Pick any popular web service today and it’s most likely to be free. It’s a wonder then how many of them survive or even prosper. Those confined to the TechCrunch Deadpool are considered hapless victims of the vicious world of the Web – land of the free. Those who dare to charge a fee are derided and castigated at every turn – until they either become so successful as to render reproach news-unworthy, or they too perish.
With VidSlide, the debut web service by our start-up venture, VantageLabs, we were faced with the conundrum of whether to go totally free and ad-supported, or 100% paid-subscription. We settled for something in-between – what’s been dubbed “freemium“. And we are not alone. Shopping centres, real estate brokerages, information technology providers, auction houses, and employment and dating services – have all found it most business-worthy to have a set of customer who pay little or nothing and are subsidized by another set of customers; the rationale being that this will attract a critical mass of “freeriders” that will then draw in larger numbers of paying customers, with the income generated by paying customers exceeding the cost of acquiring and serving the freeriders. In the web space, this usually manifests in the form of freeriders getting almost all services free, with some limitations, while paying customers get everything the provider has to offer at a price, or multiple prices (i.e., tiered pricing).
However, the value and significance of the free customer can often be underestimated. Naturally, the temptation would be to focus on customers who generate the bulk of the revenues. Even if we wanted to pay due attention to the free customers, we lack a working model to calculate their value. HBR’s Nov 2008 edition has an article on this matter that identifies three questions to ascertain the value of free customers:
The optimal way to grow—how much should a company spend at various points in time to acquire and retain free or heavily subsidized customers?
The real value of the enterprise—how much should investors or acquirers pay for all or part of a business with such customers?
The best organizational design—how should the business and its incentive systems be structured to encourage the units responsible for the free and the paying customers to work together?
Answering these questions correctly is key to the continuing sustainability of our business. While the article’s position and calculation stems from 4-5 years’ worth of historical sales data, something that start-up ventures or companies in early phases of growth are unlikely to have the luxury of, the ideas suggested are definitely worth considering.
It is helpful to understand what precisely is the lifetime value of a free customer:
incremental effect on the net present value of cash flows from the population of fee customers. It depends on the degree to which a free customer attracts other fee and free customers and the ripple effects those customers have on still other customers. When these network effects are large, payments flow to the firm, and the lifetime value of the customer increases.
Such network effects can be direct or indirect, positive or negative. A direct positive effect is such as those seen in online video game services like Xbox Live: the more users there are playing, the more additional users are likely to join. A direct negative may be seen in employment sites or shopping centres where employers may not want too much competition from other firms for able candidates, or stores in a shopping centre may not want a lot of direct competition for traffic. Not wanting to participate with competitors also led to the demise of many an online exchange launched during the dot-com boom.
Indirect positive effects may also be found in the video game industry, where large numbers of owners of a particular gaming console drives more developers to create new games for that console. Such strong and positive effects generate a powerful snowball effect for the company that’s well-positioned to take advantage of it. The media industry is another where both positive and negative effects wield considerable influence. Advertisers gravitate towards channels and papers with high viewership ratings/readership scores (a positive effect), but increasing advertising relative to programming/editorial content is sure to drive away viewers/readers (a negative effect).
Knowing how the value of a newly acquired customer changes over time is also helpful. Customers acquired early in the life of a company become extremely valuable (and may in fact turn out be the strongest customer evangelists of the company). Giving the service away to them free, is a small price to pay for the ripple effect of bringing in more customers. As the business matures, the network effect of a new customer tends to decrease.
So, say we decide on the freemium model; how do we price it for the paying customers? Some pricing strategies that could be considered are:
Penetration: charge early customer a low fee to attract more of them; then raise rates over time banking on customers becoming less price sensitive over time.
Skimming: charge early customer high to maximize short-term revenues, then lower fees over time to ward off competing products and counter slowing demand.
Constant: charge the same to all, regardless of when they came on board.
It’s never a straightforward task to plug all these elements into a coherent customer development plan, especially when the marketplace shifts at lightning speed. But pointers such as those enumerated above could help.
Key reference: “What is a Free Customer Worth?” – by Sunil Gupta and Carl F. Mela; Harvard Business Review, Nov 2008.
