Compare Pandora’s original business model with The current business model.
2.5 Case Study Freemium Takes Pandora Public
Pandora is the Internet’s most successful radio service. As of June 2015, it had over 250 million registered users (225 million of whom access the service via a mobile device) and about 80 million active listeners. Pandora accounts for more than 45% of all Internet radio listening hours, more than double its closest competitor, Spotify, and a 9% share of total U.S. radio listening (both traditional and Internet). In 2014, it streamed over 20 billion hours of music!
At Pandora, users select a genre of music based on a favorite musician, and a computer algorithm puts together a personal radio station that plays not only the music of the selected artist but also closely related music by different artists. As of June 2015, listeners have created over 8 billion different stations. A team of approximately 25 professional musicians listens to new songs each day and classifies the music according to more than 450 musical criteria. These criteria are used in a computer algorithm to classify new songs into various genres. Within each of these genres are hundreds of subgenres. Altogether, Pandora has a database of over 1 million analyzed songs from over 200,000 artists.
Photo shows a page from Pandora’s website.
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Pandora’s founders, Will Glaser and Tim Westergren, launched Pandora in 2005. Their biggest challenge was making a business out of a totally new kind of online radio station when competing online stations were making music available for free, many without advertising, and online subscription services were streaming music for a monthly fee and finding some advertising support as well. Online music illegally downloaded from P2P networks for free was also a significant factor, as was iTunes, which by 2005 was a roaring success, charging 99 cents a song. The idea of a “personal” radio station playing your kind of music was very new.
Pandora’s business strategy is referred to as “freemium.” A freemium strategy is based on giving away some products or services for free while relying on a certain percentage of customers to pay for premium versions of the same product or service. As Chris Anderson, author of Free: The Future of a Radical Price, has pointed out, because the marginal cost of digital products is typically close to zero, providing free product does not cost much, and potentially enables you to reach many more people. If the market is very large, even getting just 1% of that market to purchase could be very lucrative. Other notable freemium success stories include LinkedIn, a social network for career-oriented and job networking that offers some basic services for free, such as creating a profile and making connections, but which charges for premium services, and Dropbox, a cloud storage and file sharing service that provides 2 gigabytes of cloud storage for free, but charges for additional storage. Freemium has been the standard business model for most apps, with over 65% of the top 100 apps in Apple’s App Store using a freemium strategy.
Pandora’s first strategy was to give away 10 hours of free access, and then ask subscribers to pay $36 a month for a year after they used up their free 10 hours. The result: 100,000 people listened to their 10 hours for free and then refused to pay for the annual service. People loved Pandora but appeared unwilling to pay for it.
Facing financial collapse, in November 2005 Pandora introduced an ad-supported option. Subscribers could listen to a maximum of 40 hours of music in a calendar month for free. After the 40 hours were used up, subscribers had three choices: (a) pay 99 cents for the rest of the month, (b) sign up for a premium service offering unlimited usage, or (c) do nothing. If they chose (c), the music would stop, but users could sign up again the next month. The ad-supported business model was a risky move because Pandora had no ad server or accounting system, but it attracted so many users that in a few weeks it had a sufficient number of advertisers (including Apple) to pay for its infrastructure. In 2006, Pandora added a “Buy” button to each song being played and struck deals with Amazon, iTunes, and other online retail sites. Pandora now gets an affiliate fee for directing listeners to Amazon where users can buy the music. In 2008, Pandora added an iPhone app to allow users to sign up from their smartphones and listen all day if they wanted. By 2009, this “free” ad-supported model had attracted 20 million users.
After attracting a sufficiently large user base, Pandora turned its attention back to its premium service. In late 2009, the company launched Pandora One, a high-end version of its service that offered no advertising, higher-quality streaming music, a desktop app, and fewer usage limits. The service cost $36 a year. This time around it met with much more success, so much so that Pandora went public in June 2011. By 2015, Pandora had a projected $1.16 billion in revenue with about 80% coming from advertising and the remainder from subscriptions and other sources.
However, Pandora has not yet shown a profit, and its stock price has slowly declined. The company is experiencing slowing growth rates in its number of active users, registering just a 5% increase in users in 2014, compared to an 8% increase the year prior. Music licensing costs are likely to sharply increase in the coming years, clouding their path to profitability further. And the company faces increasingly stiff competition from services such as Spotify, which also is using the freemium strategy. Fully paid services like Apple-backed Apple Music, as well as much-hyped new entrants like Tidal, founded by Jay Z and a slew of other high profile artists, represent threats to Pandora as well. But the picture isn’t totally bleak: Pandora has continued to show growth in advertising revenue and in listener hours, as its active users are listening more and more.
While freemium clearly has worked to grow companies like Pandora, LinkedIn, and Dropbox, there is ongoing debate about the effectiveness of the freemium strategy. The crux of the issue is that while freemium can be an efficient way to gather a large group of potential customers, companies have found that it’s a challenge to convert eyeballs into those willing to pay. Absent subscriber revenue, firms are forced to rely on advertising revenues.
Apple has led a recent push against freemium music streaming services like Pandora and Spotify. In 2014, Apple, sensing a shift away from paid downloads towards streaming services, acquired Beats, which made trendy headphones and had a streaming music service, for $3 billion. Pandora and Spotify have thrived at the expense of iTunes Music Store, whose revenues have declined steeply for several years, and Apple’s first attempt at a streaming service, iTunes Radio, was a bust. In 2015, Apple, after working with Beats, launched its own paid subscription streaming service app, Apple Music.
Music industry executives remain unsure of the profit potential of the freemium model, and many of them have begun to pressure Spotify to remove its free tier of service. Pandora is likely not far behind. The heads of Universal Music Group and Sony Music both expressed skepticism of the long-term prospects of the freemium model in 2015, and in 2014, Taylor Swift removed her entire catalog of music from Spotify in protest of freemium, claiming that it devalued her music. Although Apple’s activities have drawn the attention of the U.S. Department of Justice antitrust division, it clearly has no intention of stopping its assault on its freemium competitors, and music labels are optimistic about Apple’s ability to make paid streaming work, given Apple’s deep pockets and brand cachet. But other industry analysts believe that Pandora and Spotify are headed toward profitability as their subscriber numbers continue to expand. Both Universal and Sony registered strong first-quarter results in 2015, driven by streaming services. It is not clear whether the labels are truly skeptical of freemium, or just Apple.
Whether freemium services continue to breathe life back into the music business remains to be seen, but other companies like MailChimp show how freemium can turn a company’s fortunes around.The company lets anyone send e-mail to customers, manage subscriber lists, and track the performance of an e-mail marketing campaign. Despite the powerful tools it gives marketers, and its open applications programming interface, after 10 years in business, the company had only 85,000 paid subscribers.
In 2009, MailChimp began giving away its basic tools and charging subscription fees for special features, expecting that users would be more willing to pay for analytics and other services as their e-mail lists grew. In just over a year, MailChimp went from 85,000 to 450,000 users. E-mail volume went from 200 million a month to around 700 million. Most importantly, the number of paying customers increased more than 150%, while profit increased more than 650%!
For MailChimp, freemium has been worth the price. It currently supports more than 8 million subscribers worldwide, sending about 18 billion e-mails a month. However, Ning, a company originally founded to enable companies and individual users to create their own social networks, tried freemium and came to a different conclusion. Venture capitalist Marc Andreessen, founder of Netscape and co-creator of the first Web browser, launched Ning in 2004. With his assistance, the company raised $119 million in funding. Despite being the market’s leading social network infrastructure platform, Ning was having a common problem—converting eyeballs into paying customers. While 13% of customers were paying for some premium services, the revenue was not enough. The more free users Ning acquired, the more it cost the company.
In May 2010, Ning announced the impending end of its freemium strategy. The company shed staff, going from 167 to 98, and began using 100% of its resources to capture premium users. Since shifting to a three-tier paid subscription model, Ning has experienced explosive growth, increasing the number of paying customers from 17,000 to more than 100,000 and growing revenue by more than 500%. By September 2011, Ning had more than 100 million registered user social profiles and its social networks reached more than 60 million monthly unique users. After its 2011 acquisition by Glam Media for $200 million and 2013 relaunch, Ning continues to charge users a fee after a free trial period, rather than returning to its old freemium strategy.
So when does it make sense to include freemium in a business plan? It makes sense when the product is easy to use and has a very large potential audience, preferably in the millions. Using a freemium strategy can be a very successful marketing tool, because free features can help attract a user base, and are more attractive to most consumers than 30-day free trials that require a cancellation process. A solid customer value proposition is critical. It’s helpful if a large user network increases the perceived value of the product (i.e., a dating service such as Match). Freemium may work when a company has good long-term customer retention rates and the product produces more value over time. An extremely important part of the equation is that the variable costs of providing the product or service to additional customers for free must be low.
Companies also face challenges in terms of determining what products and/or services to offer for free versus what to charge for (this may change over time), the cost of supporting free customers, and how to price premium services. Further, it is difficult to predict attrition rates, which are highly variable at companies using freemium. So, while freemium can be a great way to get early users and to provide a company with a built-in pool for upgrades, it’s tough to determine how many users will be willing to pay and willing to stay.
A freemium strategy makes sense for companies such as Pandora, where there is a very low marginal cost, approaching zero, to support free users. It also makes sense for a company where the value to its potential customers depends on a large network, like LinkedIn. Freemium also works when a business can be supported by the percentage of customers who are willing to pay, like Pandora, especially when there are other revenues like advertising fees that can make up for shortfalls in subscriber revenues. The freemium music streaming services don’t have to worry about their business model being sound strategy, but they do have to worry about industry goliaths like Apple and the record labels taking a stand against them.
Case Study Questions
Compare Pandora’s original business model with its current business model. What’s the difference between “free” and “freemium” revenue models?
What is the customer value proposition that Pandora offers?
Why did MailChimp ultimately succeed with a freemium model but Ning did not?
What’s the most important consideration when considering a freemium revenue model?
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