When Goldilocks broke into the Three Bears’ home, she needed a bed that was just right—not too small and not too large. Likewise, when you break into the market, you need to set prices that are just right—not too low and not too high. Could freemium pricing be your “just right” strategy?

So, what in the world is a freemium pricing strategy? Read on to find out.

What is freemium pricing?

Freemium pricing—a mix of the words “free” and “premium”—is a pricing strategy that businesses use if they want to offer customers free services in addition to paid options. Generally, the free options are basic versions of the service, and the paid options are upgraded, or premium, versions.

Although the concept of freemium has been around for a few decades, the term only dates back to 2006.

With freemium pricing, a business offers at least two tiers of services: paid and complimentary. The free option typically has fewer features than the paid option. Or, it might have a catch (e.g., advertisements or usage limits). The premium choices are optional, but they typically offer additional features, a better experience, or both.

Freemium doesn’t just apply to businesses that offer permanent free and paid options. It can also apply to companies that offer a free trial of their services.

So, what are some examples of freemium pricing in action? Let’s take a look:

• A free app with advertisements that requires customers to pay to eliminate the ads (e.g., Pandora)
• An online newspaper or magazine that sets a limit of free articles per month and requires customers to pay to get unlimited access (e.g., Harvard Business Review)
• A company that offers a free service with limited features and a paid service with additional ones (e.g., MailChimp)

Businesses that use freemium pricing strategies hope to entice customers with the free option, then convince them to upgrade to the paid version.

Things to consider before using a freemium pricing strategy

According to one Harvard Business Review article, most companies with a freemium model have a 2% – 5% conversion rate from free users to paying customers.

To find out if this conversion rate is enough for your business, consider the following:

• Customer acquisition cost
• Business expenses
• Customer lifetime value

Customer acquisition cost

A freemium pricing strategy likely won’t work if you have a high customer acquisition cost. So, what is it?

Customer acquisition cost (CAC) represents how much money a business spends sourcing, marketing to, and acquiring each new customer. Some things that might go into CAC include marketing and sales employees’ salaries and advertisements.

A business’s customer acquisition costs can range from next to nothing to hundreds of dollars, depending on the industry and processes.

If your prices are high, you can afford to spend a little more going after new customers. But if your prices are low (or free), you need to keep your CAC low.

Business expenses

Customer acquisition cost includes some of your business expenses, but it doesn’t include all of them. Before shifting to a freemium pricing strategy, make sure you’ll bring in enough revenue from your paying customers to cover your costs.

Add up your business expenses, including:

• Rent
• Payroll
• Utilities
• Insurance
• Office supplies
• Equipment

After calculating your expenses, determine whether you’ll be able to break-even with your paying customers.

Most businesses with freemium pricing have more free users than paying customers, so be sure to take that into account.

Customer lifetime value

Is freemium pricing sustainable in your business? To find out, look at your customer lifetime value (CLV, LTV). Calculate your business’s CLV to estimate how much revenue you’ll earn over time from a customer.

Most businesses compare their customer lifetime value to customer acquisition cost by using the LTV:CAC ratio. This ratio shows you the relationship between how much you’re spending on each customer and how much each customer will spend at your business.

Take a look at your paying customers. You’ll need some data like how:

• Much they spend on your service
• Frequently they pay for your service
• Long they’ll continue using your service

Luckily, your free users have a bit of value, too. Free users can be great brand ambassadors who help promote your company to potential paying customers. Not to mention, free users may wind up becoming paying customers.

Alternative pricing strategies

If you’re not sold on a freemium pricing model for your business, consider other options. There are a number of alternative pricing strategies you can choose from, including:

• Market penetration pricing: low initial price to attract attention, then eventually raises prices
• Price skimming pricing: high initial price due to low competition, then eventually lowers prices
• Economy pricing: low prices for generic or everyday products or services
• Premium pricing: high prices for luxury or unique products or services
• Competitive pricing: prices based on going below what competitors charge
• Discount pricing: temporary discounts or promotions on products or services
• Psychological pricing: prices based on what looks most appealing (e.g., $24.99 vs. $25.00)
• Bundled pricing: bundled prices that are less expensive when items are bought together than purchased separately

Find out if your freemium pricing strategy is working for your business by tracking your income. Use Patriot’s online accounting software to manage your books, generate reports, and more. Start your free trial today! 

This article has been updated from its original publication date of December 12, 2019.

This is not intended as legal advice; for more information, please click here.