

Take Google Drive for instance. You get 15GB storage space for free and you have to pay to buy more storage. If your usage does not exceed 15GB, you can continue to use the service for free indefinitely. Similarly, you can use Zoom to make single or group calls for free, but you have to pay for a higher time limit on group calls. Dropbox, Apple’s free iCloud subscription, and LinkedIn are other notable examples.

Different variations of the freemium model are becoming increasingly popular especially with the rise of software-as-a-service (SaaS) startups. It is being employed by startups in the fields of edtech, gaming, healthtech and more. Freemium businesses generally rely on subscriptions and ads for their revenue.

Finding the right business model is key to startup survival – it is what allows you to monetize your product or service offering and generate revenue. But if you are considering a freemium model for your startup, there are some basic factors that you need to consider.

3 questions you should ask yourself before choosing a freemium model

How large is your target market?

The freemium model works best when your target market is large. If you are trying to cater to a niche market, freemium may not be the way to go. This is because freemium businesses have a low conversion rate – 2% to 5% on average. So, in order to generate any worthwhile revenue, the total number of users needs to be big.

Let’s understand with an example. Let’s assume you plan to charge $5 for subscriptions and that the total market size for your product is about 10 million. Assuming that you are able to gain 1 million users, and your conversion rate is 3%, you’ll have only 30,000 paying customers and earn only $150,000.

That means in order to generate revenue of $1 million you would need 200,000 subscribers. Assuming that your conversion rate remains constant, you would need to acquire more than 60% of your total target market – an incredibly ambitious goal, especially if you are just launching your product.

Like the CEO of Evernote Phil Libin said, “The easiest way to get 1 million people paying is to get 1 billion people using.”

Therefore, if your product or service is not meant for mass usage, the freemium model may not be right for you.

Can you handle a large base of free customers?

Since the conversion rate is so low in freemium models, you need to be able to support a large number of free customers.

Although the service is free for these users, it is certainly not free for you to provide, even if you have economies of scale. If nothing else, you need server space to handle a large volume of customer data – that means infrastructure that you need to pay for. Besides this, you’ll need to have developers and customer service representatives, as well as business development and marketing staff.

Therefore, for a freemium model to be successful, it is crucial that your cost to serve is kept at a minimum. Cost to serve refers to your cost of servicing customers, and should be such that providing your service to 100 customers costs almost the same as servicing 1000 customers.

If your cost of providing service is too high, you’ll end up draining your resources supporting a large chunk of your customer base that does not pay for your service.

Will your customers have enough incentive to pay?

For freemium model to work, you need to ensure that your customers find enough value in your offering to pay for it. If you provide the chunk of your services for free and your paid offerings are not valuable enough, customers will not pay.

Take YouTube premium for instance. The premium option offers ad-free videos, offline playback, and a few other perks, but it failed to gain popularity for a long time because people did not think it would be worth paying for the additional features.

In order to ensure that the freemium model works out for your startup, carefully analyze your product and service offerings and understand what you can offer for free and what you should not.

In the end, freemium may or may not turn out to be the right model for your startup. But it can definitely help you acquire your first customers faster. The key is to be agile and make sure you are ready to switch your business model the moment you find out it’s the wrong one for your business.

Header image by Startup Stock Photos from Pexels

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