The Construct of Diminishing Freemium Monetization

The Construct of Diminishing Freemium Monetization

Most entrepreneurs pursue Internet business with the mindset of a Freemium pricing strategy: offer services for free and earn revenue through advertisement. With Google AdSense readily available, you see many websites operating on that business model. It is not just websites – most apps, games and web apps are based on Freemium with the advertisement support.

Freemium is a pricing strategy by which a product or service (typically a digital offering or application such as software, media, games or web services) is provided free of charge, but money (premium) is charged for proprietary features, functionality, or virtual goods.

The Freemium business model is challenging in the age of ICT juggernauts like Facebook and Google which dominate the web sector. It has one major flaw: the concept that scale will bring more value, monetarily. Pre-internet, a small newspaper could have small number of paying subscribers, and with luck, that would be enough for them to take care of their bills. But today, that small newspaper is a global firm with users that could come from any part of the world. So instead of dealing with say 1,000 print paid customers, it may have more than 100,000 digital customers through its websites. But those digital customers are coming because the content is free on the web.

There is a problem there: the newspaper has grown by 100x but its revenue might have actually dropped. Why? It might have lost the paying 1,000 print customers, who now may be going for the free internet content also. Over time, the newspaper goes all-internet because no one is buying the printed products. Think of U.S. News which I used to subscribe, until the day they told us that they would cease printing the paper. They moved all to web, and in the process cut their workforce.

It is not just newspapers; we do that when we launch products (games, apps) on the web. You are giving out free software which people come to download. The idea is that by bringing the people, you can earn money through advertisement. The goal is to increase customer growth. However, the growth, most times, does not add much value to your bottom line as advertisement, the way it is done on the web, powered mainly by Google does not deliver good returns.

Sure, I understand that most online creators also get advertisements outside Google AdSence. However, only few creators actually enjoy this privilege. Majority of creators just depend on AdSence.

The Big Challenge – Diminishing Returns

Let me begin by referring you back to the Law of Diminishing Returns

The law of diminishing returns states that in all productive processes, adding more of one factor of production, while holding all others constant, will at some point yield lower incremental per-unit returns.

The usual example is from agriculture where the addition of more fertilizers in a fixed land, will over time, not have material improvement in crop yield. I take that to explain the Freemium internet business and its monetization. You can add more users to downloading that software, but most times, the value obtainable from display ads does not improve the bottom-line significantly. You could have been better if you never have to make it free, focusing on subscription instead. This is the core of the Construct of Diminishing Freemium Monetization.

Yes, the more users have not translated to more revenue. Most blogs and digital systems follow this pattern, limiting the values they can create, as they never cross what I call the Freemium Break-even point, when huge value will be unlocked on Freemium business. That is the point, similar to the Break-even point in business, after which a business can succeed under Freemium model. That means, the business has enough user to do that. Facebook and Google are examples of companies that have significantly exceeded the Freemium Break-even point.

I do understand that not going Freemium is hard. When the quality of the product is not top-grade, it is very easy to give it away fast and wait for clicks. That is why the quality of products on the web may not be optimal compared to the printed ones where the estate is more at premium. You can have a crappy app which is free. But to ask people to pay, you have to make a great app. So, in a way, people that pursue the Freemium may be doing it based on their capacities to compete at the phase where payment will not be needed.

Case Study: Netflix and YouTube

Netflix operates on paid subscription while YouTube does not (sure, there is a small part of Youtube that requires subscription). YouTube has more users while Netflix does not. But under direct comparison, Netflix has created more value than YouTube. If Netflix is free, it surely would have had more users but the revenue it is generating today will be significantly lower. Its market cap is around $70 billion.  Without Google, a standalone YouTube would not be up to that amount. YouTube competitors like Vimeo are not close to that level.  Vimeo’s parent company, IAC/InterActiveCorp, hovers at $8.3 billion.  My point is that Netflix has created more value than Vimeo and even YouTube through its closed system despite not having many customers which it could have commanded had it been free.

Freemium Break-even Coefficient

From the pros, “in accounting, the break-even point refers to the revenues needed to cover a company’s total amount of fixed and variable expenses during a specified period of time. The revenues could be stated in dollars (or other currencies), in units, hours of services provided, etc.” For internet Freemium business, the “revenue” here should be a factor of visitor traffic, i.e., the more the visitors, the more the advertising revenue.

Because you have no product you are technically “selling”, the usual calculation of break-even point will not apply here.

The biggest problem in Freemium model is that you do not even have control on anything. You do not know how Google prices the traffic and clicks. The king of search is not really transparent as it weighs cost of traffic depending on the location of the IP address. So figuring out the most likely break-even point (in volume of traffic) is hard. More so, traffic does not just mean monetization because many people visiting from Nigeria use Opera which blocks ads. So you can have improved traffic without more revenue. You need a coefficient, the Freemium break-even coefficient, to capture all the possibilities, if you plan to make the Freemium a business. That will help you determine what traffic level you need for a break-even in your Freemium business before you run out of cash. We have the equation thus.

The alpha and beta, the Freemium Coefficients, depend on many variables: the former has five while the latter has seven. I will leave them here to avoid complicating this piece. The left hand side is the total traffic (in mille, i.e. thousands) required to produce the desire profit. The Coefficients are calibrated for each sector, signifying how much you need to improve.

Freemium That Works

Freemium model works when a company has improved its Freemium coefficients. That means the money it makes through advertisement can cover expenses and then generates profit. The ICT Utilities like Google, Facebook etc have indeed exceeded theirs and that is why they are profitable.  But that they have done it does not mean it is easy, for the following reasons:

  • You need so much scale to have the capacity to command huge revenue. Internet commoditizes value making it harder to easily differentiate. But that is possible, if you find your space. That you have a blog that looks like ThisDay and Punch will not do you so much good.
  • Your marginal cost must tend to zero since technically in a perfect internet, the marginal cost tends to zero. If that happens, it means that you can easily make profit. Your marginal price is already zero since you are on Freemium. But if the marginal cost is tending to zero, the small ads can give you profit
  • ICT utilities like Google and Facebook further puts more pressure in the system through aggregation. You will need a lot of work to differentiate to have a chance to make money.

All Together

I do think that differentiation on the web is important. That helps the ICT Utilities like Google to value your content in their models. But the greatest value is to be so good that you can enjoy subscription. The pursuit of digital growth, most times, does not hold much value because advertising cannot cover most costs unless you have a huge traffic breakout (meaning you have exceeded the Freemium coefficient). That is the big challenge for those that hope to make careers on the web, as creators. That focus of pursuing subscription from day one with high quality product should be in the central strategy. Becoming a category-king is very important to get people to pay.


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