Industry players have launched many services based on "freemium" business models – where the free service is to hook users into the service to the extent they become willing to pay for it. But most freemium sites have had lackluster results with users just not willing to dig into their pockets.

Even some of the most popular freemium sites, including business social network LinkedIn and note-taking service Evernote, have failed to convert more than a few percent of users to pay for premium services – LinkedIn has managed to convert about 1 percent of its users, while Evernote has been mildly more successful with 3 Martin Scottpercent. They may be great web applications, but these conversion rates aren't likely to lead to solid profitable growth.

These sites support the myth that only a small percentage of customers will pay for services if they're used to getting it for free. However, online music streaming site Spotify has a conversion rate of 9 percent of registered users – 15 percent of its active users. This is not only impressive, it is essential in order to secure a prosperous future.

So what makes Spotify so successful?
We believe mobility is driving take-up of premium upgrades within Spotify's freemium revenue model. The European site is expanding rapidly – it announced the sign-up of its millionth paying subscriber on March 8, 2011, and is due to launch its services in the U.S. later this year. Its current conversion rate of 9 percent is up from just 3.6 percent at the end of 2009. Analysys Mason estimates the company will report revenue of about $78 million for 2010 – almost five times its 2009 revenue.

Spotify offered just two versions of its service – Spotify Free and Spotify Premium – when it emerged from its beta testing phase in October 2008. Spotify Free was supported entirely by audio and banner advertising, whereas Spotify Premium contained no advertising and was priced at $13–$15 per month, depending on which country you were in. The company now differentiates the premium service from its free counterpart (and its later, more-limited incarnation, Spotify Open) by offering playback on portable devices, offline playback, higher-bitrate audio, access to selected music tracks before general release, exclusive content and some other bells and whistles. It is these services that the premium user is paying for. So it should come as no surprise that the most significant inflection point in the take-up of Spotify's premium services was the introduction of support for iOS and Android-based handsets in September 2009 (See Figure 1).


So how can other freemium sites replicate Spotify's success?
Firstly, they need to reserve the mobility offering for premium customers – as it is the ubiquitous availability of mobility that drives adoption of the premium service. Some providers offer mobile versions of their freemium services, giving mobility to free as well as paid-for services. As a result, their premium subscriptions merely offer access to the same premium services on the mobile application as are available through the desktop interface. Spotify, however, sensibly reserved this service for its premium customers.

Secondly, they need to innovate on top of the mobile platform. Great innovation is possible on mobile platforms, in the form of tighter integration with the handset OS. Spotify has begun to do this by, for example, waiting until users are in Wi-Fi coverage to download playlists to limit 3G data charges and it works without any cellular data coverage, which is essential when services are patchy.

This innovation can be taken further as a way to differentiate premium services from free ones. Other freemium sites – such as Flickr and LinkedIn – could innovate in this way. Flickr users, for example, would be able to automatically upload all the photos they take on their handsets to private folders on the site and LinkedIn's location-based services, for example, would enable users to see a list of LinkedIn contacts who are in the same conference hall as them. Innovations such as these drive additional future revenue opportunities and create stickiness for the entire offering.

Lastly, they need to ignore the maxim that advertising-generated revenue is the only way to make money on a freemium business. By our calculations, a Spotify Premium customer generates more than 60 times the revenue of a Spotify Free customer's advertising-related revenue. We estimate that Spotify had about 10.3 million registered users by the end of March 2011, of which 9.5 percent will have taken up premium services. (This share will be increasing at a rate of about 0.5 percentage points per month at this time.) Although the free, advertising-supported services account for the majority of users, they are the smallest share of Spotify's revenue. Based on the pricing of Spotify's service, reported 2009 revenue and our modelled subscriber numbers, we calculate Spotify generated about EUR 65 million in revenue in 2010, of which 77 percent came from the premium service (and 9 percent of users) while just 23 percent came from the advertising-supported service (and 91 percent of users).

Shattering the myth
Spotify has disproved the dreaded maxim that only a very small percentage of customers will pay for services when a free-to-use service is available. Daring to buck the trend is both difficult and frightening, but applying a similar strategy to Spotify's – to mobilize and innovate – will prove to be sound business judgement to entrepreneurial types willing to take up the challenge.

Martin Scott is principal analyst at Analysys Mason and based in the U.K.