Your business needs to acquire new customers. Yet you also need to keep an eye on customer acquisition costs. All of this is happening while customers seem to shrug off many traditional marketing strategies.

These days, customers often want to know what they're getting before committing to a new product. They read reviews, check out demonstration videos and ask their friends for recommendations.

That’s where the freemium business model comes in. The freemium model has gained a lot of traction in the last decade because it meets customers' needs, allowing them to understand a product or service upfront. It also meets company needs since it shifts the cost of education away from the business and onto the customer.

By letting users engage with their service for free, companies and apps as disparate as Skype, LinkedIn, Hulu, Evernote, Spotify and even Candy Crush Saga have grown their customer bases exponentially.

Let’s take a look at how the freemium business model works, its pros and cons and how to tell whether it will work for your brand.

What Is the Freemium Business Model?

With the freemium business model, users can enjoy a service’s basic features for free. If they want greater functionality, they can subscribe.

The subscription fees gained from premium customers typically provide a reliable income stream for companies. At the same time, the free userbase helps spread the word to a greater pool of potential customers.

The freemium model is attractive because it brings in users without the huge spending required by advertising and marketing campaigns. Customers like freemium because, let's face it, everyone likes getting something for free.

The term "freemium" has only been around since 2006 when Jarid Lukin coined the word. Since then, the model has exploded in popularity, particularly with gaming companies and internet-based services.

By 2019, according to data from Statista, the freemium model was the second most popular monetization strategy for mobile apps — and creeping up on the no. 1 strategy: the subscription model.

The freemium model works exceptionally well for internet-based companies whose customers represent a high lifetime value. Computer software companies also find the model useful, as customers can try out programs but have to upgrade to access all features.

Related Article: The Most Powerful Model for Any Business: Subscription

How Does a Freemium Model Work?

In the freemium model, customers are ranked into two tiers. In the free tier, they have limited access to the product's features. Premium users, who pay for their service, get a full-featured version of the product.

New users like the freemium model because the bar to entry is lowered as far as it can go: it's free. This setup establishes a relationship with the customer in the hopes that they will eventually pay to level up to the premium tier.

Typically, users can stick with the free version of the product as long as they want. Businesses using the freemium model know that not all customers will upgrade. That means you have to choose the limitations of the free product carefully.

You don't want to drive a customer away because of frustration with those limitations. However, you also don't want them to stick with the free version forever. To strike this balance, businesses must understand their customers' needs intimately.

Freemium vs. Free Trial

The freemium model may seem similar to offering a free trial. However, the two approaches are quite different.

Free trials last a limited time, typically a week to a month. During this period, the customer has full access to all product or service features. At the end of this period, the customer has to decide: will they pay for the product or drop it?

Free trials can result in solid conversion numbers, according to a study from Totango, with the conversion rate as high as 50% in trials where customers must opt out at the end (and a 15% rate when customers must opt in at the end).

In many cases, though, especially in the case of opt-out trials, customers can be scared off by the trial’s expiration date. That doesn't happen with freemium offerings since customers can stick around indefinitely.

Examples of Successful Freemium Companies

Many companies, especially in gaming, software and internet-based spaces, have built their brands successfully using the freemium model. These include:

Learning Opportunities

  • Spotify: With a 46% conversion rate — 217 million active users, 100 million paid subscribers, according to Spotify — the music streaming brand is by far the most successful freemium model. Free users have to sit through ads as they stream their playlists. Premium users, however, can avoid ads, skip through songs and discover new music. They also enjoy better sound quality.
  • Dropbox: This online storage company offers 2GB of storage space for free. Its business version, available to paid customers only, provides more space and comprehensive services.
  • Skype: Anyone can set up a Skype account and call from one computer to another for free. However, a paid account is required to call mobile devices or landlines.
  • Candy Crush Saga: This addictive game from King lures users in with its free model. However, when players run out of lives, they need to pay to get more. The game also racks up revenue by charging for boosters that help players advance quicker through levels.
  • Evernote: Free users have limitations on what they can store, how many devices they can sync to and the type of customer support available. These limitations drop away with the premium and business versions, which also offer extra features.

The Advantages of the Freemium Business Model

The freemium business model can be an ideal choice for certain businesses. It's a powerful customer acquisition strategy, helping build relationships and trust without stress. Other advantages of the freemium model include:

  • Minimal marketing requirements: Freemium lifts the burden on your marketing team. It's an excellent choice for startups that don't have marketing money to burn.
  • Attraction to customers: A lot of people are willing to try a new product, app or service when there's no pressure to buy.
  • Customer data collection: Even if play-for-free customers aren't generating revenue, they're still delivering a wealth of data.
  • Conversion to premium: Some freemium customers will convert to paid premium customers, delivering revenue.
  • Brand awareness: Freemium products can start to build a following with less customer support and lower advertising spend required.
  • Word of mouth: Because customers have firsthand experience with the product, their referrals carry weight. According to Harvard Business Review, freemium customers are typically worth up to 25% of paid customers due to their referrals.
  • Ad income: If the freemium version of a product includes ad support, there's still a revenue stream from the product.
  • Scalability: Businesses can scale their products as their customers' needs grow, designing new solutions for new problems.
  • Cost savings: When customers pay for a product, they expect customer service. Free products don't require the same investment in customer service and product development.

Related Article: A Recipe for Building Brand Value in an Era of Disruption

The Disadvantages of the Freemium Model

The freemium business model isn't necessarily the solution for every company. It does come with some potential disadvantages, such as:

  • Stress on company resources: Even if you don't provide full customer service to free customers, they do take up server space. It can be all too easy to burn resources on free users.
  • Low conversion rates: If conversion rates aren't what you expect, you could end up providing a lot of benefits for little to no ROI.
  • Too many features: If you provide too many valuable features on the free version of your product, there's little incentive for users to upgrade.

The Conversion From Free to Premium

One of the keys to making the freemium model work is focusing on the conversion from free to premium. As a starting place, businesses must determine their target conversion rate.

This calculation depends significantly on whether you're going to generate revenue from online ads. If you are, you can aim for a lower conversion rate. If you rely on subscriptions for income, your conversion rate target must be higher.

Don't assume that every business has a high conversion rate target. Remember, one of the true benefits of the freemium model is its ability to spread the word about your brand and generate new users. If you experience a remarkably high conversion rate, it may indicate that your free product isn't attractive. You could be pushing away larger numbers of potential customers.

A moderate conversion rate of 2% to 5%, according to Harvard Business Review, seems to work for most companies. If your market niche is smaller, you'll need to seek more conversions.

Keep in mind that your conversion rate may not remain steady. Expect your early adopters to convert more readily, with conversion numbers dropping slightly over time.

As you prepare to put the freemium model into practice, you must include the cost of servicing free users in your calculations. You also have to plan how to encourage free users to upgrade.

Related Article: 4 Tips to Guide Your Conversation Rate Optimization Strategy

Limitations on the Free Version of Your Product

It’s critical to establish the limitations of your free product to encourage conversions. Your product must provide enough value in its free form that customers will want to stick around. Yet the limitations must make customers decide it's worthwhile to upgrade to the paid version.

Depending on your product, some premium features you might consider offering include:

  • More storage
  • More time allowed on the service or app
  • Customizability of the product
  • Greater levels of customer service
  • Personalized services or features
  • Greater access to articles, videos or other content
  • New features

The research you gather from your free users can help you understand their needs. Once you see what they value in your product, you can establish free and paid tiers. Ensure there's a big enough gap between the free and paid versions to nudge customers toward the upgrade. A detailed assessment of what your competitors offer can also feed into these decisions.

Building Your Freemium Business Model

By building tiers of services and features into your product, you can set your business up to take advantage of the freemium model. Upselling customers and adding to your premium features allows your company to scale and grow.

Consider the freemium model if you offer products and services that people regularly use, whether for work or entertainment. By continuously looking for ways to monetize your free users, you can make the freemium model work for your business.