What is Freemium? Why Does it Work For Some Businesses and Not Others?

The freemium pricing strategy has catalyzed epic growth for multi-billion-dollar companies, but it’s not for everyone.
Mae Rice
June 17, 2020
Updated: August 11, 2020
Mae Rice
June 17, 2020
Updated: August 11, 2020

Should tech companies give away their products for free? It used to seem like a trick question to Mark Brenner, CEO of Wiss & Company subsidiary WEST Growth.

“You had a product or service, you got people to pay for it and that’s how business was done,” he told Built In.

But in the 21st century, that conventional wisdom got turned on its head. It started with Facebook and Google. Best-known for their free products, they went from objects of skepticism — what was the business plan, anyway? — to swaggering Fortune 100 companies.

Along the way, Chris Anderson published a book called Free. The year was 2009, five years after Google went public at a valuation of $23 billion, and Anderson, then the editor-in-chief of Wired, was making a business case for giving products away. In the internet age, he argued, a select few paying customers could subsidize a product that was free for all.

Just look at advertiser-supported Google — or advertiser-supported publishers.

Anderson also touched on an intriguing alternative model, Virginia Postrel wrote in her New York Times review of Free:

Less familiar [than the ad-supported strategy] is the “freemium” strategy, in which a site like Flickr offers one package of services free but charges for an ad-free package with more features, allowing a small fraction of users to subsidize the rest.

In the more than a decade since her review, “freemium” — syntactically, a mash-up of “free” and “premium” — has become much more familiar.

What Is Freemium? 

Freemium refers to a tiered pricing model where the cheapest, most basic product tie is free. Customers can pay for additional “premium” features, which might include an ad-free experience, a larger content library or more personalization.

At WEST, Brenner works with ultra-early-stage startups that are “just starting to build out revenue and go-to-market strategies,” he explained. The firm offers its clients proprietary accounting and budgeting software, and strategic advice on growth.

One key question Brenner often talks through with almost all of them: Is freemium right for you?

 

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Image: ShutterStock

The Rise of the Freemium Giants

As a longtime entrepreneur, Brenner has firsthand experience with the perils of ignoring freemium’s potential. In 2004, he co-founded a company called Vidavee, which made a video player he still considers “better technology than YouTube.”

At the time, though, freemium didn’t make sense to him. He and his team operated in the B2B space instead, selling their slick player to publishers like The Huffington Post and MTV.

YouTube, on the other hand, started out free and ad-supported — paving the way for a freemium business model — and grew like wildfire.

“Consequently, YouTube became what it became,” Brenner said, “and my company became ... something less than YouTube.”

In 2008, Vidavee got acquired by Vignette for $6.6 million; YouTube, meanwhile, got acquired by Google in 2006 for $1.65 billion.

For more than a decade, YouTube stuck with its ad-supported model. In 2017, though, it moved to freemium, and began selling monthly premium subscriptions. In 2019, those subscriptions brought in roughly $750 million in revenue, and YouTube’s ongoing ads brought in another $15 billion.

YouTube was relatively late to the freemium game, though. Before it rolled out its YouTube Red subscriptions — now YouTube Premium — other companies had paved the way, proving that freemium pricing worked. 

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Image: ShutterStock

Three Freemium Success Stories

These companies helped make freemium famous.

 

Slack

Launched in 2014, Slack’s chat app amassed more than 500,000 active daily users within its first year, and more than tripled that in its second. The key was (and remains) its free tier, which lets prospects try out basic functionality indefinitely. It comes with certain built-in inconveniences, though — for instance, it only lets free users access the most recent 10,000 messages in their archives — that only a paid subscription can solve.

Slack’s free tier, like all free tiers, fueled a product-led growth strategy, helping the app amass a user base through word of mouth and network effects. Unlike many startups of its era, Slack didn’t rely on marketing professionals or sales reps, even when it came to enterprise accounts — instead, it landed them through grassroots adoption. Employees tried Slack out and shared it with their colleagues, until the lack of a company account became an inconvenience.

 

Spotify

Spotify has a free, ad-supported tier of its music streaming app, and a variety of ad-free paid subscriptions — classic freemium. Back in 2015, in fact, the company garnered criticism for overreliance on its free tier. Could it ever be profitable?

The company defended its business model, though, saying in a statement:

Our Premium and Ad-Supported Services live independently, but thrive together. We believe this business model has allowed us to achieve scale with attractive unit economics and is a critical part of our success.

The past five years have borne out this argument; Spotify has grown faster than competing streaming services; in 2019, it was the first to reach 100 million paying users worldwide.

The company has honed its conversion strategy too. Today, it has a surprisingly high ratio of paid to unpaid users: just shy of 50 percent of its subscribers pay.

 

Dropbox

Dropbox, the pioneering cloud storage provider, rose to prominence on its freemium pricing model. The company offers new users two gigabytes of free storage when they sign up, and, once they reach their limit, it’s easier to pay for more space than to switch platforms.

This fundamental convenience factor has pushed about 4 percent of Dropbox users from free to paid accounts — a low conversion rate compared to Spotify, but robust for the tech industry as a whole. According to the Harvard Business Review, a roughly 5 percent conversion rate from free to premium is optimal: it means the free tier strikes a balance between growing the overall user base and bringing in revenue.

Dropbox is living proof of that: Since its 2007 launch, the company has amassed more than 500 million users, and its IPO valuation was $10 billion.

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size matters freemium
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But There’s a Catch: With Freemium, Size Matters

The constellation of freemium stars — which also includes Eventbrite, free games like Fortnite, and many more — all have one thing in common: scale. All of them have “bet on the idea that they can get ... mass adoption,” Brenner explained. And they won.

“Once you do have mass adoption, there’s a variety of ways to generate business value and market value,” he said.

A massive audience becomes a product in its own right. Companies can sell all that aggregated attention to advertisers, or convert enough users to paying customers to stay afloat. Some companies — like YouTube, with its two billion active monthly users — do a little of both.

A freemium product with a smaller audience, though, is not long for this world. Between 1 and 10 percent of free users convert to the paid tier in freemium models, so covering even fixed costs with freemium pricing requires a huge user base.

Most digital publishers, for instance, have struggled to reach freemium’s requisite scale. Many had been offering less and less free content before the coronavirus pandemic; its arrival triggered a precipitous drop in ad revenues, and hastened the industry shift to paid subscriptions.

Way back in 2009, even optimistic Anderson acknowledged that freemium posed a risk to smaller companies. “Everybody can use a Free business model,” he wrote in Free, “but all too typically only the No. 1 company can get really rich with it.”

In hindsight, freemium may have gotten famous on an inversion of cause and effect. It can’t turn any old company into a Slack-style household name. It’s more that any company using freemium pricing has to become a household name — or it will tank.

It’s a “high risk, high reward strategy,” as Brenner put it.

 

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Image: ShutterStock

The End of Freemium?

Now that it’s clear freemium pricing only works for an elite minority of ultra-scalable tech companies — does that mean the end of the trend?

In many ways, yes. Free and freemium products are “going out of fashion,” Brenner noted, in part because freemium works in rarer and rarer cases. Today’s tech market is more saturated than it’s ever been, and it’s harder to achieve mass scale than it was a decade ago.

But that doesn’t mean freemium is dead. Instead, it’s evolved from a common long-term business model to a common phase in a startup’s lifecycle.

Today, Brenner recommends that client companies offer their core product entirely free in the seed stage, to assess basic demand and product-market fit. It’s a way of “de-risking their business,” by finding out answers to basic questions before asking for investors’ money.

For instance: “Who is your customer? How expensive is to get people to try your product and service?” Brenner said. “What’s your market size?”

At first, wide-ranging feedback and proof of demand is worth more than money, and “pricing is a huge barrier to getting the product into the market,” Brenner said.

But that initial free offering is just a “first step” for most companies, he said — the beginning of a conversation with their audience about pricing. What features are users willing to pay for, and how much will they pay for them?

Based on this information, startups begin finding ways to combine product-led growth with revenue. That may mean experimenting with freemium pricing, or month-long free trials and demos that lead to paid subscriptions.

Ultimately, though, free and freemium pricing models rarely last. They can lead to venture funding and early growth, but it’s only financially sustainable in the long-term for a lucky, famous few.

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