Pros and Cons of the Freemium Software Business Model

One of the trends in the software business over the last decade or so has been the use of the “Freemium” business model. For those unfamiliar with the term, a Freemium software business model is characterized by an entry-level version of your software that is free to users forever.

This business model has been used in the software industry since the 80s. It was referred to then as “crippleware” or “lite” entry-level software versions. The term “Freemium” apparently entered the software industry lexicon when used by Jarid Lukin of Alacra in 2006. But enough history. Regardless of what you call it, the model on the surface is well suited to the software business due to its no (or very low) cost of goods sold.

Whatever term you use, the model is predicated on creating a large “free” user base as quickly as possible. This is usually done using viral marketing methods such as referrals, and word of mouth, along with other very low-cost methods such as SEO. This large free user base is then “monetized” by selling advertising to their eyeballs and/or upselling them on premium software features or services. Today, the Freemium model is widely used in the software business across many form factors, including open source, SaaS, and traditionally licensed software.

What’s most interesting to me about the model is the trendiness since the term Freemium came into use. I see many companies that appear to be adopting it because they feel like so many others are using it, so it must be the right thing to do. But is it the right thing to do in all cases? In my opinion, it is not. Let’s take a closer look.

Freemium Model PROS

1. Fundamentally viral: the more users you get, the more users you get. Free users will refer other users who could become paying users.
2. You can upsell your own (free) customers. Upselling a customer that’s already incorporated your tool into his workflow is generally easier than selling a new customer from “scratch”.
3. Keeps prospects in your target market from being locked in by the competition.
4. The barriers to entry to your product line are at the minimum possible (even less friction than free trials and money-back guarantees)
5. Great for startups to be able to say  “We have X gazillion users”.
6. Enables Free Beta testing of new products with a large number of users.
7. “Free” traffic and user bases can sometimes be converted to advertising revenue.

Freemium Model CONS

1. A low conversion rates compared to paid versions, the average is about 1-5%–although this varies widely.
2. If you offer customer/technical support to free users, it’s potentially a substantial expense unsupported by little if any revenue.
3. If you don’t offer support or poor/reduced support to free users (such as forum-only support), what does that mean to your conversion rates to paid users? As well as to your overall reputation?
4. If you offer reduced or no support to free users, much time can be wasted trying to figure out who “qualifies” for what level of support.
5. 95% will never pay you a dime–are they REALLY customers?
6. In addition to customer technical support costs, the cost of data/bandwidth/hosting for free users can be significant if you’re SaaS-based.
7. Requires EXTREME application ease-of-use to work well.
8. There is some evidence that having a free version reduces your conversion rates on free trials of your paid product.

My Preference for paid versions & free trials over freemium

The main reasons I don’t like Freemium  models, except when circumstances very clearly call for it:

• Having a free version conditions the market that “free” is the appropriate price.
• A free version can reduce the overall value perception of your product.
• It’s critical to the success of a Freemium model and very difficult to get the free/paid feature set split “just right.” If you don’t get this split right, you won’t be able to attract enough free users (there is too little value in the Freemium product). Offer too much in the free version, and you won’t be able to convert your Freemium users to paid versions (there is too much value in the Freemium product).
• “Free” is a mentality that’s hard to overcome once in a user’s mind. It’s harder to convert a free user to a paid user than from an entry-level paid user to a premium paid user. An example is the difficulty of online newspapers in converting readers to paid models. This after years of “training” them that their content should be “free.”
• I prefer to use available profits on professional marketing programs rather than starving the marketing budget due to excessive support/hosting costs.

Even taking my biases above into consideration, there is a place for a Freemium business model in many situations:

The Best Circumstances for Using a Freemium

• Although the Freemium model has worked in B2B markets, I believe it’s generally better suited to consumer mass markets. Where viral is more possible, price points are already low, and free user bases and traffic can be high. Thus making it possible to monetize the traffic via advertising.
• Entering a market with strong, embedded competitors.
• When attacking a market with limited resources or lacking in marketing skills.
• A product with great “social pull”, lending itself well to viral marketing.
• Freemium has already become the standard in your market segment, so you’re almost forced to follow suit.
• As an act of desperation when nothing else has worked.

I’m sure there are other circumstances where a Freemium model makes sense. The list above is what comes to mind quickly.

So that’s what I think about Freemium–many will not agree. Some awfully smart people in the software business believe it’s essential in 2025. What’s your experience with it?  Leave a comment below with your thoughts, lessons, or best practices.

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