A simple formula to gauge a freemium model's success

For all the value that open-source development provides, Red Hat CEO Jim Whitehurst recently reminded the industry that open source may be more potent as a business model than as a development model:

Open-source development is great and all that, but I think more of the value of Red Hat comes from our open-source business model than from the development model.

The truth of this statement came home clearly to me in a conversation with Michael Mullany, vice president of marketing at Engine Yard, a cool company that provides on-demand deployment and management solutions for Ruby on Rails applications. Mullany walked me through some calculations he has been running to determine optimum business models for Engine Yard and others in the industry.

As Mullany tells it, despite all the chatter about free and freemium business models, the debates have yielded a paucity of valuable, actionable information. A mostly free business model like Craigslist rocks. A free but poorly-monetizable business model like YouTube does not. There's more to "free" than a price tag. But how do you determine when, where, or whether to use "free" as part of your business model?

After running a variety of models, Mullany filtered down the free (or freemium) vs. non-free debate to just four factors:

• The cost of marketing and selling to a user in a paid model
• The cost of serving a free user
• The cost of acquiring a free user
• How successful you are at converting users from free to paid (whether it's a cross-sell or a premium offer)

If these factors trend one way, in Mullany's math, free or freemium is a good idea. If the factors trend another way, then paid-only is a better idea. (Free trials are practically always a good idea--that's not what this debate is about.)

So how does this work? Here's where Mullany's mathematics background kicks in, so follow his formulae carefully.

Before we talk about free, we should talk about "paid," where the basic formula is: Sales - Costs = Profit. Or in long form:

Price Paid By User - Cost of Providing the Service - Cost of Selling & Marketing to Signup a User = Profit Per User.

Or in formula form:

PP - PC - PS&M = PPU

Free or freemium models are more complicated, however. Generally, you have a free offering that comes with restrictions and limitations, and a premium, paid offering that you sell as an upgrade. On one side, you spend money to get free users to sign up to a basic level of service (SEO and PR aren't free!), and then you spend more money to provide that free service.

On the other hand, you usually get to convert some percentage of those users to premium users with minimal additional costs in sales and marketing.

With this in mind, Mullany's equation for freemium businesses looks like this:

Price Paid by Premium User - Cost of Proving the Service to the Premium User - [ (1/Ratio of Premium:Free Users) * (Cost of Free Service Per User + Cost of Marketing to get a Free User) ] = Profit Per Premium User

Then in formula form (labeling the percentage of Premium to Total Users the Conversion Rate (CVR)):

PremP - PremC - 1/CVR * (FreeC + FreeS&M) = PremPU

So...to figure out which is the better model for your business, compare the two profits. Freemium is better than a paid model if:

PremP-PremC - 1/CVR * (FreeC+Free S&M) > PP-PC -PS&M

As an English major, I was asking Mullany for some simplification at this point. Fortunately, he provided it because, as it turns out, the price and cost to serve a premium versus a paid user will be fairly close, allowing us to cancel out on both sides.

This leaves the formula looking like:

1/CVR x (FreeC+Free S&M) > PS&M

With a little algebra you get a magic formula of sorts. Namely, freemium will be a better choice when:

Conversion Rate % > (Cost to Serve a Free User + Cost to Acquire a Free User)/Cost to Acquire a Paid User

From some informal surveys, it seems like best-in-class freemium conversion rates are anywhere from 2 to 8 percent (at the very high end). The implication of this, as Mullany noted, is that for free or freemium to make sense, your cost to serve and acquire a free user has to be from between one-twelfth and one-fiftieth the cost of acquiring a customer under an alternative paid model. (This is one reason why successful freemium businesses have a laser focus on conversion rates.)

Based on this (perhaps overly simple formula), it becomes clear why freemium models make sense when a business has either very strong word-of-mouth marketing, a very low cost to support a free user, or where the cost of sales and marketing to acquire a paid user is relatively very high. If your marketing costs are high, it can be either because it's an audience that's really hard to target or because it's a very new product category that requires a lot of education and assistance for a potential paying user to understand.

I really like the framework Mullany brings to open source, in particular, where "freemium" translates to Open Core and other business models.

His formula removes some of the dogma from open-source debates. The question is how to solve customer problems at the lowest possible cost/highest possible value, not whether one should join the Church of Free Software.

Sometimes "free" is absolutely the right way to provide customer value. And sometimes it is not. Mullany's formula helps to elucidate the decision-making process.

Follow me on Twitter @mjasay.