“Freemium” has become the default pricing model for every new startup. After all, today a startup’s user acquisition rate is the metric that primary decides the number of zeroes at the end of its valuation. And Freemium definitely offers un-throttled user growth.
But beyond the startup phase, is freemium always sustainable in long term? When is it better NOT to use Freemium? I asked Ash Maurya this question on Twitter and he replied:
(don’t use freemium) When either the marginal cost per user is unaffordable and/or no quid pro quo from free users
This makes sense but needs to be discussed in more detail, given the brevity of his tweet. Put differently, Freemium makes sense when:
Life Time Value (LTV) from a free user > Life Time Marginal Cost (LTMC) of retaining a free user
This condition ensures that each free user brings a net positive value to the business over his/her entire lifetime. To put this to test, I took up the case of Dropbox (recently valued at $10bn) to see how things stack up for them.
Life Time Value (LTV) from a free Dropbox user
There are three sources of value a free user brings to Dropbox:
- Upgrade value: If a free user upgrades to a paid plan at some point in future. Assuming an average order value of $250, (assuming $250 mn revenue from 1 mn paying accounts). Assuming that 0.1% of free users upgrade and will have a lifetime of 3 years, this is worth: 0.1% of $250 * 3 = $0.75/year.
- Cross-sell value: If one uses other Dropbox services (such as Mailbox). This is too new a stream for Dropbox, but given that Dropbox will surely add more services in future, let’s assume a random value of $0.05.
- Strategic value: The “notional value” of each customer relationship. This is a $ equivalent of the brand, influence and all other potential future sources of revenue such as selling ads, using usage data etc. For a very “display” service such as FB this value today is close to $7/year (based on its $7.12 bn revenue from a 1.2 bn customer base). Since Dropbox is less “ad friendly”, let’s scale this down by 1/10th to reach a value of $0.70/year or $2.1 for the life time.
Hence for Dropbox, the LTV of each additional user: $0.75 + $0.05 + $2.1 = $2.80
Life Time Marginal Cost (LTMC) of retaining a free user
Each free user that comes along, adds following type of costs for Dropbox:
- Cost of Service: Dropbox provides 2 GB free to each user. Based on my cloud storage experience, I’d assume that:
- The actual storage used by an average customer would be about 0.5GB. At a price point of $0.15/GB-year, this would be about $0.22 over the customer lifetime of 3 years.
- The other costs of servers, bandwidth, etc won’t be more than 1/3rd of storage cost.
- Indirect costs: This will be largely the employee costs. Now, Dropbox has 552 employees today (source: Quora), which in the silicon valley is equivalent to a cost of about $80mn/year. For 200 mn users, this comes out to be about $0.4 per year or $1.2 for the customer life time.
Hence LTMC of each new Dropbox user = $0.22 + $0.07 + $1.20 = $1.5
Since each free user represents a value of $2.80 but costs only $1.50 over the life time of 3 years, it does seem that Freemium model is a “balanced business model” for Dropbox, as David Skok drew up in his post here:
Out of all sources of value, it seems the “strategic value” of a user ($2.10) is what is tilting the balance for Dropbox today. If not for this value, Dropbox would be forced to reconsider its freemium model or at least tweak it to either increase revenue or reduce costs. (Update: This is exactly what SugarSync, a Dropbox competitor did – it recently quit Freemium model. The same was done by LogMeIn a few months ago). For instance, I do think that the upgrade rate for free users (assumed 0.1% above) is too little, given that Dropbox pro plans are not very expensive. Its fencing between free and paid plans is rather weak and gives away too much value away for free.
This “strategic value” is hinged on the hope that Dropbox will someday be able to monetize users better to achieve a higher life time value. For a well funded and quality team such as Dropbox, this may be very much real. But for teams that are not, it may be just an illusive dream.
Have something to say? Please weigh in with your thoughts!