Is free the way to sell an app?

Of the top 10 grossing apps in Apple's (NASDAQ:AAPL) App Store in June, six are free. In the Android market, eight of the top 10 grossing apps in June--including all of the top seven--are free. If mobile gaming is a multi-billion dollar industry, then how are developers making money from free apps? And if so many apps are free, why would users pay for apps at all?

TeamLava's mobile apps (pictured) are free but offer in-app upgrades.

The answer to these questions lies in a business model that straddles the line between free and paid. Dubbed "freemium," a portmanteau of free and premium, these apps offer some services for free, incentivizing users to try an app before paying for additional features.

The freemium model isn't a new concept. Consider VoIP calling service Skype, a free, ad-supported program that provides free calling between Skype users but charges for calls to landlines and mobile phones. The same goes for online video company Hulu, which allows users to watch television for free online but charges for access to a wider variety of older programs. Freemium services can succeed due to add-ons that provide a continued stream of income, much in the way a magazine or newspaper subscription works.

"If you have a service with the potential for a regular revenue service, then it would be stupid to give it away for free," said Windsor Holden, an analyst with Juniper Research.

What makes it freemium?

In the mobile world, offering a freemium app can be advantageous. Users are more likely to download a free app. If the user is impressed with the app, he or she can pay for additional content, such as an ad-free version of the same app, additional levels, in-app items or virtual currency.

The primary source of income for many freemium apps is in-app downloads: items within a game or application that the user pays for while using the app. In-app downloads include usable items such as special weapons for Mortal Kombat and decorations like wallpaper or chairs in Café World.

"It's safe to say that in-app purchases are becoming quickly the favorite monetization mechanism on the app store," said Bertrand Schmitt, CEO of App Annie, a mobile application analytics firm. But Schmitt noted that the success of in-app purchasing varies by country.

A new study from Flurry found an increasing number of freemium apps populating the top 100 grossing games list in Apple's App Store. The number of freemium apps in this category jumped from 35 percent in January to 65 percent in June. 

Many of the top grossing apps designed for Android and iOS leverage the freemium model. For example, in TeamLava's Restaurant Story free game, the user runs a cafe, cooking various dishes that require different amounts of real-time cooking. Users must promptly take goods out of the oven or off the stove and serve them to customers, so it is important for them to regularly return to the game in 5 minutes, 3 hours, 2 days, etc. Buying game add-ons can speed up the process of leveling up or reverse mistakes a player may have made (such as waiting too long to log-in and burning a cupcake or letting a dish spoil). By this method, these types of games win either way. If a user returns frequently to play, they are exposed to more ads and are more likely to purchase add-ons. If the player is unable to log-on as often, they may purchase add-ons to upgrade their restaurant. Apps like these comprise eight of the top twenty highest grossing games between the Android Marketplace and Apple's App Store.

Another type of freemium model simply uses ads to supplement the lost revenue. Hanging with Friends, a Zynga game, and Scrabble are both word games that offer the same content in two forms: free and paid. The games are essentially identical except for the additional ads in the free version. The ads, however, require the user to be playing in an area with 3G service or Wi-Fi, even in one-player mode. The ad-supported free version encourages the user to upgrade to the version without ads.

Halfbrick Studios' Fruit Ninja and Chillingo's Cut the Rope offer free versions with fewer capabilities. Fruit Ninja Lite, for example, only allows standard play; the premium version includes arcade play, Zen mode and a multi-player option. Users are able to taste the lite version and are then more likely to buy and continue using the freemium version.

GetJar CMO Patrick Mork noted that these types of apps are doing well. "Consumers download the game for free, and they can progress and game through the game for free, but then if they want to get certain powerups or buy certain items or access certain levels they have to purchase those. Those models are successful as well."

However, venture capitalist Fred Wilson warns developers to "make sure that whatever the customer gets day one for free, they are always going to get for free. Nothing is more irritating to a potential customer than a 'bait and switch' or a retrade of the value proposition," he wrote on his blog AVC.

App	How it works	Example	Image
Ad-ons	Users pay for extras	Smurfs' Village
Gambling	Users pay for chips/currency	Texas Poker
Lite Edition	Pay to access the full version of the game	Fruit Ninja
Pay-to-Progress	Users can buy tokens to engage in more in-app activities per day	Zoo Story
Subscription	Users get a free trial and pay for how long the app is active	McAfee WaveSecure

When does this model work?

For the most part, the apps and types of apps that are popular in the Android Marketplace are similarly successful in Apple's App Store. Distimo analyst Gert Jan Spriensma, however, sees developers profiting more from Apple's App Store. He explained that the average Android user does not download as many paid apps as the average iPhone user. Spriensma notes that there is no paid version, for example, of Rovio's super popular Angry Birds game available in the Android Market.

The iPhone app market for freemium apps is growing rapidly. App Annie found that iPhone app revenues coming from apps with in-app purchases increased 301 percent in May 2011 compared with July 2010. Worldwide in-app purchase revenues increased 360 percent.

In addition, App Annie looked at the top 100 apps by overall revenue, and the number of apps with support for in-app purchases grew from 33 in July 2010 to 66 in May 2011.

Smurfs' Village offers in-app purchases that can cost up to $100.

The biggest freemium app successes are often social games, like Zynga's collection of "ville" games (Farmville and so on). These games, in addition to charging for add-ons, require the user to invite friends to play with them in order to complete certain in-game tasks and to proceed with game play. This method draws in additional users, adding to a game's popularity. Zynga, itself, has proved to be a monster success, and recently filed for a $1 billion initial public offering.

So which users are doling out cash for these types of games? Contrary to popular opinion, these types of games are becoming increasing popular with older uses. Flurry published a survey in February finding that the majority of social-gamers were women aged 18-49. The study surmises these games are attracting older users with steady incomes who are more likely to afford more expensive smartphones than teenagers or young children.

The bottomline

So what is the likelihood that a user will spend money on a free game? Spriensma explained: "An average application in the top 300 most popular free [category] is downloaded about 10 times as much as an average application in the top 300 most popular paid [category]. [And] with high conversion rates, freemium is favorable."

However, he notes that these are just averages and that some apps, like WhatsApp Messenger, probably does better offering only a paid version as it is more likely to keep the user engaged with the app.

For developers offering free and paid versions of an application, there needs to be an incentive for users to upgrade to the premium version, or users will stick with the free option. Flurry found that only 0.5 percent to 6 percent of users spend money on free apps; however, those that do often spend much more than the price of a traditional app, with some players spending "tens of thousands."

Freemium app users are not charged a fixed price, allowing for a range of revenue options, which may or may not be as profitable as charging a fixed price upfront.

Holden explained: "If it's not likely to be an app that engages the user over an extended period of time, you're better charging off upfront." He added: "The vast majority of apps do not have that level of stickability; it has to be a very special kind to justify that."