Business Model 101: Number Crunching before you try Freemium

I started a series on the Freemium business model a couple of days back since this seems to be one of the most misunderstood business model among startups. Today we get into number crunching that one needs to do to make the Freemium model work.

As with every business, the ultimate goal is to make money, be profitable, grow revenues and become self-sustaining and cash-flow positive at the earliest. However, depending on which stage the business is in, the metrics that you use to decide for or against Freemium can be different.

The only number that really matters when you are starved for cash
For an early-stage bootstrapped business, it is very important to stay afloat and stay cash-flow positive. In such a case, one really needs to have a compelling reason to implement Freemium. For such a business, it is extremely important that
Marginal cost to maintain a user = 0 (or close to it)
It is important to note that marginal cost is the delta that an extra user adds to your operations and will not, in general, include costs which go into maintaining the user base but are not a function of it as such. E.g. in case of Youtube, bandwidth costs per user are marginal for viewers and storage costs are marginal for contributors. One of the reasons Freemium might not be a great model to start with at an early stage is that it is very difficult, near impossible, to have marginal costs close to zero.

Segmenting and Pricing correctly to have a profitable user base
While analyzing new ventures as part of what I do, I have a bias towards always starting with analyzing the per-user economics before I look at any other numbers. After all, if the per-user economics themselves don’t make sense, it is impossible for the business to turn profitable and stay cash-flow positive.

In case of Freemium, the per-user economics maps out as follows:

ARPU: (No. of paid customers*Price per customer) / (No. of paid + No. of free users)

Compare this with the average cost of maintaining a user. Note that this is NOT the marginal cost! To be talking about the right numbers, it is very important that one understands the difference between these two.
Hence, the first step is to ensure that

ARPU > Cost of maintaining a user
An important point here is that while the ARPU calculation may look fairly straightforward, it is an extremely tricky proposition when a business is still planning on going Freemium since one needs to estimate the percentage of the user base that will actually pay for the product to work out this calculation.
Estimating the paid user percentage can be as much of an art as it is a science. There are two key elements to doing this correctly:
1.Segmenting your market correctly
Segmentation of your market is more important than ever in case of a Freemium product. Firstly, it is important to figure out upfront the exact user profiles who will want to pay for the Freemium product. Secondly, it is very important to size exactly those user segments. After all, you need to be sure that there are going to be a certain number of user segments who clearly will be compelled to pay for your product and that their numbers lead us to the kind of ARPU that we would like to have given our costs.

2.Finding the right price point
More often than not, your paid% can really change with the price point that you set. Firstly, it is important as a business owner to understand whether your market is a price-sensitive market. Second, irrespective of whether the market is price sensitive or not, it is important to get the pricing right so that you cover your costs well (per user as well as for the business as a whole) and are still perceived value for money. I could go into a long discussion about the various ways pricing is done depending on your market, product and operations but we’ll save that for another post. In a nutshell, cover your costs and talk to customers often to reach at the right price point.

An important point is that this is not just a one-time activity. This number crunching needs to be done over time because average costs, unlike marginal costs, will definitely change over time as the business develops scale and efficiencies.

Also, per-user economics is only a starting point. Over time, the business should show signs of profitability as a whole (i.e. profitable on the entire cash base).

So far so good! We now have some of the numbers that make a sustainable operating business with the Freemium model. However, we’ve left a third important element.

What about the cost of Customer Acquisition?
Maintenance costs are important but often, the biggest cost bucket for a growth business without a brand to leverage is the cost of customer acquisition. Simply defined, the cost of customer acquisition is the amount of money that the company needs to invest to get a paying customer.

If you think about it, Freemium is not just a business model; it is also a marketing channel. “Try and Buy” has been an age-old marketing technique ever since hawkers started giving out samples of the food they cooked to passers-by (which also makes it my favorite marketing technique from a consumer perspective ).
Most models on Freemium eventually want to entice users into paying for it. Hence, it is important to see that the cost of customer acquisition via Freemium is lower than the cost of customer acqiosiiton in a pure subscription model where the business would have indulged in other marketing, tiral and awareness activities. In this regard, there are 3 important numbers to look at
1. Number of Paid Customers
2. Number of Free Customers who wouldn’t pay if the free service ceased to exist
3. Number of Free Customers who would probably start paying if the free service ceased to exist

It is important to make the distinction between 2 and 3 because by running a Freemium, you are possibly losing out on revenue that you would have got from customers in 3.
Hence, the final very important calculation that you need to do is:
Cost of maintaining Freemium user base < Customer acquisition costs through other channels + Revenue that could have been generated from customers in 3
The RHS is essentially the opportunity cost of implementing Freemium. You need to have an estimate of customer acquisition costs from other channels. There is no general rule to that and it really is about how much of marketing, branding and other activities you would need to do to get to the same customer base.

About the Author: Sangeet Paul Choudary is a leader in the New Ventures group at Intuit Asia-Pac
First published at Venturati