Is Freemium really win-win?

Spotify’s latest announcement that it is limiting free streaming of its music begs the question, can successful businesses be built off of the freemium model? And, if so, is Spotify getting it right?

As a refresher, the freemium model is where a company offers at least two levels of service. The basic version is free of charge, though users may have to deal with advertisements, while more fully featured versions come with a monthly or yearly price.

We all know the major players: besides Spotify, Skype, LinkedIn and Dropbox are classic examples of freemium models. Even newspapers are jumping into the mix (see previous post about the New York Times paywall).

What do conversion rates look like for these companies? Let’s look at the classics.

LinkedIn, in its recent IPO filing, reported a revenue for the first 9 months of 2010 of $161m, double that of the previous year. Interestingly, less than a third of that came from premium subscriptions, at $44m. The rest of the revenue is from hiring solutions (essentially job postings) and marketing (advertising). Being conservative, if all of the premium subscriptions are at the cheapest rate ($19.95/month), then that’s about 180k premium subscribers, or less than 0.2% of its total user base of 100m.

Dropbox’s actual revenues are a deeply guarded secret, but the $30m quoted by an anonymous Quora user is probably within the realm of realistic. So, if we assume, again being conservative, that all premium users are on the basic rate of $99 per year, then there are about 300k premium users. That’s just over 1% of the total 25m users they recently announced. Compared to LinkedIn, they’re doing a lot better at conversions.

The veteran, Skype, surpasses both with nearly 1.5% of all users paying, and almost 7% of active users paying, according to reports put out around the time of its August 2010 IPO filing. That’s on numbers of 124m active users and 560m total subscribers.

Finally, let’s look at Spotify. It is the smallest of the lot, with 10 million users, yet 1m, or a whopping 10% of them, are paying customers.

Conversion rates alone don’t tell us whether companies can make enough off of the freemium model to earn healthy profits, but these numbers can be viewed two ways. We could say that conversion rates hovering around 1% do not bode well for a healthy business. Alternatively, a look at the number of users each of these companies has gotten to register suggests the model is brilliant for generating demand.

So, for companies considering the freemium model, what’s the best way to make a go of it?

1. Think of freemium as a way to get users interested in your offer

In a way, the freemium model isn’t really about pricing, but rather an option for building a healthy user base and giving potential serious users a good taste of the product. If everyone does it, however, then all of those million-plus user numbers are shallow. Consider the fact that Spotify’s competitors Pandora and have 80m and 40m users respectively; the liklihood is that there is a lot of overlap among the three.

2. Make upgrading desirable, even essential for users

Of the four companies mentioned, Dropbox does this the best, by helping users build up a set of personal data, which it would then be a pain to move. When they want to share more files, they either have to clean out their folders or take the path of least resistance and pay to get more space. Spotify also does a lovely job of this, by offering free streaming on the computer and requiring users to pay to play on mobile phones or iPads. Smart.

3. Roadmap the service and consider the reaction from taking away anything “free”

While Spotify clearly has a well thought out roadmap, it is in a bit of a sticky situation now due to recent changes in its model. Besides the reduction in free songs, it also recently changed its streaming functionality. While previously users could simply search for an artist or genre (e.g., Lily Allen) and click the first song to stream them all, now they have to create a playlist. Neither change is likely to be devastating, but it is always preferable to have positive news reports rather than negative ones. Thinking long-term about how your model might change over time could help mitigate the perception of reduced functionality.

4. Limit the initial subscriber base and use them to learn

Spotify started out in Europe partly because of its origins (it is Swedish) and partly because of digital rights management challenges in the US. But it has done a great job of building up interest and a healthy paying user base, which is no doubt making raising additional funding a lot easier. Not to mention helping them hone their business model before taking it big.

Despite its recent struggles, Spotify might be the company to be getting freemium right, with the healthiest conversion rates and speculated value of $1bn. It will be interesting to see where they take it next, and whether all they’ve learned in Europe will make them a smash hit in the US.

LinkedIn Files For IPO; Revenue $161 Million For The First Nine Months Of 2010
Dropbox Hits 25 Millions Users, 200 Million Files Per Day
Skype Files For IPO, Only 6 Percent Of Users Pay

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