Customer-centric Growth by Lincoln Murphy

Classical Freemium Doesn’t Exist At Scale

“Classical Freemium” is the marketing tactic where a SaaS or Web App vendor offers a Free-in-Perpetuity version of a product or service, often feature- or usage-limited, as well as a version of the same product or service with less limitations to which the vendor will attempt to up-sell the user.

NOTE:  I originally published this paper in late 2010 exclusively for subscribers to my Mailing List. Below is the original paper, published in it’s entirety. I’ve provided updates to the numbers I cited at the bottom of this post.

This form of Freemium is actually on the decline as the primary go-to-market method for a number of valid reasons. Aside from the notion of the “Penny Gap” being a very real idea – the idea that trying to charge people *anything*, even a penny, for what they already get for free is a major hurdle – other realities are becoming apparent.

The concept of “near zero” support costs have been found to be “near untrue,” most find it difficult to justify and continue to support a 3-5% conversion rate, and most are realizing what Freemium really is – a marketing tactic and not a business model. Freemium is evolving, however, so there are other types of Freemium that are on the rise which will be covered in a separate article.

There is yet another reason Classical Freemium as the only method of customer acquisition is falling out of favor; many SaaS and Web App companies are realizing that the true motivation behind the Freemium companies they look up to has little to do with revenue generation by converting free users to paid subscribers and everything to do with building a user base as fast as possible without consideration for a sustainable monetization strategies. These companies are instead looking to make money through M&A or IPO activity. If they stumble into a way to make money along the way, great, but that is not the primary motivation. Twitter is a great example of this.

Twitter is a company that continues to raise money ($160M in disclosed VC funding through 5 rounds to date) and spend money to acquire more and more users but still lacks a fully defined monetization strategy. But they are changing the world so we can forgive that, right? The motivation is clearly not to generate revenue but to gain traction and grow the user base. Twitter continues to experiment with different ways to make money such as selling the tweet “firehouse” to Google, Bing, and through data aggregation providers like gnip, or promoted tweets which reportedly pull in $100k a pop, and the recently announced analytics which may or may not be a revenue source.

None of these, however, have emerged as the revenue model they’ll hang the future of the business on. Also of note; all of the revenue streams they have attempted to tap required the critical mass they had already achieved by having a 100% free service. Without the massive funding – and perfect timing and luck – required to get Twitter to the point it is in terms of “market penetration,” the monetization methods they are exploring would not be viable in the first place.

The founders of Twitter have likely already made millions of dollars through private stock sales and the company will likely be able to acquire several additional funding rounds as needed to ensure they stay around long enough to be acquired for billions. In other words, there is a very good chance the founders of Twitter will have built the company and made hundreds of millions for themselves and their investors all while having generated little actual revenue – let alone profit – along the way. Is this bad business? Certainly not. If you are building a business to generate revenue is it a model you will want to copy? Probably not. Twitter has used a risky strategy, to say the least and while it might seem counter intuitive, Twitter is successful probably because there was not a strategy there in the first place; you just couldn’t plan for what they’ve done.

Using Twitter as an example is a double-edged sword since it is an anomaly and difficult to categorize as B2B or B2C. But Twitter is such a pervasive technology service in today’s world that it is a great company to examine from the perspective of Freemium. But if you have a niche or vertical B2B SaaS or Web App, is Twitter really an appropriate analog? Obviously not. But it is a great example of a company being built around Free with little motivation to generate revenue or create profit. It is this piece of the puzzle that could be missing when companies look to Freemium as the go-to marketing method; they don’t fully understand the real motivations behind many of the companies employing Freemium. This is why it very important to know that Classical Freemium does not exist at scale!

You need to know that few companies are able to build a real, sustainable business off of the 3% conversions that most Freemium companies see. Evernote seems to be one of the few, but they are in a great position to play the numbers game required by Freemium. First, they aren’t B2B only; business customers can use the service, but so can anyone else. In fact, Evernote is one of the few companies to say – and mean – that anyone with an Internet-connected device is a potential user / customer. Most companies being honest with themselves cannot say that. So in the B2B world, building a sustainable business off of 3% conversions just doesn’t happen.

Freemium is a marketing method for getting users, for sure. But it is also a marketing method for getting a foot in the door, generating buzz or brand awareness, entering more price-sensitive market segments, or disrupting competitors. These are the scenarios where Freemium is going to flourish in the coming years for most business that leverage it. Few will be pure-play Classical Freemium and have any real success. To date, no B2B company has built and scaled a business through pure-play Classical Freemium – that is, one product line that has a free-in-perpetuity component and one or more premium versions of the same product for the same market segment.

All companies at some point must start generating revenue to remain viable. For many Freemium companies this occurs after they’ve reached some level of scale and either have new investors to answer to (especially post-IPO) or have otherwise reached a critical mass of adoption and now can begin to generate revenue. The thing to take note of is that many companies do not rely on converting free users to paying subscribers but instead rely on other revenue streams than premium versions of the free subscriptions to monetize.

You must have a clear path to monetization regardless of whether you will use Freemium or not and if you do choose it, you must do so on the applicability to your goals, your market, etc. and not because another company is doing it “successfully.” It is necessary to really and fully understand how so-called “Freemium companies” evolve over time.

If you are considering using Freemium as your go-to-market strategy, you must understand this before you choose to employ Freemium in your company. You cannot build your business based on what you see on the outside of these other “Freemium companies”. You don’t know what is going on behind closed doors. From first hand experience, anecdotal accounts, and publicly-disclosed accounts, it is clear that its not what you think!

Freemium seems to work best when the goal is simply to get people into the system and not as part of a monetization or sales strategy. If you create a free product for people to use and not as part of a sales process or what appears to be a free trial with no expiration – Freemium seems to work well. But what does it work well for? Getting users. Not generating revenue. However, if it is obvious that the free product is simply a free trial with no expiration or is limited in ways that ultimately makes it unusable without paying, it will fail to gain traction meaning it won’t even help you get users. People aren’t that stupid.

This is why the most successful and profitable methods of monetization right now in B2C revolve around an entirely free product with monetization through credits, virtual currency, product sales, or add-ons; think Facebook or Zynga. This is why over one-third of the top grossing iPhone apps are are Free, but offer in-app purchases for add-ons (additional levels, characters, chapters, etc.).

Back in the B2B world, we can look to a company like Helpstream, founded in 2004 and having raised just under $10M in VC funding as an example of a company where Classical Freemium failed and took the company with it in early 2010. While it is terrible that they failed, some transparency by the former CEO, Bob Warfield, helped shed some light on what happened. The main takeaway from Warfield’s post mortem was that Helpstream didn’t attract the right kind of users; the kind of users that would convert to paying customers. He said they were able to get 200 free users and convert 5 of those to paying customers; a conversion rate of 2.5% – just under the standard 3% conversion rate.

The biggest problem it would seem based on Warfield’s post is that they simply didn’t have enough traction to make the numbers game work. 200 users is simply not enough. Consider the numbers game here – they would have needed 100x the amount of free users they had to get just 500 paying customers if the conversion rate held. We don’t know what number of customers would have resulted in a sustainable business for the company, though.

The real tragedy with Helpstream seems to be that they didn’t make Warfield CEO earlier. His ideas about market segmentation, having the Freemium version be only for smaller businesses by putting upper limits on it (50 users in their case), and having only a free trial for larger businesses – those who are more likely to become customers anyway seem to be spot-on all things considered. Unfortunately this realization – the realization that basing their entire business on Classical Freemium was a recipe for failure – was just too little, too late; they had already ran out of money!

What is frightening interesting is that some companies are actually developing their pricing and building their business around a goal of 3-5% conversions. A fascinating post from Hootsuite – a builder of social networking tools for B2B marketers with just under $4M in VC funding – where they claim to want to build a business off of 5% conversions are hopefully putting up a smokescreen to the real revenue streams at scale. This quote is from a post clarifying their pricing after they initially released pricing that did not sit well with their customers:

“To determine the pricing levels, we analyzed data from active customers to ensure that 95% of current users would remain free based on current patterns”

Without deviating from the point of this article too much, only looking at usage data to determine pricing is not ideal. It speaks volumes when a company justifies its pricing decision based on data analysis to its users who are upset by the pricing announcement / change. Clearly, the company is not listening to what its users and customers want, but is instead looking at data that doesn’t tell the whole story to find the answers. In this case, they are using data to back into a Freemium Strategy and Pricing Model where 5% of their users will want or need to pay to use the service? Best of luck to them, but this seems like a very bad idea.

What Hootsuite seems to be failing to realize is that companies leveraging Freemium that have a 3-5% conversion rate from free to paid are not happy with that. They want higher conversions, it just seems to be that the nature of Free and the Penny Gap keep that from happening. Some do achieve higher than 3-5% and that should be the goal. Backing into a pricing strategy with a specific conversion rate in mind is a bad idea – and severely limiting. This is why pure-play Classical Freemium does not exist at scale in B2B SaaS; no B2B SaaS company actually sets out to build a system where 97% of the users of their system do not pay.

It would seem that Hootsuite might be falling into the trap of building a business around a marketing strategy employed by those that have no real interest in revenue generation on the product for which they’ve used Freemium. It must be noted Hootsuite has begun to use market segmentation within their marketing website and pricing and Freemium strategy by offering regular customer and Enterprise customers different options. Perhaps they quickly saw the err of their ways.

Here’s the dirty little secret about externally-funded Freemium companies and you must understand this. Most are not out to generate revenue – only grow the user base. Generating revenue and growing a free user base are two very different things and in many cases, doing both well is very difficult in B2B SaaS. For most companies using Free or Freemium, it is as a way to get a large number of users and build an audience. Many of these companies have no intention of getting money from those users – ever. This is so critical for bootstrapped companies or those with just a little external funding. Freemium is a Marketing Strategy used to get a lot of users fast – “hyper scale” as some people have put it. if you don’t have the money to support hyper scaling of a huge free user base, you should not attempt Freemium.

This is hard for the bootstrapped startups with a couple of founders simply looking to replace their corporate income with a SaaS or Web App to wrap their heads around. Why would you do something in your business that is not going to immediately result in revenue – even if it is only 5% of those people that pay? For the founders of companies employing a strategy that does not include revenue generation they will make money in other ways – ways that might even be counter to the longevity of the business as a stand-alone entity.

There is often a tipping point where you start to see products being more aligned with market segments, different versions being created specifically for revenue generation, you might see acquisitions of smaller-yet-profitable businesses, etc. Generating revenue is very different than acquiring users. Many of the entrepreneurs standing behind Freemium made their money not from revenue generated by the services they worked for but by the sale of those companies or the IPO. Is this a bad thing? No… its great and we should all be so lucky. But it speaks to the underlying fact that Freemium is not about revenue generation as much as interest generation by others – acquirers, investors, or an ecosystem.

Now the latter of those three – ecosystem – is very exciting and a very real, sustainable, viable and profitable business can be built around that – M&A or IPO be damned. But do not for one second forget that it takes a substantial amount of funding to get to this point. All of this comes down to the fact that Freemium is itself not just one thing. There are five types of Freemium in use today (covered in a separate article) and the type of Freemium to employ must be based on many factors, including the time-line to reach goals. Freemium strategies are either short- or long-term.

Short-term Freemium strategies are used for market disruption, to get a foot in the door, crush an upstart competitor, etc. and is often used on existing product lines or new alternative products (as detailed in the original “The Reality of Freemium in SaaS” under Alternative Product Strategies). Long-term Freemium strategies are employed by those businesses built from the ground-up to leverage this pervasive go-to-market strategy and is where the idea that Freemium is a “business model” comes from. These companies basically put all their eggs in the Freemium basket and if it doesn’t work, it often leads to complete failure.

For short-term strategies, monetization occurs through more traditional methods often using the free version as a foot in the door for a brand to up- or cross-sell to more established products to new customers, market segments, etc. Aside from M&A or IPO as the method of “making money”, long-term Freemium strategies are designed to monetize in ways only possible at scale by tapping into the network effect, ecosystem, or ancillary revenue streams made possible only after “critical mass” (which is relative) is achieved.

Consider companies that build an audience and monetize through ads – critical mass occurs when they have enough eyeballs to get the advertisers attention. For some companies, like Spiceworks (founded in 2006 with $29M in funding so far), they’ve been able to monetize not only the eyeballs of their 1.2 million users, but the activity of those users by selling network effect data to the advertisers.

Spiceworks has 1.2 million free users, but only around 200 customers – the advertisers – and is a perfect example of the notion “if you aren’t paying for the product, you aren’t a customer, you are the product.” Over time, Spiceworks – who is really in the advertising business not the IT management business – has used network effects generated by their 1.2 million users to add more value to the offering for advertisers. Spiceworks is technically Freemium since users can pay a monthly fee to turn off the ads, but this is not promoted as they see advertising – not subscriptions – as their primary and most scalable revenue stream. Again, Classical Freemium is not present in a company many consider to be one of the most successful B2B “Freemium companies” around.

Evernote is another example of a company building a big enough audience to get the attention of those that will pay to have access to that service in other ways. Evernote has been the poster-child for Freemium over the last few years and while they are not an analog for most B2B SaaS companies, it is definitely an interesting study in how to leverage engagement or “investment” in your product to produce conversions. We should all be thankful to CEO of Evernote Phil Libin’s frank and open discussions of Evernote’s growth and even revenue. Evernote, founded in 2005 and having raised $45.5 Million over 3 VC rounds, worked hard to build an immense user base. Libin has shared that many users and customers alike access the Evernote service from multiple devices, therefore as the service grows, makers of devices that could access Evernote are taking note.

As of May 2010, the poster-child for Freemium was making $500k per year – a not-insignificant amount – from licensing (the ecosystem revenue stream) by mobile carriers and device manufacturers to pre-load the Evernote app for their customers. Carriers and device manufacturers want to attract the attention of the vast – and dedicated – user and customer base of Evernote to sell more devices or network access.

If Evernote had charged for access to their service from day one, not only would they not have reached the scale they have and arguably the amount of subscription revenue due to the aforementioned engagement-based conversions, the reduced scale would not have attracted the attention of those that want to buy access to – in the form of licensing – that user base. Evernote clearly has a long-term Freemium strategy that employs Classical Freemium, but they are not pure-play Classical Freemium since they also employ other revenue streams. Also remember that it takes millions of dollars – $45.5 million so far – to get to this point.

The moral of this story is – for the companies that saw success from a revenue standpoint with Classical Freemium, that success was achieved by raising a lot of money and using that to build a large base of free users. Once they reached a certain level of scale, they had to branch out – or finally could branch out – to other, more lucrative revenue streams. When we can literally point to just a handful of “successful” Freemium companies with few of those employing pure-play Classical Freemium at scale or even in a very long time, it is at best difficult to consider Freemium a successful “Business Model.” For some heavily-funded narrowband horizontal SaaS companies, Freemium and Free have been the key to gaining critical mass before employing monetization strategies outside the scope of Classical Freemium.


Since I published this in late 2010, some things have changed…

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