AdvertisingBusiness modelsConsumer Internet

An analysis of the ‘freemium’ business model – what are the free customers worth?

By November 5, 2008 3 Comments

On his LongTail blog Chris Anderson has picked the nuggets out of an article in this months HBR which asks ‘what is a free customer worth?’ (the full article is only available to HBR subscribers).

One surprising conclusion is the prevalence of businesses which in effect offer a freemium business model – i.e. they have a large number of customers who pay little or nothing and are subsidised by another set of customers who do pay.  From the HBR article:

[industries operating the freemium model include] shopping malls, real estate brokerages, information technology providers, auction houses, print and online media, and employment and dating services. According to one estimate, this business model accounts for a  majority of the revenues of 60 of the world’s 100 largest companies.

Running these businesses effectively is all about knowing what these free customers are worth (i.e. the extent to which you can monetise them directly plus the value of a converted paying customer times the conversion rate).  In many industries this is pretty difficult to calculate, but on the internet all the pieces are measurable.  You can therefore calculate the value of a free customer and acquire as many as you can at prices up to what they are worth.

In the early days a lot of assumptions will be required – e.g. what the conversion and churn rates will be but these can be estimated using industry benchmarks and then tested at small scale before customer acquisition budgets are ramped up.

This is all pretty obvious stuff – but I hadn’t appreciated that much of the economy is based on fundamentally similar models.

Where it gets more complicated is when the minimal monetisation of the free customers forms a good portion of the revenues, particularly if that monetisation comes via advertising.  In these situations it is much harder to know what each customer is worth, which really means you need to be acquiring customers for pretty much $0 – i.e. you need to unlock the magic of viral growth.  This has probably always been the case, but is unequivocally so now.