[U4] Update: Is free a viable strategy?
Disruptive business models by some leading tech companies
This week in Product | Strategy | Innovation, we expand on last week’s profile [E4] on Spotify and Daniel Ek to compare his freemium business model to other leading tech companies using similar strategies. These are also companies we will discuss in future profiles and include:
Box
Cloudflare
Slack
Spotify
Square
Zoom
So, what is the freemium business model? Freemium is a Software-as-a-Service (SaaS) subscription strategy with a scope of services provided at no cost to the user. Options to upgrade to premium later with paid access provide a broader scope of services. Freemium expands on the concept of a 30-day free trial that automatically converts into a paid subscription at the end of the trial. The difference is freemium users can use a limited scope of services at no cost as long as the freemium option is available which could be indefinitely.
The business is then tasked with converting an adequate percentage and scale of users to paid subscriptions to build a viable business. This is where venture capital is often used to scale the freemium SaaS business model with net losses until a sustainable business is reached with adequate gross margin and annual recurring revenue (ARR) to thrive.
However, using a freemium business model needs to meet the majority of 4 basic criteria for success:
Total addressable market (TAM) is adequate to achieve a scale in the 10s of millions of users including those who are using a scope of services at no cost;
Free access to a scope of services provides a specific and significant market advantage required to win;
The scope of services provided at no cost have limited complexity to enable full automation with limited customer support required; and
The incremental cost to add each additional user should be negligible.
To expand further on those criteria, more info is provided below. The first requires adequate scale to make the paid premium services viable to cover the overall costs. The next 3 address total costs to operate free services with limited scope.
Scale dictates whether freemium is even feasible
Most Enterprise SaaS businesses cannot successfully execute this freemium business model unless they also serve a consumer market. Targeting small to medium size businesses (SMBs) can provide somewhat of a hybrid to the consumer and enterprise business markets. And if they serve a business market they would need to either use the business market to expand into a larger consumer market to achieve adequate user scale or a large consumer market to expand into a premium business market for revenue growth. This is illustrated with premium services that average $100/year/user. To achieve an ARR of $100 million with a 4% conversion rate from free to premium services you would need 25 million active users.
All the companies I listed above have corporations, SMBs and consumers as customers today. And they used free services for consumers and start-up ventures to test, build out their product portfolio and drive awareness of the their value proposition with large corporations. But the Enterprise SaaS business sales cycle makes it difficult to scale enterprise deployments with the time required to produce 100k employee users vs. 100k consumers. Adding consumers to scale sounds easy, but reaching 25 million users eliminates most who try. What drives scale is TAM. And this is why VCs pay so much attention to market size.
Of the companies listed above, Spotify has the largest scale with 345 million MAUs. And for Spotify, free does not mean no opportunity to generate revenue. Free means you are the product and you are monetized by matching your profile and interests to target personas for Advertisers who pay Spotify to promote products and services to you. But you also get unlimited access to audio spanning music and podcasts at no cost. If you don’t like the ads or being monetized as the product then upgrade to a paid premium subscription. Either way Daniel Ek and Spotify win.
Advantage determines if freemium could be better than alternatives
Free access to a limited scope of services must provide a significant competitive advantage to help drive user adoption with low marketing spend to minimize the cost to acquire a customer. Multiple freemium business models targeting the same customers with similar products and services make conversion from free to premium paid services challenging. An example would be Google Drive, Dropbox and Box all targeting consumers and businesses for cloud data storage services. Google can afford to take a loss on data storage if it helps drive revenue for other paid services. This provides more challenges for Dropbox and Box. Also, if I’m reaching the limit for free data storage with one company then I can enroll with another company to expand my available free storage. This is a great example of why tech can help control inflation with such low cost options to access services.
Many of the companies listed above started during or right after the 2008 financial crisis. The circumstances helped identify a problem to solve. If the solution was unique and offered significant advantages over legacy solutions, then free could accelerate early adoption. Slack was built out of internet chat relay (IRC) features including chat rooms (channels) built for internal use within Slack itself. Tech startups in particular adopted Slack because it allowed development teams to build out internal collaboration separate from external email communication. Slack provides a free option, but does encourage the use of a work email address. This allows Slack to build a large pipeline of company contacts using their free accounts.
The Box pricing plan illustrates the Freemium business model well. Individual plans start for free with up to 10 GB of storage, but can be upgraded with other features for $14 per month (or $120 annually).
The free individual plan allows corporate users to adopt Box for personal usage. This is much more cost effective than providing an enterprise trial. Startups are also likely to use multiple individual plans until they validate the strategic value of a preferred online storage tool. Multiple pricing tiers allow Box to provide the right level of service for a wider spectrum of accounts.
Simple helps freemium scale cost effectively
Free access to a limited scope of services should influence product design. Customer sign-up for the service should be easy and automated. And then use of the product and services should be intuitive to limit the required training. Short explainer videos can help automate on-boarding new customers as needed to limit expenses. If more complexity is required for the premium paid services then at least these services provide revenue to help offset the cost of customer and technical support.
Box has added integration with 3rd-party services from companies like IBM, Google, Adobe, Salesforce, Slack and Microsoft to add value for business plans beyond just data storage. But these integrations require a business pricing plan and the number of integrations are determined by the tier of the subscription. And the customer support cost required for these integrations is offset by the revenue generated by the paid premium subscription.
But Box operates the free individual plan with services limited to data storage, collaboration with file sharing and integration with Office 365 and G Suite to link files to these tools. These services are simple to use and can be handled by most users on their own. This simplicity enables free access to a platform that also enables much more complex functions for paid premium subscriptions.
Efficiency drives sustainability of freemium business model
Free services also require leveraging fixed costs to establish the infrastructure for quality services to the first user with negligible incremental cost to add each additional user thereafter. As the user base scales, additional fixed costs will be required and will need to be recovered through future earnings, but the variable cost per user should still be negligible and trending down. As discussed in profile [E3.1] regarding Wright’s Law, when cumulative unit production doubles, the cost for production declines linearly. This scaling with MAU growth using access to free services helps inform and accelerate the product feature roadmap, user experience, quality assurance and cost reductions. But the expenses required to drive that growth are not offset with revenue growth for the free services unless there is a means to monetize this user base.
A key driver for the efficiency of MAU growth is the cloud hosting fee incurred to operate free services. Scale, product development and development operations should continuously work to reduce this cost per user over time. The required conversion rate to paid premium services is lowered as this efficiency improves.
The freemium business model also has some variations in how it is implemented. As previously mentioned, companies that provide premium paid services to businesses can provide free access to services that also meet the needs of individuals. This allows users to try and use the services beyond just a 30-day trial. Traction with using the services can drive adoption in the business setting with a cohort of champions who are already using it individually. Examples of this strategy from the companies already mentioned include:
Box
Cloudflare
Slack
Zoom
Cloudflare primarily targets businesses with entry-level services that speed up and make online services more secure. Startup ventures that participated in the TV show Shark Tank would experience a surge in traffic to their website when the show aired featuring their venture. This would often crash the startup’s website when needed the most to handle this surge in demand. Cloudflare is a common intervention now to prepare for this surge since the show is taped and then released later. The company’s own website cannot scale to meet the demand, but the website distributed across the Cloudflare network can exponentially. But Cloudflare also offers free services to individuals to support personal and hobby projects that are not mission critical. This helps trial the service to verify performance before implementing basic paid premium services for personal websites or blogs. The cost for mission critical business services start at $200/month.
Cloudflare offers the Uber of edge computing, but you can also upgrade the service from a Honda Civic to a Porsche.
Cloudflare was founded in 2009 by two students (Matthew Prince, CEO and Michelle Zatlyn, COO) attending Harvard Business School and is one of the great outcomes of the annual HBS New Venture Competition. A third co-founder (Lee Holloway) joined as the CTO. Efficiency was a core feature of Cloudflare from the beginning due to its ambition to actually build a better internet.
Another variation uses free access to start use that triggers premium paid services when a threshold is reached like a data storage limit (Box) or message limit in a channel (Slack) or web-conference limits like duration (Zoom). These criteria even convert some consumers to premium paid services.
And another variation uses free access for consumers to build one side of a marketplace or ecosystem for transactions with businesses.
Spotify
Square
Spotify has scaled to 345 million monthly active users using free access to listen to audio in the form of music and podcasts. This attracts recording artists who want to distribute their work to this audience. As the number and quality of artists scales then listening by consumers increases. Spotify has converted 155 million of their users into premium paid subscribers for uninterrupted listening. The value proposition of the premium service increases as listening hours increase, too.
Square is building out one of the most advanced freemium business models out there and could rival major banks over the next decade.
Square has scaled to 36 million monthly active Cash App users using free access to build a digital wallet ecosystem with features like receiving direct deposits, peer-to-peer money transfers, debit card, buying stocks and bitcoin, etc. Square also has a separate ecosystem built to support small to medium sized businesses with point of service transactions with customers. The freemium business model for Cash App helps these businesses when Cash App Boosts are provided to active users for incentives when accessing services from the business promoting the Boost. The more Cash App users with access to the promoted Boost services, the more effective the Boost promotion will be. This ecosystem is illustrated here.
As these Square ecosystems scale to form a platform network, it provides a competitive advantage when the business and consumer ecosystems serve mutual needs. Partnerships then drive efficiencies to scale the network with lower costs to acquire customers. Squares partnership with Spotify is an example. Spotify for Artists enables artists to promote fund-raising campaigns to their fanbase during the pandemic when touring has been halted as a major source of artists’ income. Cash App enables an artist to use a unique digital wallet to receive those funds. As artists enter this Cash App ecosystem and become familiar with Square’s broader services they can also access e-commerce and other business services. And these artists also pull their fanbase into the Cash App ecosystem. So a peer-to-peer money transfer to support a favorite artist’s fund-raising campaign can lead to that same fan buying bitcoin with additional funds and opting in to receive direct deposits from their employer to accelerate access to funds with Cash App. Eventually Square serves all their financial needs without using a traditional bank.
In a future update, I will comment on business models that start with paid options as an alternative to the freemium business model limited to a very select group of successful ventures who meet the majority of the 4 criteria mentioned above.
Update on Tesla’s Giga Press
A prior profile [3.1] mentioned Tesla’s casting machine to manufacture one whole part to form the rear underbody segment vs. 70 individual parts that must be spot welded to form a single part. Elon Musk commented Giant Die Casting Machines that form the rear underbody segment would replace 300 robots used in the prior process. Tesla released this video showing this Giga Press operating at the Tesla Gigafactory Shanghai.
Best,
Stephen
Nothing in this post is intended to serve as financial advice. Do your own research.