Confessions of a Perpetual Freeloader: When to Jettison the Freemium Tier

I’m a perpetual freeloader. Like a houseguest who has overstayed his welcome with hundreds of people, I depend upon the generosity of strangers - in particular, software teams. I’ve used HelloFax to sign documents for years, but I haven’t paid them a nickel. The same is true for GMail, Google Docs, TripIt, TypeKit, UberConference, LogMeIn, Evernote, the list goes on.

For all of these companies and products, harboring freeloaders like me is part of their growth strategy. At the product’s launch, free plans generate the majority of new users and eventually customers for the business and in the case of B2B companies, leads for the sales team. The positive goodwill engendered by a free product feeds word-of-mouth and the product achieves lift-off. All of this is possible because in small numbers, the marginal costs to support perpetual freeloaders are insignificant.

In the past few weeks, I've been working with two growth-stage B2B freemium SaaS companies outside the Redpoint portfolio which both have significant perpetual freeloader populations. Like those above, both products launched with free tiers. As word spread about these great products, larger customers started to pull the companies up-market, flourishing contracts 100 to 1000x+ larger than converted-from-free customer base. For 12-18 months, these startups reoriented their product direction and sales effort to focus on these larger customers. Consequently, the businesses grew at a terrific clip.

At this point, these startups are exploring how to grow faster. In both of these cases, the freeloaders have become a point of focus. How do we update pricing to generate more revenue from these customers? is the question they each proposed to me. The implication of that question is that the carrying costs of the free tier have become too large to sustain.

But before changing pricing, it's worth asking the question for any startup with a free tier of the value of the free customer base compared to their cost. Because the calculus of that decision for a company at a growth stage may be very different than one just starting out. Every business will value the free tier differently. But here's the rough framework for determining the value of a free tier to a startup that I've been using:

  1. Marginal cost to support free customers as a percentage of revenue - includes the infrastructure costs, customer support costs, product management and engineering time, marketing time
  2. Marginal benefit in leads and ultimately revenue from the free tier - benchmark the lead quality, conversion rates, average contract value and ideally ultimate LTV of customers in the free tier compared to customers acquired through inside and outside sales, and marketing/demand generation campaigns.
  3. Softer benefits of a free tier - perceived brand benefit of the free tier, potential impact to mobile app rankings or other distribution channels

The free pricing tier can be an amazing growth engine. It can be an end unto itself, a lead source that fuels a company to an IPO as in the case of LogMeIn or it can be a booster rocket to moving up-market and pursuing larger customers. In the latter case, the free tier drives a company to support two or even three different customer segments (small, medium and large businesses). This increased breadth taxes the organization. In addition to the growing infrastructure required to support the free tier, customer support, engineering, product management and product marketing carry the burden of managing the needs of very different customer segments.

Periodically examining the value of the free tier as a growth engine and comparing the costs to support it is essential as freemium SaaS companies evolve. I suspect for most businesses keeping the free tier is the way to go because the positive brand impact and lead generation capability outweighs the marginal cost per customer. But for some businesses, jettisoning the free-tier booster rocket as the company evolves to focus on an enterprise business will free a business to focus on the opportunity up-market.

22 May 2014

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