Freemium isn’t just for “Startups with Nothing to Lose”

A common misconception about Freemium is that it is just for startups with nothing to lose. This myth is perpetuated by many of the Freemium advocates whose backgrounds – and current experience – are limited to early-stage, venture-funded startups. Unfortunately, this misconception really misses the point.

Freemium is a marketing strategy – or quite often a tactic – and used most often to disrupt markets, competitors, etc. So, since when is disrupting markets relegated to startups? It is a bad idea to be focused only on the near-term and to miss the big, longer-term picture because of it.

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.

While startups are often the first to market or the first to try new and risky things when it comes to marketing, if something works – or could be made to work by exploring lessons learned by failed startups – often the larger more established companies will come around. And when they do, that could be a big problem for the early-stage startups whose only real value proposition is that they are free.

No matter how you slice it, to really disrupt a market – the odd vendor that got lucky notwithstanding – requires significant capital regardless of whether Freemium is leveraged as the marketing strategy or not. But isn’t it interesting that for a startup to gain significant market penetration and traction using Freemium within the large markets required for the numbers game to work, it must raise significant capital for infrastructure and customer acquisition? Hmmm. It would seem Freemium is quite expensive for the vendor.

Here are some of the popular case studies in Freemium and how much equity capital they have raised to date (in late 2010):

Evernote $45M
YouSendIt $53M $30M
Pandora $56M
Xobni $32M

So, who cares that you have to raise so much money to get a Freemium business to work? You should. The myth is that the built-in virality of the network effect enabled by Freemium is enough. Obviously it is not. Freemium is almost always associated with low Customer Acquisition Costs – CAC – through word of mouth, viral and game mechanics, social networking, etc. On top of that, with open source stacks and cloud infrastructure the cost – as you often hear – to support a free user is “near zero?” But support costs are just one expense usually not added to the actual CAC even though “near zero” support costs in aggregate at scale often result in something with “near many zeros.”

As was shown in the original “The Reality of Freemium in SaaS” the CAC metric must take into account all of the expenses required to land a paying customer. The true definition of CAC is the aggregate costs associated with discovering, reaching and getting the attention of a potential customer, getting them to your site or calling on them, converting them to a user, serving them (marketing, technology, human services) during the non-paying period, and then converting them to a paying customer.

In a Freemium scenario, you will have on average 97 free users for every 3 paying customers. If you have 10,000 users in the system, on average, 300 will be paying customers. That means, the aggregate CAC for each of those 300 is not what it costs only to attract and convert each of those 300, but what it also costs to attract and support the other 9,700 users while they wait to become customers. And of course, none of this is static so the 9,700 at a given time could include any number that churned out over time.

Some have argued that if you know 95% of your users will never convert then they aren’t customers and should not be figured into the CAC. Whatever it takes to justify your position, do what you will, but know that if you spent $100 on AdWords and got 100 people to come to the site, and converted 3, it was not a CAC of $3… it was a CAC of $100, or just about $33/customer. You have to get real.

If you are in a very small niche where you provide a significant amount of value to your business customers, Freemium should probably be the furthest thing from your mind. There are so many very targeted methods of reaching your customers in ways that add value and raise the value perception of your offering that you don’t need to worry about brand building or market making. Just tell people how you’ll solve their problems or help them take care of new opportunities, charge them for the privilege, and you will likely have a great deal of success.

In large, horizontal markets – especially in B2B – much of the cost associated with Freemium at a large scale is in market-making and brand building. That is, orchestrating the “organic” viral campaigns, greasing the palms of pundits, traditional PR… wait? What? None of that sounds like the Freemium we all know and love, right? The build it, make it free, and let the product sell itself. Yeah, that doesn’t work.

Even if the only costs associated with customer acquisition are the result of directly pulling in users and converting them to paying customers, few companies will look at the CAC correctly – at best forgetting to figure in “user acquisition,” too. But we know – as previously mentioned – the bulk of the expense is not in the highly-targed direct acquisition – a Google AdWords campaign – of Users or Customers.

No, for most, the cost is from the indirect acquisition methods (i.e brand building, PR, market making, etc.) and that is harder to keep in check. In fact, it is too often not calculated properly in the actual CAC and is relegated to other marketing, S&OP, etc. expenses.

How does the specific issue of Customer Acquisition Cost tie to whether Freemium is only for startups with nothing to lose or not? Well, its simple really. The problem with the way most companies leverage Freemium is that CAC goes UP simply because of the way they use it. They emphasize the FREE version rather than the PAID version in order to get “traction.” This simple marketing decision can be the death of a company or the point at which they thrive. No one ever said you MUST go through the free version to get to the paid version.

Yet, most startups are looking to get “traction” and are therefore pushing to get as many free users in the door as possible. Established companies used to generating revenue will be more likely to use Freemium as the marketing method it is but push heavily, from the moment the would-be customer lands on their website, the premium version. Free was what got you to the site, but the value of the premium product is what will get you to stay and pay.

SocialText – founded in 2002, $19M in VC funding over 6 rounds – hardly a startup – is an example of a company that has created a Free version of their service but is not putting all their eggs in the Freemium basket. For instance, they do not emphasize the Free version on their pricing page. In fact, it is not found on their pricing page at all but is instead a special program they have created to be leveraged in other ways.

SocialText can be considered Freemium, and will use that to get traffic to their site, but will de-emphasize the Free tier outside of those specific marketing campaigns. That is – if you come to the SocialText marketing website directly and not via a search for Free or Freemium or not through their carefully orchestrated campaign, Freemium landing pages, etc. then you will not be presented with that opportunity.

But is SocialText really benefitting from Freemium in the way that their competitor Yammer (founded 2008/$15M funding) is? Are they getting the press, the traction, etc. associated with Freemium in the way that Yammer is? It is hard to tell without any level of transparency, but the answer would seem to be no. So in SocialText’s de-emphasizing of Freemium, they are likely not seeing the same level of “traction” that Yammer is. The big question is then – is that a problem?

SocialText by all accounts has a thriving Premium offering and perhaps they are using Freemium to win over customers who bring up Yammer in sales calls. Perhaps it is something more. The interesting thing here is that they HAVE a Freemium offering and could be waiting to unleash it on the market. Yammer – who claims penetration in “80% of Fortune 100” companies as of October 2010 – has an interesting Freemium strategy that will be covered in a separate article.

So, while Freemium startups are out trying to make noise and get the market or industry to notice them, incumbents can leverage the same Freemium tactics of market penetration as the new kids on the block, but without the need to build a brand from scratch. Whereas Freemium startups think they’ll come in and disrupt the status quo with Free and knock the stodgy old-school monoliths off their pedestal, some are being beaten at their own game. Guess what? If Free is your only claim to fame, that is all you’ll get – fame – as you enter the deadpool.

Yes, large established companies are slower to pull the trigger on things like Freemium – many will never attempt it – but for others this “slow and steady wins the race” mentality is because they want to fully think it through. They need to fully understand what happens if it the strategy fails. How will it affect their market position, the brand value, etc. What happens if it is successful? How will it affect their market position, the brand value, etc. There is a very real issue around protecting their brand from the potential of “free = zero value.”

Wherever possible, established companies will look to existing products or services that they’ve already invested in the development or acquisition of but that are new or have yet to establish a strong market presence to experiment with Freemium. Due to the inherent risks of Freemium, this is a great way for a company to try Freemium without damaging an established product line, brand, etc. If you are a startup or are in a market where larger competitors have acquired smaller companies or if you know companies have invested in IP that directly competes with your Freemium offering but they have not yet begun to market it, that should be considered a direct threat.

There are many pitfalls that established vendors will want to overcome, but when they do figure it out, look out. If you see an established company leveraging Freemium, it is likely that they have figured out a specific opportunity to go after, a market segment adjacent to their current position that they want to penetrate, or they might just want to stop competitors in their tracks. And as established brands with a lot of money in the bank, they might just be able to do that.

Amazon Web Services (AWS) would hardly be considered a “startup with nothing to lose” but they recently “went Freemium.” This is a perfect example of a company that is very successful – not a startup – deciding to use “Free” to disrupt their competition and gain even more new market share. While the bulk of the noise in the industry was around their 1-year free trial for their core services – EC2, S3, EBS, ELB – the real news was around a real Freemium offering for their proprietary ancillary services like Queueing, Notifications, and Non-Relational Datastore.

Those services are unique to Amazon and once you are using them – which requires deep integration into your application – you are effectively locked-into AWS at some level. You can always move your app from EC2 to your own data center, you can move your objects from S3 to another file host, but the *services* that AWS provides in those ancillary offerings you cannot (easily) move. Brilliant and very disruptive to other “cloud computing” players.

Another great example of a successful and established company “going Freemium” is Mailchimp. It is true, many people think of Mailchimp as an overnight success since Freemium did its job – it got them noticed. However, the company has been around since 2001 and did not get into Freemium until they had been a successful company for nine years. Mailchimp was looking for a boost – a way to disrupt the status quo in the email marketing industry and knock the leaders down a peg or two. Freemium was the method they chose.

The key to the success of Mailchimp’s Freemium strategy was the fact that they had so much time in-market that they could anticipate and plan for the additional support burden – and system abuse – associated with a surge in free users of an email marketing system. Where they didn’t or couldn’t anticipate challenges, it was that time in-market and experience that allowed them to roll with the punches and make adjustments along the way to make Freemium work.

Startups should take note of that – the additional support and ABUSE that free users would bring was the major challenge with Freemium for Mailchimp. This is where existing companies will have an edge over startups in Freemium – they know what the early-stage companies don’t yet understand. For young companies hanging their hat on Freemium, they need to be very aware of this threat.


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

My suggestion to any SaaS or Web App company considering Freemium is simple: Make sure you’re targeting a large enough market that would actually want to use your product (B2B or B2C) and then seek out Venture Capital firms that have funded OTHER successful Freemium ventures.

Don’t try to do it on your own, bootstrapped. Freemium requires MASSIVE AMOUNTS OF MONEY and a large enough audience. Without both, Freemium is unlikely to work for you.

About Lincoln Murphy

I invented Customer Success. I focus primarily on Customer Engagement. Learn more about me here.