Venturati

I started a series on the Freemium business model a couple of days back since this seems to be one of the most misunderstood business model among startups. Today we get into number crunching that one needs to do to make the Freemium model work.


As with every business, the ultimate goals is to make money, be profitable, grow revenues and become self-sustaining and cash-flow positive at the earliest.
However, depending on which stage the business is in, the metrics that you use to decide for or against Freemium can be different.


The only number that really matters when you are starved for cash
For an early-stage bootstrapped business, it is very important to stay afloat and stay cash-flow positive. In such a case, one really needs to have a compelling reason to implement Freemium. For such a business, it is extremely important that
Marginal cost to maintain a user = 0 (or close to it)
It is important to note that marginal cost is the delta that an extra user adds to your operations and will not, in general, include costs which go into maintaining the user base but are not a function of it as such. E.g. in case of Youtube, bandwidth costs per user are marginal for viewers and storage costs are marginal for contributors. One of the reasons Freemium might not be a great model to start with at an early stage is that it is very difficult, near impossible, to have marginal costs close to zero.


Segmenting and Pricing correctly to have a profitable user base
While analyzing new ventures as part of what I do, I have a bias towards always starting with analyzing the per-user economics before I look at any other numbers. After all, if the per-user economics themselves don’t make sense, it is impossible for the business to turn profitable and stay cash-flow positive.

In case of Freemium, the per-user economics maps out as follows:


ARPU: (No. of paid customers*Price per customer) / (No. of paid + No. of free users)


Compare this with the average cost of maintaining a user. Note that this is NOT the marginal cost! To be talking about the right numbers, it is very important that one understands the difference between these two.
Hence, the first step is to ensure that

ARPU > Cost of maintaining a user
An important point here is that while the ARPU calculation may look fairly straightforward, it is an extremely tricky proposition when a business is still planning on going Freemium since one needs to estimate the percentage of the user base that will actually pay for the product to work out this calculation.
Estimating the paid user percentage can be as much of an art as it is a science.

There are two key elements to doing this correctly:

1.Segmenting your market correctly
Segmentation of your market is more important than ever in case of a Freemium product. Firstly, it is important to figure out upfront the exact user profiles who will want to pay for the Freemium product. Secondly, it is very important to size exactly those user segments. After all, you need to be sure that there are going to be a certain number of user segments who clearly will be compelled to pay for your product and that their numbers lead us to the kind of ARPU that we would like to have given our costs.


2.Finding the right price point
More often than not, your paid% can really change with the price point that you set. Firstly, it is important as a business owner to understand whether your market is a price-sensitive market. Second, irrespective of whether the market is price sensitive or not, it is important to get the pricing right so that you cover your costs well (per user as well as for the business as a whole) and are still perceived value for money. I could go into a long discussion about the various ways pricing is done depending on your market, product and operations but we’ll save that for another post. In a nutshell, cover your costs and talk to customers often to reach at the right price point.


An important point is that this is not just a one-time activity. This number crunching needs to be done over time because average costs, unlike marginal costs, will definitely change over time as the business develops scale and efficiencies.

Also, per-user economics is only a starting point. Over time, the business should show signs of profitability as a whole (i.e. profitable on the entire cash base).

So far so good! We now have some of the numbers that make a sustainable operating business with the Freemium model. However, we’ve left a third important element.


What about the cost of Customer Acquisition?
Maintenance costs are important but often, the biggest cost bucket for a growth business without a brand to leverage is the cost of customer acquisition. Simply defined, the cost of customer acquisition is the amount of money that the company needs to invest to get a paying customer.

If you think about it, Freemium is not just a business model; it is also a marketing channel. “Try and Buy” has been an age-old marketing technique ever since hawkers started giving out samples of the food they cooked to passers-by (which also makes it my favorite marketing technique from a consumer perspective ).
Most models on Freemium eventually want to entice users into paying for it. Hence, it is important to see that the cost of customer acquisition via Freemium is lower than the cost of customer acqiosiiton in a pure subscription model where the business would have indulged in other marketing, tiral and awareness activities. In this regard, there are 3 important numbers to look at

1. Number of Paid Customers
2. Number of Free Customers who wouldn’t pay if the free service ceased to exist
3. Number of Free Customers who would probably start paying if the free service ceased to exist


It is important to make the distinction between 2 and 3 because by running a Freemium, you are possibly losing out on revenue that you would have got from customers in 3.

Hence, the final very important calculation that you need to do is:
Revenue from paid customers > Customer acquisition costs through other channels + Revenue from customers in 3
You need to have an estimate of customer acquisition costs from other channels. There is no general rule to that and it really is about how much of marketing, branding and other activities you would need to do to get to the same customer base.

Freemium is a much debated topic among startups as few companies have really done it well. MailChimp recently went on record talking about its great success at implementing Freemium though the author also claims that there wasn’t a great deal of science to their success. While a lot of MailChimp’s decisions seem to have been based on gut, instinct and a thing for Ben & Jerry’s free ice cream, they don’t deny the fact that a lot of thought does need to go into Freemium.


To start with Freemium, while a very “internet” term, is not a new concept. It simply refers to a model where basic services are free and access to premium services is at a price. It is important to note that the free users and the paid users are essentially from the same group of users. A website which is free to the students and charges access fees to the teachers is not a Freemium model.


Most startups end up messing up a Freemium implementation because the reason they implement Freemium isn’t correct in the first place:


Case 1: Some startups put on Freemium because a subscription model doesn’t see significant uptake for them.

Not every product can support a Freemium business model. There are two very basic criteria that a product needs to meet to go Freemium:

1. The “free” service should have real value to build a user base. The free user should get real value out of the product rather than feel restricted. There should be at least one critical action he can successfully complete with the product without hitting “Pay Now” banners at every point.

2. The “paid” features should add substantial value to the “free” service to be compelling for users to pay for it.

a. Some of the best examples are file sharing services like Rapidshare where the free service gives you a taste of what you can get but the paid service gives you significant advantage in terms of download time, broken downloads and parallel downloads.

b. The worst examples of Freemium are cases where the core service is delivered free and other VAS is charged for. In this case, the VAS is a luxury and not a need.


Case 2: Some startups think of Freemium as an architectural model rather than a business model. They go ahead and try out Freemium just because it is as simple as turning some features ON and OFF based on login and because their site is already architected for such performance.


To start with, Freemium is not something that works for every product just because you have the ability to restrict access to some features. More importantly, Freemium is not about features, it’s about workflow and access.
Before implementing Freemium, it is important to do the following product analyses:

• Listing out all possible use cases for the product and detailing the workflow(s) for each use case
• Creating user profiles for each use case
• Ensuring that at least one work flow with a unique user profile can be completed with the free product
• Ensuring that other work flows are critical enough for some user profiles to pay for them

It is important to understand features from the perspective of workflows. This is the only way one can legitimately decide which features to put under premium access.


Case 3: Some startups, having failed with subscription, believe that Freemium is something they should just try out since; after all, there is nothing to lose, by opening up some of the product to trial users.


Yes, it worked for MailChimp but you can’t just “try” Freemium without doing some number crunching first. There is a cost to maintaining a free community. As in every business, an analysis needs to be done to ensure that the ARPU exceeds the cost of maintaining a user in the very least.