The Three Rules of Freemium

At the SaaStr Europa conference in Paris a couple of weeks ago I sat down with Joaquim Lecha, the CEO of our portfolio company Typeform, to talk about “Freemium at Scale”. Founded and headquartered in Barcelona, the company launched a free version of its service seven years ago. During our conversation Joaquim revealed that this free service helps drive 180,000 monthly signups, and about 3% of those signups convert into paying users who are billed anywhere from €25 to €70 per month, depending on the plan they choose. In other words, Typeform is effectively leveraging a free version of its product to drive paid subscriptions at scale.

I have a bit of a love/hate relationship with the freemium model. Done right, freemium can lead to amazing success. One of the best examples is Dropbox, which Tomasz Tunguz called the “King of Freemium”. What makes the company unique, he argues, is how it transformed its free users into evangelists. “Unlike other SaaS companies, Dropbox spends more of its revenue on engineering than sales and marketing,” Tomasz wrote. “Typically, businesses spend twice as much on S&M.” In a piece I wrote when Dropbox went public last year, I pointed to the section of the company’s S1 that detailed how Dropbox drove sales of its enterprise solutions. Unlike most other enterprise software, which traditionally used to be chosen by the IT department, Dropbox is typically adopted by individual employees from various departments, who then lobby management into switching. As I noted in my piece, Dropbox was one of the early champions of the ‘consumerization of enterprise software’ movement, which was one of the strongest drivers of SaaS success in the last ten years.

But not every SaaS company can be a Dropbox or a Typeform. Done wrong, freemium can end up cannibalizing your paid user base while also draining your company’s precious engineering and customer support resources. So how do you know if launching a freemium product is the right move for your company?

Let’s discuss some of the pros and cons of the freemium model.

The downsides of freemium

I think many SaaS companies are too optimistic in thinking that they can just offer a free, pared-down version of their software and that this will result in a wave of user signups followed by increased revenue once those users make their way down the purchase funnel. But there are a number of factors you should consider first:

Added costs: Given that SaaS is an extremely high-gross-margin business, one might think that you can easily support free users. However, even if your gross margin from paying customers is 80% to 90% (i.e. your CoGS are only 10% to 20%), those costs can become very significant if you grow a large user base that doesn’t generate any revenue.

From engineering to hosting, the freemium model will require consistent upkeep that drains resources that would be otherwise devoted to your paying customers. And even though your freemium users won’t be paying a dime, they will still expect some level of customer service. In our discussion at SaaStr Europa, Joaquim revealed that, on average, 70% of Typeform’s support tickets come from free users and that the company spends $130,000 per month supporting them.

Now, Joaquim didn’t consider this too high a price to pay for the various benefits of having a free plan (more on that below), but for other companies, the upside/downside assessment may look different. If your business has lower-than-usual gross margins (e.g. because your SaaS solution includes a service component or because your product is particularly costly in terms of infrastructure), you should think extra hard about whether freemium is right for you.

Cannibalization of paying users: For any freemium model, the running assumption is that a certain percentage of non-paying users will eventually convert into paying customers. But what should also be considered is how usage will flow the other way. In other words, some people, who without a free plan would have become paying customers, will be fine with the free plan and won’t need the paid version.

An imbalance of product features: A freemium approach requires a delicate balance. Provide too many features for free and you risk cannibalizing your paid user base. Offer too few features and you eliminate the value proposition for users to sign up in the first place. Typeform walks this tightrope well, limiting its free surveys to 10 questions and 100 responses. Converting to the paid version grants the user unlimited questions and responses, as well as advanced features such as logic jumps and design personalization options. Not every SaaS company can strike that kind of balance.

Less focus on core users: An important factor to keep in mind is that having a freemium model will almost inevitably have a strong impact on your product roadmap. If you have a free plan, chances are that for every paying customer you’ll have 10–20 (or more) non-paying users. It’s hard to ignore the feedback of a group of users that represents 90–95% of your total user base. Listening to those users doesn’t have to be a bad thing, but it may. It all depends on how similar your non-paying users and their use cases are to your paying customers. In this interesting analysis about the “rise, fall, and future of Evernote” — once the poster child of freemium — Patrick Campbell and Hiten Shah conclude that “trying to appeal to everyone and not building the functionality that core customers want to use made Evernote’s product feel stagnant, which is definitely a tradeoff they should never have made.”

Widening the top of the funnel also makes it critical that you are excellent at identifying the best leads effectively and efficiently. If you don’t do that, your valuable signups might fall through the cracks in all the noise.

The benefits of freemium

Most of the above challenges can be overcome if your free plan leads to a much larger top of the funnel and if you can convert enough free users into paid. A freemium model will likely lead to a lower conversion rate, but that’s OK if it’s more-than-offset by the increase in signups. Assuming that you can keep conversions at a sustainable level, then the freemium model can have several benefits:

More active users: One of the biggest challenges that SaaS companies face is driving adoption of their product. And while some users can be enticed by a free trial period, there’s a subset of consumers who are just more likely to keep using the product if it’s free. Others won’t even sign up in the first place if there’s no free plan.

More evangelists and a positive impact on your brand: You shouldn’t measure a user’s worth solely on whether they eventually start paying you. The larger the number of active users, the greater the pool of potential evangelists who will promote your product to new users. In my discussion with Joaquim, he told me that users who were aware of Typeform’s brand prior to signing up were twice as likely to convert into paid users than those who came in via non-organic channels. Qwilr, another Point Nine portfolio company, has made the same observation.

Amplify virality: The strongest rationale for going freemium is having a product with a built-in viral loop (like Typeform or Dropbox). If you’d like to dig deeper into viral growth in SaaS, check out this great post by my colleague, Louis. One caveat I’d add is that you can’t take it for granted that your free users will have the same viral coefficient (or k-factor) as your paid users. In many cases, your average free user will be less active than your average paying user and will therefore lead to fewer referrals. It doesn’t have to be like that, though. In an ideal world your paywall is built in such a way that users have an unlimited ability to share (or do whatever it is that makes your product viral) and monetize something else.

More user feedback: In our talk, Joaquim pointed out another advantage of having a large user base: It allows Typeform to learn from a much larger number of people. That’s a very interesting aspect that I hadn’t thought about before. Keep in mind, though, that as mentioned further up, depending on your product and industry, feedback from free users may be more or less relevant.

Re-engaging trial users: Every SaaS company will have a certain subset of users who will sign up for a free trial of the paid product and will not convert into a paying user once the trial period ends. Introducing a freemium version allows you to re-engage these users with the possibility of converting them at a later date.

Making the decision

So now that we’ve looked at the potential upsides and risks, how can you decide whether launching a freemium product is the right choice for your company?

Ultimately, only an A/B test can answer this question. However, getting reliable results will take a lot of time, especially if you want to measure the impact on virality and if you have a viral cycle time of, say, six months. If you can’t wait that long (or if you’re not equipped to do a complete-funnel A/B test), here are my “Three Rules of Freemium”:

1) Does your paid plan have a gross margin of 80–90%?
If you have a lower gross margin — for example, because your product is not fully self-service, requires extensive customer support or is extremely costly in terms of tech infrastructure — freemium will probably not work for you.

2) Does your free plan attract the right audience?
If your free users are too different from your paying users, your free-to-paying conversion will be low — and you’ll risk developing your product for the wrong audience.

3) Is your product inherently viral?
If your answer is no, that doesn’t make it a complete no-go, but it does mean that it’s much less likely that freemium is right for you.

Wrapping up

In the end, freemium only makes sense if a certain percentage of your free users do one of three things: 1) Eventually convert to paid, 2) refer paying customers, or 3) provide the kind of valuable feedback that will improve your product. A freemium product that fails to achieve any of these effects will merely saddle you with extra costs and distract you from servicing your most important users. Not every company can be a Dropbox, but the good news is that not every SaaS company needs to adopt Dropbox’s freemium model to succeed.


This post was first published on Point Nine's Medium channel.

10 Observations from Dropbox's S1

In last week's post I shared some thoughts about Dropbox and why, although Dropbox is unquestionably one of the most amazing SaaS companies ever built, I am a tad less confident in the company's long-term future than I am in other SaaS leaders such as Salesforce.com, Zendesk, or Shopify.

As mentioned in the first part of the post, I took a closer look at Dropbox’s recent IPO filing and would like to share some tidbits, along with a few observations.

#1 – Dropbox on consumerization

"Individual users are changing the way software is adopted and purchased
Software purchasing decisions have traditionally been made by an organization’s IT department, which often deploys products that employees don’t like and many refuse to adopt. As individuals increasingly choose their own tools at work, purchasing power has become more decentralized."

As mentioned in the first part, Dropbox was one of the early champions of the "consumerization of enterprise software" movement. This paragraph is a great description of that concept. If you ever have to pitch the idea of consumerization to anyone, copy these lines. :-)

#2 – The King of Freemium

Viral, bottom-up adoptionOur 500 million registered users are our best salespeople. They’ve spread Dropbox to their friends and brought us into their offices. Every year, millions of individual users sign up for Dropbox at work. Bottom-up adoption within organizations has been critical to our success as users increasingly choose their own tools at work. We generate over 90% of our revenue from self-serve channels — users who purchase a subscription through our app or website.

Before reading the S1, I didn’t know if Dropbox has become somewhat more focused on enterprise sales over the years. But here you have it – it really is the King of Freemium, generating more than 90% of revenue from self-service channels.

#3 – It’s a Mouse Hunter!

Dropbox’s ARPU is around $110 per year, confirming that the company is indeed the ultimate Mouse Hunter. It’s worth pointing out that $110 is the average revenue per user, not per account, and one account can consist of multiple users, so the company’s ARPA (which hasn’t been disclosed) is probably significantly higher. However, according to the S1, 70% of the company’s 11 million paying users are on an individual plan as opposed to a "Dropbox Business" team plan, so at least 70% of the company’s revenue does indeed come from mice.

#4 – More than half a million $ per head

As of December 31, 2017, Dropbox had 1,858 employees. Revenue for 2017 was $1.107B. That’s $595,800 per employee. Mind blown. For comparison, according to a Pacific Crest survey among private SaaS companies, the median SaaS revenue per employee of that group of companies was $136,000 in 2016.

Salesforce.com generates a similar (actually, even higher) amount of revenue per employee, but the company is almost twice as old and has much bigger scale, so you’d expect them to be more efficient. When Salesforce had around $1B in revenue, in 2008, it had around 3,300 employees, so at that time its revenue per employee was around $327,000. Not a bad ratio at all, but Dropbox’s revenue-per-employee ratio is truly spectacular – a testament to its extremely effective and efficient bottom-up adoption driven by product virality.

#5 – WTF?!

“Although it is important to our business that our users renew their subscriptions after their existing subscriptions expire and that we expand our commercial relationships with our users, given the volume of our users, we do not track the retention rates of our individual users. As a result, we may be unable to address any retention issues with specific users in a timely manner, which could harm our business.”

We “do not track the retention rate of our individual users”. Wait, what? Did I read this right?

#6 – A unicorn’s worth of office rent

“In October 2017, we entered into a new lease agreement to rent office space in San Francisco, California, to serve as our new corporate headquarters. The total minimum obligations under this lease agreement are expected to be approximately $827.0 million.”

When I read this number for the first time, I was wondering if there’s a typo. $827 million is going to be spent on office rent? A rough calculation shows that the number isn’t as crazy as it might appear on first sight. Assuming the company currently employs around 1,500 people in San Francisco and that that number will grow to 5,000 in the coming years, and assuming it’s a 12 year lease, rent per employee per year (at 5000 employees) would be around $13,800. That’s still expensive, but not “they must have accidentally added a zero” expensive.

#7 – I don’t understand this … is it just me?

“As of December 31, 2017, our blended Annualized Net Revenue Retention across the entire business, including individuals and Dropbox Business customers, was over 90%.”

“We continuously focus on adding new users and increasing the value we offer to them. As a result, each cohort of new users typically generates higher subscription amounts over time. For example, the monthly subscription amount generated by the January 2015 cohort doubled in less than three years after signup. We believe this cohort is representative of a typical cohort in recent periods.”

If you don’t understand how to reconcile these two statements, you’re not alone. Looking at the cohort chart on page 62 of the S1, you’d expect Dropbox to have a significantly negative net dollar churn rate, i.e. net revenue retention of significantly over 100%. The only scenario, in which the two statements above could be compatible, is if a user cohort’s revenue doubles during the first three years but then declines steeply, but I have no idea if that is the case. If you know or have an idea what I’m missing here, I’d love to hear it!

#8 – Weaning off AWS

Look at this. From 2015 to 2017, Dropbox increased revenue from around $600M to ca. $1.1B. During the same period, the company decreased cost of revenue from over $400M to less than $370M. In percentage terms, CoGS decreased from around 67% to around 33%. You don’t often see a company halving its CoGS percentage within two years. Either Dropbox was pretty wasteful in 2015 or they are extremely efficient now. ;-) I think it’s a bit of both.

According to the S1, the remarkable CoGS reduction was achieved primarily by closing accounts of inactive users and by moving more than 90% of all user data from AWS to Dropbox’s own server infrastructure. For what it’s worth, this also gives you a hint on the margins of AWS.

#9 – Eleven 9s?  

"Our users trust us with their most important content, and we focus on providing them with a secure and easy-to-use platform. More than 90% of our users’ data is stored on our own custom-built infrastructure, which has been designed from the ground up to be reliable and secure, and to provide annual data durability of at least 99.999999999%. We have datacenter co-location facilities in California, Texas, and Virginia."

I thought six 9s are considered best-in-class, so I was surprised when I counted eleven 9s in this paragraph. Eleven 9s correspond with 0.00032 seconds of downtime per year, which for all practical purposes means that Dropbox can never go down. I re-read the sentence and noticed that Dropbox isn’t referring to availability (i.e. uptime) but data durability, which, as I now know, is something else.

#10 - Multiple personalities?

This is how Dropbox wants to be viewed:

This is how I view it:

If you read the S1 and take a look at Dropbox’s website, it becomes clear that the company wants to become much more than just a service that takes care of file storage and synchronization behind the scenes. They don’t want to be just an icon in your file system, they want to unleash the world’s creative energy by designing a more enlightened way of working (Dropbox’s mission statement).

That makes perfect sense, as being a “background service” might ultimately prove not to be a defensible, high-margin business. I’m somewhat skeptical if their (relatively) new “Paper” product will become a success. But with 500 million registered users, 11 million paying users and 300,000 paying work teams, the company has time to figure it out.

Dropbox, the ultimate Mouse Hunter

I’m late to the party here, I know. Dropbox went public a bit more than a month ago and I’ve finally had a chance to take a close look at the company’s S1. I’ll be sharing a few specific observations from the S1 review, but let’s start with some more general thoughts about the company.

The mighty king of Freemium

Like Zendesk, Yammer, and a few other SaaS companies that were all founded around 2007-2008, Dropbox was one of the early champions of the "consumerization of the enterprise" movement. In contrast to Zendesk (and I think, Yammer), which eventually moved upmarket and now generates an ever-increasing percentage of revenues from larger customers, Dropbox is still getting most of its revenues from individual users and small teams. The company hasn't disclosed how much revenue it is generating from larger companies, but according to its S1 filing, a staggering 70% of its 11 million paying users are on an individual plan as opposed to a "Dropbox Business" team plans. More than 90% of its users are acquired via self-service channels, presumably driven in large part by the inherent virality of the product. These characteristics make Dropbox the "King of Freemium", as Tomasz put, or the ultimate “Mouse Hunter”.

And what an almighty King it is! Dropbox was the fastest SaaS company ever to hit $1B in ARR. As every aspiring SaaS entrepreneur knows, getting a hundred million dollars in ARR within around eight years is incredibly hard and extremely rare. Getting to more than one billion within the same timeframe is completely nuts. If the improbability of reaching a $1B valuation is epitomized by a unicorn, getting to $1B in SaaS revenues within eight years is as unlikely as seeing a unicorn with three heads.

Dropbox is one of the very, very few companies in the top left corner of the LTV/CAC chart.

A three-headed unicorn

So what is it that made Dropbox beat all odds? I believe that no single factor alone can explain a success of this magnitude. Instead, I think that the right team has to hit the right opportunity at the right time. Call it the positive equivalent of a perfect storm.
More specifically, here are some factors that I think contributed to Dropbox's success, in no particular order:

1. Timing
As consumers tend towards using more devices over time, they’ll experience a  bigger need for a solution that synchronizes files across all of their devices. Until 2005 or so, most people used only one or maybe two devices to work with their files: a desktop PC and/or a laptop. Dropbox was founded in 2007, the year the iPhone was launched and just when the move to a multi-device world started to become inevitable. Dropbox also benefited from an ever-increasing number of remote workers who need easy access to their company's files. According to a 2016 study by Deloitte that is mentioned in the S1, 30% of full-time employees primarily work remotely.

2. Product
Dropbox managed to beautifully solve a very difficult problem. It might look like a simple product on the surface, but from handling versioning conflicts to building deep integrations with different operating systems to ensuring secure and fast access to files, it required solving a number of hard technology problems. I remember that before switching to Dropbox, I used another piece of software to sync files across two computers. It was pretty messy. With Dropbox it just works.

3. Virality
While it's possible to use Dropbox just by yourself, my guess is that at some point, most users use Dropbox to share files with one or more other users. It's this built-in virality that allowed Dropbox to grow at a pace that no other B2B SaaS company has seen before. As if this wasn't enough, Dropbox also had a famous two-sided referral program that augmented the inherent virality with additional referral incentives.

4. Team
I don't know the founders of Dropbox, but looking at the quality of the early product and their referral program, it's clear that the founding team combined excellent product and tech skills with a strong growth mindset. In any case, the results speak for themselves – there's no question that a remarkable team must have been at work here.

Dark clouds on the horizon?

As much as I love Dropbox – the product and the company – I'm not entirely sure about the company's long-term prospects. Dropbox's one big weak spot, in my opinion, is that the product is almost UI-less. While you can access your files using Dropbox's (simple) Web app, there's very little need for it. We use Dropbox for all of our files at Point Nine and I have it running on four devices, but Dropbox does its magic almost entirely in the background. That makes me think that Dropbox is much less sticky than other SaaS products, e.g. workflow tools that require training. I could imagine that if a company's IT department decides to switch the file storage and sharing provider for its entire workforce overnight, most people wouldn't even notice it. In contrast, imagine the outcry that would ensue if you took away Zendesk from a support team or if you tried to get your development team off Slack.

Would I switch to another provider to save $20 a year? No, not worth the hassle. Would I consider moving all files to Google Drive if it's significantly cheaper and if a tighter integration with GMail, Google Calendar and Google Docs offers more and more benefits? Yes. (Interestingly Google Drive’s “Quick Access” feature is already using e.g. information from your calendar to predict which file you are likely to need at which point in time.)

I think the company has recognized this issue. Two and a half years ago they launched "Paper", a collaborative document-editing app, presumably to get more "face time" with its customers and to own a bigger part of the value creation chain. However, I know almost nobody who uses Paper and the company doesn't disclose any usage numbers, so my guess is that it's not a big success so far.

Don't get me wrong, more than $1B in ARR and 500 million registered users are an incredible asset. The King of Freemium won't be dethroned any time soon. But for what it’s worth I didn't buy the stock yet :-)

Update: Here is part 2 of this post.

The Price is Right (or not)

One of the most important questions which every SaaS company has to solve is to find the right pricing – the right pricing model as well as the right price levels. It’s obvious that getting pricing right is extremely important: If you’re too cheap you will leave money on the table and reduce your ability to invest in customer acquisition. You may also hinder adoption especially from bigger customers who think that your product can’t be good because it’s so cheap. If you’re too expensive you might be scaring away the majority of your potential customers.

It is of course impossible to find the optimal price point in a way academic textbooks would define it. Finding that would require you to do more tests than you can possibly do. What you should do is try to get to that point as close as possible, and when I talk about the “right” pricing I mean a reasonably right pricing.

Unless your target customers are all very similar (which is unlikely), the most important thing that your pricing model has to accomplish is to capture different amounts of money from different customers based on their willingness and ability to pay, which correlates with the value that they’re getting from your product. In the old enterprise software world this used to be the job of the sales people – talk to the customer, find out about his needs, get a sense for what he can pay, offer him a solution and negotiate a price. In the world of SaaS, customers (rightly) expect more transparency and will look for a price list on your website before they start a trial.

In many cases a per-user pricing (often also referred to as “per seat”) is an obvious choice, and some of the most successful SaaS companies including Salesforce.com are using that. Other successful examples include pricing based on:

• number of clients managed with the software (e.g. Freshbooks)
• number of newsletter emails sent (e.g. MailChimp)
• number of email recipients in the system (e.g. ConstantContact)
• amount of storage that is used (e.g. Dropbox)
• number of events tracked (e.g. KISSmetrics)

What these companies have in common is that they've found an "axis" that highly correlates with their customers' willingness to pay, which allows them to keep their service affordable for small customers while asking bigger customers for much more. It also allows them to benefit from the growth of their customers, since a growing company needs more seats/emails/MBs/events/etc over time. Ideally this can lead to what is known as "negative churn" – the wonderful situation when the MRR growth of some customers of a customer cohort more than offset the effect of terminations from that cohort.

Importantly, most successful SaaS companies differentiate their prices along more than one axis (David Skok wrote about this here). Secondary axes include the level of support, additional features or other usage parameters. For example, Freshbook's pricing is based on a combination of the number of clients that you can manage and the number of seats, plus two additional factors:

So what's the right pricing model for your SaaS startup? For obvious reasons it depends and I have no general answer to that question, but here are a few practical tips:

• Try to find one or more axes which correspond with the value that your customers are getting from your product and which correlate with your customers' willingness to pay. Talk to your customers and analyze how your early users are using the system to find out the ways in which larger customers are using your product differently from smaller customers.
• In the beginning, err on the side of being too cheap rather than being too expensive. In the beginning the most important thing is to get customers. You can optimize your margins later.
• Later on, make sure you're not leaving too much money on the table. If not a single customer ever complains that you're too expensive that's a strong sign that you're too cheap.
• Accept the fact that it's very unlikely that you will get your pricing right at the first shot. Go out with something that you think makes sense, get feedback from the market and be prepared to make changes quickly.
• If you increase prices, try to do it along with new value-add features that help justify the price increase. And offer your existing customers extremely generous grandfathering terms.
• If your pricing is differentiated based on features, consider giving all users the high-end plan with all features during their trial so that they can play around with the full product.
• Maybe not necessary to mention since these are all known best practices, but just in case: Give users a self-service free trial. Offer monthly pay-as-you-go subscriptions that users can cancel at any time. Provide an option to pay in advance for a year (with a discount). Create a clean, beautiful pricing page. 

Do you know any examples of pricing models that worked or didn't work, or would you like to get my feedback on your pricing model? Get in touch!