Matt Schnitt

Product Manager @ HubSpot. I think and write about product management, SaaS and travel.

Freemium: A Behavioral Approach

Posted by Matt Schnitt on Jan 31, 2014 10:09:00 AM

Recently, I stumbled across an excellent guest post on TechCrunch that delved into whether startups should consider a freemium model or not. The authors (VCs from IVC) likened freemium to a samurai sword, in that unless you are a master at using it, you're likely to hurt yourself ('tis just a flesh wound!). I think mastery takes into account not only the economic calculus to make the model viable - COCA, LTV, conversion rate, churn - but also the mental calculus consumers use when deciding whether to pay for a service they already use for free. The best way to accomplish this seems to me to be to look at the model through the lens of behavioral economics. If you've read the excellent Predictably Irrational, most of the rest of this post is an application of the theory in that book.

In a recent Wall Street Journal article, Dropbox's head of business development said, "It's about getting people engaged with the core free version and if they love it, they'll move upstream." This seems logical, but it may be more wishful thinking than reality. The initial free price will end up acting as an anchor, or reference price, for customers. Accordingly, once a product is viewed as being free, it's very hard to charge people more for it, and is impossible to charge significantly more for it. The reference price also acts as a signal of quality to consumers, so companies are subconsciously telling potential customers "we're not worth your money." Needless to say, it's pretty hard to upsell a consumer who views your product in that way.

Companies are also likely to face a diagnostic problem in that it's not always obvious what aspects of a business should be free and which should be paid. Indeed, the behavioral economics community would point out that many consumers do not know if some features actually help or hinder their utility of using a product, let alone whether they'd be willing to pay for it. If a business can't find a salient answer from your user base as to what features drive revenue, how can they?

So, is the freemium model doomed in the eyes of those pesky economists that view the world through a dispassioned lens fitting of the nihilistic henchmen in The Big Lebowski (and trust me, after 4 years of studying econ, it is indeed exhausting)? Not necessarily. It's been found that in markets where money is not a factor, altruism becomes people's motivation, whereas in monetary markets, reciprocity is. In other words, introducing money alters consumers perspectives on products. So by extension, a smart system could be one in which early adopters or consumers who find a product through a certain source, and are offered the product for free. If the product delivers value, I would expect their altruistic motivation and affective response would lead them to become product evangelists naturally. Everyone they refer to the product are opted-in to a pay model automatically. This has the additional benefit of confounding the reference price in the consumers eyes, so that they don't know exactly what it is, but they know it's positive in some capacity.

While the suggestion of a referral model would probably make any investor or entrepreneur cringe, the idea hangs on the periphery of our minds because we intuitively know it works. The problem is no one has been able to port the concept to SaaS in a way that makes total sense. My prediction is someone will, and soon.
For better or worse the freemium model is here to stay. The economic calculus to achieve success within the model is pretty universally accepted, but acknowledging the human element of how the model effects a user base is woefully lacking. Incorporating and embracing it, and tweaking the model accordingly, can go a long way.  

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