The hidden dangers of Freemium

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I believe startups should never offer a freemium service, and there’s a lot of evidence to support this. From painfully low conversion rates to the strain it puts on resources, the freemium model is more trouble than it’s worth for most startups.

Understanding the SaaS Freemium model:

In the world of early-stage startups, especially those offering software-as-a-service (SaaS), the freemium model has become very popular. SaaS companies typically lease their software to other businesses on a subscription basis, offering multiple tiers.

The first tier is usually free—a watered-down version of the full product with limitations. The second tier is the “standard” package, with more features but limits on things like the number of users. The top tier is usually called something like “premium” and includes nearly everything the customer demands. This package is often customized for bigger companies with bigger budgets.

In a perfect world, businesses would just offer their product, and customers would line up to pay. But the freemium model tries to create a paying customer deal flow channel by enticing people to become users via a free version, hoping they’ll fall in love with the product and eventually upgrade to a paid tier once they realize the free option isn’t cutting it. Although this sounds like a good strategy, the truth is that things rarely go this way.

Why Freemium models fail

In reality, between 95-98% of free users never become paying customers, and there are several reasons why this happens. Sometimes, businesses give away too much in their free version, making it so good that users never feel the need to upgrade. The New York Times faced this issue in 2012 when they let free readers access 20 articles a month. That was way too much; most readers were content with that free tier and had no reason to pay for premium. So, the Times cut it down to 10 free articles in 2012 and eventually to five in 2017. When you give away too much, users tend to stay on the free plan because it satisfies all of their needs.

Another problem is when the difference between the free and paid tiers is unclear or isn’t compelling enough. In my opinion, Canva falls into this category. I use their free version to create presentations and flyers a few times a month. The paid version gives access to more design elements, but for someone like me, the free version gets the job done just fine. There’s not enough extra value in the paid tier to make me feel like I’m missing out or that their free version isn’t solving my pain point.

Lastly, supporting free users costs money. Free users still take up server space, require customer support, and eat up resources. While each free user might not cost much, when you scale up to hundreds or thousands of users, those costs can add up. Meanwhile, these free users probably aren’t bringing in any revenue. So, not only are they unlikely to convert, but they’re also costing you money!

Charging for your product: The key to identifying ideal customers

As a business, you should be offering a product or service that solves a problem that a reasonably sized market is experiencing. It goes without saying that the market should find value in your solution, which is why they want to become your customer in some capacity. It shouldn’t be understated that for a business to survive, it needs to be profitable, have a sustainable business model, make more money than it burns and have repeat customers.

When we look at each of those elements in the aggregate, it’s not unreasonable to say that because the end user receives value from the solution or may even use the solution to create and generate an even greater amount of value for themselves, it is reasonable to charge the end user (customer) for the product or service that is doing this for them. If your product or service truly solves a problem for a market, people should be willing to pay for it. If they aren’t willing to pay, that’s a problem—you’re either targeting the wrong customers, or your product isn’t delivering enough value.

I’d even go as far as to say that if an end user isn’t willing to pay for the good or service that your business offers, then that type of user is not what your business really wants. If someone isn’t willing to pay for your product, they probably aren’t your ideal customer. The customers who need your product the most will find value in it and be happy to pay for it, assuming the price is fair.

Why Freemium works for tech giants but fails for most startups

To be fair, some large companies can offer freemium because they have the resources to do it. Think tech giants like Google (NASDAQ: GOOGL) or Meta (NASDAQ: META), which offer free services but make money in other ways, like gathering user data to improve their products, selling ads, or just selling their users’ data outright to another company. These tech giants can afford to operate with millions of free users because they’re monetizing them in other ways.

But unless your business model includes some other way to make money off free users—whether that’s ads or data collection—you’re better off avoiding freemium altogether.

For most startups, especially early-stage ones, the freemium model doesn’t make sense. It might help you build a large user base, but if those users aren’t converting to paying customers, you’re just burning through cash without building a sustainable business. What’s even worse is that it might scare your potential investors, sending them a signal that customers don’t see enough value in what you’re offering to pay for it.

These are some of the reasons that I advise startups to charge for their products and services right out of the gate instead of giving them away for free. If people are willing to pay, you know you’ve got something valuable. If they aren’t? That’s valuable feedback too—it tells you that you need to rethink your product, pricing, or target market, which is much better than running a ghost-ship of a business that is bound to fail one day in the future but is keeping its lights on, burning money and other resources with the hope that one day, its users will decide they want to be paying customers of the business.

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