Pricing model

Freemium

Offer a basic version for free and a premium version for a fee

Illustration of Freemium

Recipe

See also: Add-on, Bait and Hook

Key Partners Key Activities Value Propositions Customer Relationships Customer Segments
Key Resources Channels
Cost Structures Revenue Streams
The business model canvas was designed by Business Model Fondry AG and distributed under a Creative Commons license.

How: Give away a product or service at no cost to the customer to establish a foundation for future transactions. Having built a relationship with customers, advanced services, add ons, enhanced storage or usage limits, or similar benefits can be sold for an extra cost.

Why: A free offering can often attract a high volume of potential customers and give you a chance to convert users into paying customers after delivering value.

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Freemium is a business model that offers a basic version of a product or service free of charge, while a premium version is available for purchase. The free version allows the company to attract a large initial customer base, with the hope that some of these customers will upgrade to the premium version.

Since the majority of users take advantage of the free version, which must be subsidized by premium customers, it is essential for the cost of the basic product to be low, or ideally zero. This ensures that the business model can be profitable for the company, even with a large number of free users.

An important metric for Freemium businesses is the conversion rate, which is the ratio of paying to non-paying customers. This percentage may vary depending on the specific business model, but it is typically in the single digits.

Where did the Freemium business model pattern originate from?

In 2006, venture capitalist Fred Wilson was among the first to articulate the Freemium business model. He characterized it as a strategy of giving away a product or service for free, potentially with ad support, and then offering premium, value-added services or enhanced versions of the product to the acquired customer base. The term “Freemium” was coined in a blog post by Wilson in which he sought a suitable label for this business model. It has since become a widely accepted term.

The Freemium model has been made possible by the digitization of services and the proliferation of the Internet. These developments have created an “economy of bits” in which a vast array of products can be reproduced virtually at no cost and sold at a minimal price. Some of the earliest Freemium business models were web-based email services that emerged in the 1990s, such as Microsoft’s Hotmail. These services provided a free basic account but charged a premium for additional features, such as unlimited storage.

Applying the Freemium business model

The Freemium business model is particularly well-suited to Internet-based companies that operate with marginal production costs approaching zero and that benefit from external network effects. In the past, these types of businesses have often employed the Freemium model as a way to gauge user acceptance of new software releases or business models. When combined with a strong customer focus, the Freemium model can be an especially effective strategy.

There are a few things to consider when evaluating whether you should go for the Freemium business model:

  • Determining What Should be Free. When implementing a Freemium business model, it is important to carefully consider which features should be offered for free and which will require payment. This decision can be challenging, as it involves finding the balance between providing sufficient incentive for users to register on the site and offering enough value through paid features to justify their cost.
  • Make the Premium offer easy to understand. When customers do not fully understand what they stand to gain by upgrading from a Freemium to a Premium plan, the conversion rate (the percentage of free users who upgrade to a premium plan) may suffer.
  • What conversion rate do you strive for? Carefully consider the target conversion rate you are aiming for – the percentage of free users who upgrade to a premium plan. A rate of 1% or lower may be problematic, particularly if the company relies solely on subscription revenue. This could indicate that either too much is being offered for free or that users do not sufficiently understand or value the premium features. On the other hand, a very high conversion rate may not be optimal either, as it could limit the growth potential of the user base. A moderate conversion rate of 2-5% coupled with a high volume of traffic is generally the most sustainable long-term strategy. However, if the target market is smaller, a higher conversion rate may be more appropriate.
  • The conversion lifecycle. When forecasting growth and revenue for a Freemium business you should consider and try to map out the conversion life cycle. Early adopters, who are often less price-sensitive and for whom the value proposition is particularly compelling, are more likely to upgrade. As the user base expands to include people who are more price-sensitive or who see less value in the service, the conversion rate may dip.

    It is also important to consider the costs associated with servicing a large number of free users, as these can add up over time. Companies that fail to anticipate these costs may need to pivot away from the Freemium model, switching to free time-limited trials or eliminating free offerings altogether. This has been the case for companies like LogMeIn and SugarSync.
  • Can users become evangalists. In addition to potentially converting to premium subscribers, free users can also bring value through their referrals to the service. Research has shown that a free user is typically worth 15-25% as much as a premium subscriber, with a significant portion of this value coming from referrals. By managing referral incentives and communications effectively, it is possible to increase the value of these referrals. When considering a Freemium model, it is important to consider the potential for satisfied users to help the product go viral.
  • What ongoing innovation can help you, and are you commited to it? Freemium should not be seen solely as a customer acquisition tool, to be abandoned when the rate of upgrades dips or when new customer acquisition slows. Latecomers to the service are often more difficult to convert, meaning that it is important to continually increase the value of premium services in order to maintain or increase the rate of upgrades. Companies that view freemium as not just a revenue model, but also as a commitment to innovation, are more likely to succeed.

    As the marginal costs of many digital products continue to decline, the Freemium model will likely become increasingly popular across a range of industries, including media and education. To maximize their chances of success, companies should carefully consider the key questions outlined in this article.

The difference between Freemium and Free Trials

Many people confuse the principles of Free Trials and Freemium. Free Trials often only last a week or 30 days, creating a firm deadline by which the customer needs to decide if they want to pay for the product. Within this time frame, they enjoy full access to all or most of the product’s features and experience its maximum value. This model has several benefits for companies that use it, including the ability to generate more revenue from paying users and a higher conversion rate of 30% or higher. However, the expiration date of the free trial can be a disadvantage, as customers may not have enough time to fully experience the value of the product in their daily lives before deciding whether to pay.

In contrast, the Freemium model allows customers to use the free version indefinitely and upgrade to premium at any time. While this may not generate as much immediate revenue as the free trial model, it can ultimately lead to a larger customer base and a more stable source of income. Customers are also more likely to fully experience the value of the product before deciding to upgrade, resulting in a potentially higher conversion rate.

The Benefits of Freemium

The freemium model is an effective strategy for customer acquisition that allows companies to attract a wide audience without the use of traditional marketing tactics. By providing a free version of their product, companies can build relationships with users in a pressure-free environment, encouraging them to upgrade to the premium version when they are ready.

One of the primary advantages of the freemium model is its scalability. When users first encounter the product, they may not need all of its features. However, as they become more familiar with it and incorporate it into their daily routines, the limitations of the free version may become more apparent. This often leads to conversions, as customers decide for themselves which functions they need and are willing to pay for.

In addition to generating revenue from converted users, the free version of the product allows companies to collect valuable user data and insights into customer habits and interests. This information can be used to show targeted ads and to enhance the product with newfound knowledge.

Challenges of the Freemium Model

While the freemium model can be an effective strategy for customer acquisition, it also comes with its own set of challenges.

One such challenge is the strain that free users can put on a company’s resources, particularly in terms of server space and customer service. Companies must be prepared to support a large number of free users with the revenue earned from a smaller number of paying customers.

Perhaps the biggest drawback to the freemium model is the risk that free users may never decide to upgrade to the premium product. To avoid this outcome, companies must strike a careful balance between offering enough value in the free version to hook users, but not so much that they see no need to pay for the premium product.

Trigger Questions

  • How would Skype manage our business?
  • How can you lock customers into your solution in the free version that will pave the way for paid premium later?
  • What features provide added value and can increase your customer’s willingness to pay?
  • What are the needs of our customers?

Examples

Dropbox

A limited amount of hosting space is provided for free with the opportunity to expand for a recurring monthly fee.

LinkedIn

Regular use of the platform is free; however premium features can be unlocked for a fee (e.g. recruiter and sales access).

Skype

Its Voice-over Internet Protocol program enables users to make calls anywhere in the world over the internet for free, but customers can also purchase call credits for use with landlines and mobile phones. Skype has had a significant impact on the telecommunications industry, with over half a billion users.

Spotify

Non-paying users are exposed to advertisements, but they can upgrade to a premium package that is ad-free. Spotify was introduced in Sweden in 2006 and acquired over a million customers within its first year. It has since modified its freemium model to allow non-paying users access to the service for a limited number of hours each month, encouraging them to switch to the premium version.

Related plays

Sources

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