Freemium

What does freemium mean?

Freemium (the freemium model, a combination of "free" and "premium") is a pricing model in which a company offers a basic version of its product permanently free of charge. Revenue arises only when users switch to a paid tier. Payment is made, for example, for more capacity, additional users, extended features or support. Unlike a trial period, free use does not end after a fixed period. With a freemium app, the download and the basic functions are free; payment is made through a subscription or through in-app purchases.

The model is widespread for software that can be used without an onboarding project and is sold through self-service (product-led growth). The free tier serves as a customer acquisition channel: users get to know the product and switch when their needs grow. In the financial model, freemium is therefore mapped as a funnel in which each stage has fewer participants than the one before: from active free users through conversion to paying customers. Investors check whether this channel wins paying customers more cheaply than advertising or personal selling. The yardstick is the cost of acquiring each paying customer (customer acquisition cost, CAC).

Drawing the line between the free and the paid tier

The economics of the model are decided at the boundary between the two tiers. The free version has to offer real benefit so that it is used and recommended. At the same time, it has to leave a reason to switch that is tied to the user's growing needs. Three kinds of limitation are common:

• By quantity: free up to a number of projects, contacts or a storage volume. The limit grows with the user's success.
• By number of users: free for individuals, paid from a team upwards. The need arises with spread within the company.
• By feature: features for organisations, such as rights management, single sign-on, logging or interfaces, only in the paid tier.

Conversion rate in the freemium model

The most important key figure is the conversion rate (free-to-paid conversion): the share of free users who switch to a paid tier within a given period. The reference base determines the value. As a rule of thumb, the rate measured against all registrations is in the low single-digit percentage range; measured against active users, or for products for teams, it is often higher. Only a rate whose base and time window are stated is meaningful.

Formula: Conversion rate = new paying customers in the period / free users of the reference group × 100%

Conversion only becomes robust in the analysis by cohort (cohort analysis). For the users who started in a particular month, it is recorded how many are paying after three, six and twelve months. If the curves stay stable or rise across the cohorts, this speaks for a sustainable model.

Costs of the free users

Every free user causes costs: data centre and storage, support, defence against abuse and the obligations under data protection law, which apply to free users just as they do to paying ones. Freemium is sustainable only if the cost per free user stays low and conversions cover it by a wide margin.

For assessment by investors, the allocation of these costs matters. If they are allocated to the cost of service delivery, the gross margin falls, that is, the share of revenue that remains after these costs. If they are shown as sales and marketing costs, they instead raise the cost of acquiring customers. In a profit and loss account structured by the nature of expense method (Section 275(2) of the German Commercial Code, HGB), gross margin cannot be read off directly in any case. It arises in internal reporting, and there the allocation of the free costs has to be disclosed and maintained.

Key figures and assessment by investors

A large number of free users alone does not count as proof of demand. Investors and acquirers look at the chain of key figures:

• active free users under a fixed definition of activity
• conversion rate per cohort and time to conversion
• cost per free user per month
• acquisition cost per paying customer (CAC), including the cost of the free tier, and the time until it has been recouped (CAC payback period)
• ratio of customer value to acquisition cost (LTV/CAC ratio)
• revenue per converted customer (ARPA), churn and downgrades to the free tier

Free users do not count towards ARR and are not valued directly. Their value lies in future conversions, and revenue multiples apply only to the recurring revenue of paying customers (revenue multiple). In due diligence, user numbers from product analytics are therefore reconciled with billing data, and the definition of an active user is questioned.

Worked example: acquisition costs in the freemium model

A software provider has 40,000 active free users. The number stays constant, because new registrations offset departures and conversions. In the example, the cost of the free tier is treated as part of customer acquisition.

• Cost per free user per month: EUR 0.10 infrastructure + EUR 0.05 support = EUR 0.15
• Cost of the free tier: 40,000 × EUR 0.15 = EUR 6,000 per month
• Marketing to win new free users: EUR 20,000 per month
• Conversion: 0.5% of active free users per month = 200 new paying customers
• New monthly recurring revenue: 200 × EUR 30 = EUR 6,000
• Acquisition cost per paying customer: (20,000 + 6,000) / 200 = EUR 130
• Gross profit per customer at 80% gross margin: 30 × 80% = EUR 24 per month
• Payback: 130 / 24 = around 5.4 months
• Customer value at an assumed monthly churn of 3%, simplified: 24 / 3% = EUR 800
• Ratio of customer value to acquisition cost: 800 / 130 = around 6.2 to 1

If conversion halves to 0.25%, the company wins only 100 paying customers at the same cost. Acquisition cost rises to EUR 260 per customer, payback to around 10.8 months, and the ratio of customer value to acquisition cost falls to around 3.1 to 1. Both values are then only just within the marks that investors apply as a rule of thumb: payback under twelve months, a ratio of at least 3 to 1. The whole calculation therefore hangs on the conversion rate.

Distinction: freemium, trial period, product-led growth and revenue model

• Trial period (free trial): time-limited, usually complete free use. When it ends, the user has to pay or loses access; with freemium, the basic version stays free indefinitely.
• Product-led growth: a customer acquisition strategy through the product itself. Freemium is one of its possible pricing models, a trial period another.
• Revenue model: the overarching term for what customers pay for and how often. Freemium determines from which tier payment starts, usually within a subscription.

Common mistakes

• Counting free users as customers. Only paying customers belong in customer count, ARPA and churn rate. Otherwise the key figures are not comparable with other companies.
• A free tier that is too generous. If the free version covers the needs of most users, many users and little revenue result.
• A free tier that is too narrow. If users do not experience the benefit, recommendations fail to materialise, and the model loses its purpose as an acquisition channel.
• Cost of the free tier not shown. Without a line of its own, the model looks better in the plan than it is, and the correction follows in due diligence.

Frequently asked questions

What conversion rate is realistic for freemium?

That depends on the product, target group and reference base. As a rule of thumb, low single-digit percentages apply against all registrations. More important than comparing with other companies is whether one's own rate stays stable across the cohorts.

When is a trial period better than freemium?

When the product shows its benefit quickly and completely and the purchase is accompanied by a sales team. Freemium fits better when the benefit builds up over weeks and the product recommends itself through spread within the company.

How many free users does a freemium model need for a funding round?

There is no fixed number. Investors do not value the number of users but the recurring revenue of paying customers. They check whether conversion is stable across several cohorts and whether the acquisition costs, including the free tier, pay back within a reasonable time. Many free users with low conversion are regarded more as a cost item than as value.

Can a free tier be restricted retrospectively?

In principle yes, within the framework of the terms of use. In consumer business, however, the provisions of the German Civil Code (BGB) on digital products limit such changes; they also apply when users pay not with money but with personal data. Economically, a transitional arrangement for existing users is advisable, because abrupt restrictions damage trust.

The Roemer Capital view

In financial models with freemium, we keep active free users and paying customers in separate rows and show the cost of the free tier as a position of its own. We plan conversion per cohort and not as a flat percentage on the user base, because that is the only way to check whether the assumptions fit the cohorts so far.

Our yardstick is whether the acquisition costs, including the free tier, pay back in less than twelve months. If they do not, we clarify with the management before a funding round begins whether the line between the free and the paid tier should be redrawn.