The cost side of freemium

When people talk about freemium businesses and business models, most of the time they’re talking about it from a revenue or product perspective. Revenue, because the essence of the model is to give away something for free. And product, because this is the key to freemium success. Only a compelling, unique and engaging experience will keep people coming back regardless of whether they pay you or not.

One often overlooked side of freemium is the cost side. Freemium works if the incremental cost of providing your free product or service is essentially zero. Most of us get this. But if you don’t have limits on the cost side of your free offering, you could be in big trouble.

Let’s look at VoIP for example. Skype charges nothing for in-network callng (calling another skype client). Not coincidentally, its costs are also more or less nothing. Especially given its P2P architecture. If you want to call a phone however, you pay since Skype has real termination costs to pay carriers. Not all VoIP players have so clearly separated their free vs. paid based on costs. I know this from experience, having been CFO at Mobivox, where we were very generous out of the gate with our free calling. The problem was that every new user cost us real money every time they made a call. Mobivox was not alone facing this. We were in an intensely competitive space and we all gave away free minutes.

There are many more examples of freemium businesses that have gotten it right and wrong when it comes to assessing the cost side of their business model. Take the battle of the social networks as the most visible example – Facebook vs. Linkedin. Both networks are successful by any measure, but they have very different cost and capital efficiency profiles.

Facebook, which just passed 200M members has raised $ 516M in total capital (or just over $ 2.50 per user). This amount includes $100M of debt, and they’re off looking for more right now to fund growth.

Linkedin, with over 30M members has raised $ 103M or $ 3.43 per user. However, according to them only $ 28M (93 cents per user) of that (everything before last September’s Bain Capital round) was used to fund growth. The new money is in the bank for acquisitions.

Why the difference in capital required per user? I’m sure there are many reasons, but incremental costs have to a big one. Look at your own Facebook profile for example. How many photos or videos do you have there? Lots, right? And what is the main thing you do on Facebook? If you’re like most people you post photos and videos and look at friend’s photos and videos. There are seemingly no limits to the amount of content you can upload.

Now look at your Linkedin profile: No matter how many connections you have, you’re probably using the same bandwidth. You can have one profile picture. They now have a slideshare app, but you’re limited to four presentations.

The point is: Linkedin has placed very clear limits on the costs to serve an individual user. Facebook has not. As such they have very different cost structures.

We also see this phenomenon with Youtube which is apparently losing $ 1.65M per day .

In your business, if you have real, tangible costs of serving your free users, then you need to better segment your offerings to get these people paying you or leaving the service. If it costs you every time someone uses your product or service, make sure you’re getting paid directly (through subscriptions) or indirectly (through ads).