Software pricing: When does freemium really work?

Free beerFreemium — the combination of a free basic version with paid “premium” versions of a software product — is an increasingly popular business model for software. Many Internet startups and even giants like Microsoft and Oracle are using this model for at least some of their products. A lot of iPhone apps for instance are available in a basic “light” version that needs to be upgraded to the paid version for more functionality or content — a typical freemium strategy.
The advantages of freemium seem obvious: It’s a good way to get free marketing. It can reduce sales costs dramatically, because users can self-educate. It lets the product speak for itself, thereby leveling the playing field, which is a particular advantage for smaller companies with small marketing budgets.

But does freemium really work that well in practice? There are early signs of a backlash against this model. Google recently strongly de-emphasized (i.e. practically killed) the previously offered free version of its Google Apps suite, which used to be free for companies up to 25 users. Potential customers are now encouraged to try the product for free for 30 days and then start to pay $50 per user per year. A similar change can be seen at 37signals, once the poster child for freemium, who now hides the permanently free versions of its products pretty well. Startups like photo sharing site Phanfare and the recently demised LucidEra (a vendor of SaaS business intelligence) tried freemium models, but weren’t successful. And many other startups that use freemium are still far away from profitability.

So the question is: Under what conditions does freemium really work for software vendors? Obviously, customers like freemium, but how can software companies use this model to build a really sustainable business?

It think there are probably six conditions:

1. Your marginal costs have to be extremely close to zero.
Freemium only works if the distribution and support of an additional copy of your product (i.e. the marginal costs) costs you almost nothing. Thanks to the Internet, the digital distribution of software is now nearly free, both for downloadable applications and online apps.

That sounds obvious enough, but I think many companies underestimate how close to zero the costs really need to be. Web-based applications for instance need to provide enough server capacity and storage for all these freebie users. This can quickly add up to substantial amounts, even if the capacity for one single user is cheap.

2. The target market has to be big enough.
There doesn’t seem to be any reliable data about how many users of a free product end up buying a paid edition. Obviously, this will strongly differ from product to product. But from anecdotal evidence, it’s probably safe to assume that typically less than 10% of users convert to the paid version.

If freemium is your main sales channel, this obviously means that your target market needs to be large enough so that you still can build a sizable business just from getting paid by a few percent of the total potential user base. Furthermore, the free marketing benefits (and maybe even positive network effects) of freemium can only kick in if there are enough people to spread the word about your product, and for that they first have to be interested in what you have to sell. In other words, niche products that only appeal to relatively few users are probably not ideal for freemium. Some more targeted form of sales might be the way to go there.

3. Your product has to be very simple.
It’s great that users can self-educate about your product while using it for free. Hopefully, they will soon reach the limits of the free version and feel the desire to upgrade to the paid edition.

But for this to work, your product has to be very, very simple. People don’t read manuals and rarely follow online tutorials. The product just has to be easy to use and has to provide obvious value almost instantly, so that users will have enough motivation to dig deeper. Some of the better iPhone games are a good example.

4. If your product is not simple, you need competent customers.
Not all software products can be and should be simple. This has nothing to do with a lack of usability, but with the scope of features that a product offers. Photoshop is not simple. Database systems and application servers are not simple. Content management systems (the decent ones) are not simple. They’re powerful tools for skilled professionals. Products that satisfy the needs of professional users are almost certainly not as easy to use as consumer software, because you need a certain skill set to make sense of what the product does. That’s a problem for freemium.

LucidEra’s founder tells the story of his company’s failed attempts at selling through the freemium model. Many trial customers were simply not able to figure out what the product was good for. They never really used the more advanced features and therefore never really saw a lot of value in the product.

So if you want to sell a complex, powerful product using freemium pricing, make sure that you address a well-defined, skilled audience. Your users need to already understand what they want to do with your product, and they have to be motivated and skilled enough to invest considerable time into working with it. Only then will they discover enough value to upgrade. If you offer a complex product to a user base that has not previously used this type of software (like in LucidEra’s case, selling BI to mid-market customers), freemium will be tough.

5. There has to be a minimum useful feature set, but plenty of additional functionality.
We’ve probably all used freemium software for which we didn’t see a need to upgrade. There are probably two cases where that happens: When the free version of a product doesn’t offer enough functionality, you don’t recognize that this is a useful product that is worth paying for. On the other hand, some free versions offer so much functionality that it will only make sense for relatively few users to upgrade to the paid version.

Google Apps prior to the recent strategy change was an example of the latter case: Small companies got almost all the functionality for free. If you had less than 25 users (and most small companies are way smaller than that), there was simply no good reason to upgrade.

Most successful freemium vendors now use a carefully designed combination of feature restrictions and a limit on the amount of data you can store or the number of users you can sign up. It’s clearly not easy to strike the right balance. Setting the right restrictions is probably the single most difficult thing in the freemium model.

6. You need to really understand the demand curve.

A demand curve in economics describes how many people are willing to buy a product at a certain price. If you can have only one price for your product, you lose a lot of potential customers (who don’t want to pay that price) and you lose a lot of potential profit (by undercharging the customers that would have been willing to pay more).

The solution for this dilemma is price differentiation. Why does Microsoft offer eight different versions of Windows Vista at different price points? Because it wants to ride the demand curve and extract as much money as possible from different customer groups. If Microsoft would offer only one version at a low price, it would leave a lot of money on the table (but maybe have happier customers).

Freemium is of course a form of price differentiation. The assumption is that there are many people who have a very low willingness to pay, but still find a certain product useful enough to spend some time with it and maybe tell their friends about it, some of whom will be willing to pay something. Most freemium products offer several different paid product levels with different feature sets — price differentiation at work.

The problem is that it’s really difficult to find out the shape of the demand curve and match it with your cost curve. One question is what the price point for your cheapest paid edition should be. Will many people pay $9.99 a month? Or is it better to start at $99/month and hope that you get so much free marketing out of your free version that many people will sign up who are willing to pay that price?

A key consideration is your cost curve and the usage pattern that users at different levels have. In some businesses, the most active users who use the most resources are also the most profitable ones, because they have a high willingness to pay. In that case, it makes sense to have a relatively high minimum price. But there are also cases where the low-intensity users are the most profitable. Then it makes sense to extract money from as many people as possible, even if it’s a far lower amount per user.

Conclusion: More an art than a science. And watch out for pitfalls.
There are obviously many variables that go into effective software pricing. Freemium can be a great model, particularly for smaller companies. But it is hard to get it right, and it can also be dangerous on several levels. If you get the demand structure wrong, you might leave a lot of money on the table. If you underestimate the costs caused by your free users, it will reduce your profits dramatically (and it’s not easy to get rid of these users without risking a hit to your reputation). Oh, and how about liability? If you lose a freebie user’s data, can he sue you? Better make sure that your terms of service are watertight.

Freemium is not a panacea for the software industry, it’s just another tool for the hard task of getting software pricing right. It’s great for certain market segments, but software companies should avoid to go freemium just because it’s convenient and reduces sales costs. Sure, a freemium model can get you more users relatively quickly, but in the long term, it might hurt your bottom line and growth prospects dramatically.

Finally, what would Google do? There’s probably a good reason why Google basically got rid of the free edition of Apps and now does pretty conventional software marketing with billboards and the like. They now even do competitive upgrades, as well as channel sales through resellers. Sounds more like traditional software industry tactics than the wonderful world of free Internet-based software.

(Picture: Timothy Lloyd, CC license)

35 thoughts on “Software pricing: When does freemium really work?”

  1. That sounds obvious enough, but I think many companies underestimate how close to zero the costs really need to be. Web-based applications for instance need to provide enough server capacity and storage for all these freebie users. This can quickly add up to substantial amounts, even if the capacity for one single user is cheap.

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