Friday, August 24, 2012

When Should an Entrepreneur Pursue a Freemium Business Model?

Yesterday the Wall Street Journal published an article about how many companies with "freemium" business models have failed to become solidly profitable.  Freemium refers to the idea that some firms give away a basic version of their product or service, in hopes that some significant fraction of consumers will upgrade to the paid version.   According to the Wall Street Journal article written by Sarah Needleman and Angus Loten, "The 'freemium' strategy is turning out to be a costly trap, leaving them with higher operating costs and thousands of freeloaders."  

Of course, some companies have enjoyed spectacular success with a freemium business model.  Take LinkedIn, for example.  Most people use the free version.  However, LinkedIn generates significant revenue and profits by offering a premium service, which has become very attractive to company human resource departments that use LinkedIn as part of their recruitment and hiring strategy. 

What types of firms should consider a freemium strategy?   I think there are two key attributes that entrepreneurs should consider when determining whether a freemium approach suits their business.  First, is there economic value (and early mover advantage) to be derived from a "get big fast" strategy?  Specifically, are there strong network effects in the business?  If so, then attracting high numbers of users can enhance the perceived value to each user.   Second, are the marginal costs of providing the good or service  close to zero?  If so, then adding a new non-paying user doesn't drain the company's finances. If, however, there are some incremental costs that will be incurred, then the firm may have a serious problem with a freemium approach.  The problem, of course, is that many start-ups assume that marginal costs are zero, when in fact there are some hidden costs for each additional user for which they have not accounted properly.

For more on freemium business models, see the video below featuring Chris Anderson, author of Free: The Future of a Radical Price.

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