Freemium is a business model that works by providing free basic services while charging for more advanced or special features. The term freemium is a contraction of the two words that define this business model: “free” and “premium”. This business model has gained in popularity among companies operating in Web 2.0.

There are several freemium business models, including:

Restricted features: one of the most common models. The free product or service offers a limited number of features. If customers want more advanced features they have to pay a premium. Skype uses this format

• Time restrictions: the product or service is free for a given time, but once the test period is over users will have to pay (very common in the software industry)
• Capacity restrictions: the product or service can only be used a limited number of times or offers limited capacity (numerous cloud services, such as Dropbox)
• Restrictions on use: a limited number of licenses (usually 1) are offered for free. Users have to pay if they need more. The key is for the restriction to be coherent, such as 1 license per network
• Restrictions by client type: free only for certain group of customers, such as those with loyalty card privileges (Iberia plus Oro with VIP waiting rooms)
• Advertisement restrictions: while this may not be included in the official definition, it is a widely used model. The free service is initially based on the advertising model. If you don't want to see the advertisements, you have to pay (like YouTube or Spotify)

The 10 secrets to a successful freemium business model

1. VALUE: It is absolutely essential that your free service offers something great, because just providing something free of charge won't be enough to attract users. And once you offer a great free service or product, the premium version must be extraordinary and must address the needs of more advanced users with more complex requirements than free customers.

It is also important to ensure that the free service represents a floor rather than a ceiling, i.e. under no circumstances should free features be removed or scaled down in order to incentivize migration to the premium version. This will rankle with users and drive them away from the service en-masse (as unfortunately happened to Spotify when it decided to restrict its free service).

2. VOLUME: Imagine that you aim to earn €20,000 a month from an App, and that your premium version costs €2 a month. To earn €20,000 you will have to provide the service to 10,000 premium clients each month (20,000/2). Given that a good freemium conversion rate is around 1%, this means attracting some 990,000 registered free users ... which is no small matter!

The above calculation is always the first thing that companies need to look at when considering a freemium model, as it shows the reality of what it takes for a freemium model to be a success: the USER VOLUME must be enormous, with a very small percentage of paying users having to support the majority of free users.

3. CONVERSION: Following on from the above, any company operating a freemium model must understand and constantly improve the percentage of free users that they convert to premium. An optimal strategy is required to incentivize users to migrate to premium, without bombarding them with nuisance messages, and while understanding and respecting the maturity cycle of each customer.

It is also key to use the sales funnel as your main business model performance indicator, and to remain focused on driving the conversion rate of free users to premium... all of which means improving all of the steps right through the funnel, ensuring that more users register for the service and buoying the number of registered users that make regular use of the service, etc.

4. CANNIBALIZATION: One aspect that needs particular care is the balance between free and premium features, as the free service must be sufficiently good to be absolutely useful for one group of clients...but only that. The key is identifying the exact threshold at which free services will not cannibalize premium sales, meaning that the free product caters to customer that would not otherwise use the service, while also allowing premium customers to experience the benefits that it can offer.

5. PRICE: Price is always one of the thorniest issues in any business model, but even more so in the freemium format: the lower limit must be enough to ensure that revenue from premium customers can subsidize free users and cover the company's costs structure. Obviously at first it is impossible to reach such an equilibrium, but achieving this revenue floor must be one of the company's primary targets, with any growth above this threshold then boosting profitability.

It is generally difficult to get users to pay for a service (even just €0.01), meaning the goal is not just to identify the right price (meaning in terms of volume but also how it looks ... a "nice" price will always convert better than a cheaper but uglier price), but also to provide an extremely reliable and easy-to-use payment format, as well as a very short registration process.

6. MARKET: Following on from the point about volumes, it is critical that freemium models are only used when targeting massively large markets. This is not a useful business model when aiming at highly vertical or niche markets, as an enormous volume of customers are required to make the approach profitable. So, "How big is the market?" is another question that must be asked when embarking on such business models.

7. SERVICE COST: In freemium models the cost of providing service each customer must be close to zero, i.e. a significant increase in user numbers must not lead to a significant increase in costs. This is because the model’s profitability (which will be meager until critical volumes are reached) has to be maximized, making scalability of the model (automation strategies, economies of scale and process efficiency...) critical, with any human interaction exponentially driving up the cost of the process and thus eroding margins

Curiously, it is also important to bear in mind that free users carry higher maintenance costs than paying customers, as non-paying customers tend to disregard things such as FAQs and instructions.

8. VIRALITY: With volumes and minimal service costs being absolutely critical, customer acquisition strategies with extremely low user acquisition costs are required.

This means any viral trends that can help one customer attract more users (adding more customers to the top of the funnel) are crucial. One option is to invest in improving services to free users if they attract customers to the service, such as Dropbox gifting an extra 500Mb in space... but the cost of such an increase must be lower than what the company can expect to earn from the new user.

9. SCALABILITY: One consequence of the above is that freemium models must be a paradigm of scalability, with the cost of operating the model growing very slowly and lineally, while revenue can (potentially) grow exponentially. This means taking even greater care to design a scalable mode (self-service, foresight, sizing, economies of scale and revenue strategies).

10. EXPLORATION: Freemium models are usually used to explore new markets, where customers are unaware that they may require the service and need to be educated... given that it is much easier to attract users with a free value proposition. Having said this, when using such a strategy to explore a market, companies must be clear that this only serves to educate customers and raise awareness of their value proposition... but NEVER to validate the business model (which can only be done through sales).