Author: Hermann Simon
Freemium models (free + premium) are pricing strategies that combine a basic free version of a service with a more functional, robust premium
(paid) version. The goal of freemium models is to use the free price to attract the largest number of potential customers in the hopes that they will become comfortable enough with the basic functionality and develop a desire for the more powerful premium version. In this article, the author explores freemium models and how they can be successful. Hermann Simon is Founder and Chairman of Simon, Kucher & Partners Strategy & Marketing Consultants. He can be reached at hermann.simon@simonkucher.com.
The Pricing Advisor, February 2016
Freemium is a combination of the words “free” and “premium.” It describes a price strategy under which a customer can either get a basic version of a service for free or can purchase a premium version of the service. On the internet, the number of freemium business models has risen sharply. The marginal costs for many internet services are zero (or close to it), which means that the free offer does not cause incremental costs. “Freemium-like” models also existed in the offline world. Banks lured customers in with free checking accounts, but if the customer wanted anything beyond basic services, they had to pay.
Admittedly, the free offers for the basic bank account often came with conditions, such as a minimum balance requirement.i But such offers only look like freemium models. The customer pays because they earn little or no interest on their deposits. A similar hidden payment occurs with “zero-percent” financing offers from retailers or car dealers.ii The financing costs are hidden in the purchase price.
The goal of a freemium models is to use the free price to attract the largest number of potential customers. The company hopes that if the user becomes comfortable with the basic functionality, he or she will have a growing interest in paying for a version which is more powerful, more advanced, or offers additional functionality.
Freemium fits very well with experience goods, whose full value only becomes apparent when customers have had a chance to use the good. One could interpret freemium as a specific form of penetration strategy. Freemium is becoming more and more popular. Typical industries include software (e.g. Skype), media (e.g. Pandora), games (e.g. Farmville), apps (e.g. Angry Birds), and social networks (e.g. LinkedIn).
The key success factors for a freemium model are:
- An attractive basic offer: which can attract a lot of users
- The right fencing: between the basic and the premium offer, in order to convert first-time buyers
- A customer loyalty concept: to turn the first-time buyers into repeat customers, who have the highest lifetime value
There is a trade-off relationship between the first two factors. If the basic offer is too attractive, it will be hard to develop a clearly differentiated premium product and encourage customers to trade up to it. The company will definitely attract a large number of free users, but will struggle to convert them to paid users. On the other hand, if the basic version offers too little value, it may not attract enough free users at all. One may achieve a high conversion rate to the premium model in that case, but the absolute number of users remains small. The fencing between the basic and the premium versions is achieved through features, product versions, or differences in usage intensity.
In contrast, the communications software Skype offers a complete array of functionality, but restricts free calls to within its own network. It also offers instant messaging and file sharing free of charge within its network. If Skype users grow accustomed to the intuitive user interface, they are more likely to want to make calls to landline networks or cell networks, and also be willing to pay for those calls. When it began, Skype primarily sold individual talk minutes. Later on, it structured its service portfolio to resemble a classic telecommunications offering. The current paid offerings include bundles of minutes or flat rates for selected domestic phone networks.
Newspapers have introduced freemium models, after years of enduring the “free” culture for digital content. Newspaper websites used to earn their money online solely with advertising. In order to get money directly from readers as well, many publishers erected paywalls. The main fencing instrument here is not a better version of the product, but rather the reader’s usage intensity. The New York Times, for example, allows a reader to access 20 articles in a month free of charge. Whoever clicks through more often needs to pay. But print subscribers receive free access to the online version. The German newspaper Die Welt is also experimenting with paywalls.iii Each of those newspapers offers digital subscriptions for 99 cents per month, even though the list prices are between 4.49 and 14.99 Euros for Die Welt and between $15 and $35 for the New York Times. The Kindle version of the New York Times costs $29.99 per month. The offers of 99 cents for a monthly subscription are not too far from being truly “free”, but the fact that these small amounts create a paid relationship makes a fundamental difference for the customer as well as the publisher. The largest hurdle in freemium models is getting customers over this initial price barrier, or getting them to cross the “penny gap.” The challenge for the publishers is to draw customers away from the “free” culture and to establish their digital content as a paid experience. IBM manager Saul Berman has called this “the challenge of the decade.”iv Stephan Scherzer, the head of Germany’s newspaper publisher trade association, says that this is the “question which decides our future: How do the publishers get readers to pay for content online?”v Right now there are few media companies that make their money entirely from content. One example is the French investigative and opinion portal Mediapart, led by former Le Monde editor-in-chief Edwy Plenel. The portal charges a monthly subscription fee of 9 Euros, has 65,000 subscribers, and generates revenue of 6 million Euros. This is a small amount, but the company is profitable and achieves a margin of over 10 percent.vi Mediapart accepts no advertising at all.
At the beginning of a recent pricing engagement for a social network, only 8 percent of its users were premium customers. Using online price tests, they found out that price changes would barely affect revenue. Because the company faced many comparable competitors – some with completely free offers – the number of premium users fell quickly in the tests after a price increase. Price cuts, in contrast, did not attract many new customers. The price elasticities were roughly 1. That means that price changes would be more or less revenue-neutral, as volume changes tended to balance them out. What did have an effect, however, were changes to the portfolio and to the offers themselves. On the strength of better, more content-rich offers, the share of premium customers rose from 8 percent to 10 percent. That represents a growth of 25 percent and corresponded exactly to the increase in revenue. It was the network’s most successful project ever, and it confirms the central role tha tusage plays. The usage difference between “free” and “paid” must be large enough to get customers across the penny gap.
Based on its popular Need for Speed racing game, Electronic Arts has developed a freemium product called Need for Speed World. The player can use real money to purchase play money, which he or she can then use to buy additional cars or optional equipment to improve their cars’ performance.
From a company’s perspective, whether a freemium model is better than a conventional price structure or scheme depends on the competition, the target customers, and the product features.vii The key metrics are conversion and the customer lifetime value of the premium customers. A company can get several hundred dollars from such customers, whereas users of the basic product generate no revenue at all. A systematic optimization of price and product using a freemium model typically increases revenues by about 20 percent, according to industry experience.
Media companies, however, can do very well without pursuing a freemium model. A leading magazine in the US recently tested a hypothesis, which ultimately found that equal but slightly increased annual prices of $118 for its digital and online editions would increase revenue. The price for the bundle of digital and online was $148, a discount of 37 percent against the combined price of $236, which is the sum of the two individual prices. After implementation, the average revenue per subscriber rose by 15 percent, with no relevant loss of subscribers. One must note here, however, that this magazine enjoyed a very strong reputation. Customers are obviously willing to pay for it, and they perceive the combined access to the print and online versions as true added value.
References
- Direct mailing from Commerzbank dated March 26, 2013.
- “Nicht jedes Angebot ist ein Schnäppchen. Null-Prozent-Finanzierungen werden für den Handel immer wichtiger,” GeneralAnzeiger Bonn, April 3, 2013, p. 6.
- “Axel Springer glaubt an die Bezahlschranke”, Frankfurter Allgemeine Zeitung, March 7, 2012, p. 15.
- Saul. J. Berman, Not for Free – Revenue Strategies for a New World, Boston: Harvard Business Review Press 2011.
- “Das nächste Google kommt aus China oder Russland”, Frankfurter Allgemeine Zeitung, March 18, 2013, p. 22.
- “Enthüllungsportal Mediapart bewährt sich im Internet”, Frankfurter Allgemeine Zeitung, April 4, 2013, p. 14.
- “Eine kompakte, gute Analyse von Freemium bietet Uzi Shmilovici, The Complete Guide to Freemium Business Models”, TechCrunch, September 4, 2011.
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