Should You Use Freemium? Do the Math!
Students and readers often ask if they should use a freemium pricing model. In the past, I’ve used the following rules to help with that decision.
- Is it a low cost to serve the user? (Usually for software or content.)
- Can you offer real value to your free users?
- Is there a segment willing to pay you for more functionality?
- Does your market have network effects where the value to one user increases the more other users participate? (Think social media or peer-to-peer games.)
Jason Lemkin in his blogpost, “Why You Need 50 Million Active Users for Freemium to Actually Work,” points out a fifth.
5. Is the market big enough?
Please read his article. It’s brilliant and he lives in this world. Here is the gist. If you want to build a $100M business with a freemium offering that brings in an average of $100/year from the paying customers and you have a 2% conversion rate, then you need 50 million active users.
50 million active users is the exception, not the rule. This is hard to achieve.
So you’re thinking, I will get more than a 2% conversion rate. Not likely. When you can find the numbers for successful companies, you will see they are almost always in the 1%-5% range.
- Evernote, 4.1%
- Dropbox, 4%
- Google drive, 0.5%
Can you be as successful as these companies? More successful?
Or are you thinking: “I will get way more than $100/year?” That could be true if you’re in a B2B market, but your market size will likely be much smaller. Not many B2C SaaS products get significantly more than $100/year.
Or you’re thinking, I don’t need a $100M company. I’d be happy at $50M. Okay, pick your number. $100M seems to be the going number for an IPO, but you can certainly make a good income at $50M if you maintain ownership of much of your company, watch your costs and pay dividends to the shareholders.
Here’s the good news, you get to make your own assumptions about conversion rate, ASP (average selling price), and company revenue goal. Given any assumptions, you can work the math to see how many active users you need. Here is the formula:
Users = Revenue / (Conversation rate * ASP)
For example, if you want to build a $100M company using freemium and you can achieve a 5% conversion rate and a $500/year ASP, you will need 4-million active users. Still not an easy feat.
One more thing Jason mentioned in his article, which you should seriously consider: If you are thinking of doing freemium, don’t make that the only revenue model. Once you have millions of users, how else can you monetize them? Remember the saying, “If the product if free, then you are the product.” How can you “sell your users?” Advertising, of course, comes to mind. How about selling the anonymous data? How about crunching the data and selling valuable market research? How about selling access to your users?
The big takeaway here: Don’t blindly jump into a freemium model. It’s not easy.
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