The Freemium Model: Making Money With Giveaways

If you know the rules, there

Want your startup to be a magnet for the eyes and ears of venture capitalists? Think about giving away your service or product. Free. No charge. And it’s more than a gimmick. You’ll attract more paying customers by giving away free stuff than you will by charging for everything.

Skype did it. As Bruce Sterling wrote in Wired, “Rather than bragging about how insanely great its VoIP products are, Skype makes its users insanely productive by letting them talk with any other user worldwide for free. The company makes money by charging users for connecting to phone systems outside of its network.”

It’s called the “freemium” model: Attract users with free services, then charge them a premium for full or special features. The name may be new, but the business model isn’t. Netscape was founded on it. Shareware producers have always used a model like this, and many successful software companies were born of it.

“People love getting something for free,” says George Scriban, an enterprise technology and strategy analyst in New York. “Having a free, yet still useful, version of the service you’re selling is a proven way to encourage rapid adoption among people who might otherwise pass you by.”

The name first turned up on venture capitalist Fred Wilson’s blog in 2006. Wilson is a managing partner at New York-based VC firm Flatiron Partners, which develops and nurtures companies that are shaping the future of technology.

He’d written a post about the model and asked readers to help name it. “Freemium” was suggested by Jarid Lukin of the New York-based content technology company Alacra, and it stuck.

David Beisel, principal at Masthead Venture Partners in Cambridge, Mass., says the freemium model is attractive to VCs for the same reason it’s attractive to entrepreneurs. “Giving away a free version of the service allows consumers to not just learn about it through collateral or a free trial,” he explains, “but it presents them the opportunity to fully adopt the service and incorporate it into their lives.

“Those types of customers are ones who begin to evangelize the product to others. Entrepreneurs then greatly benefit, as powerful and inexpensive word-of-mouth marketing kicks in.”

Barry Graubart, Alacra’s vice president of product management, has spent the last 20 years applying technology to content in developing high-value business-to-business information products. He says the freemium model also gets the attention of VCs because it allows entrepreneurs to easily test and validate their service.

“It’s easier to slap a perpetual ‘beta’ logo on something that’s free, which let’s you test versions and features and gain insights into how they’re used,” Graubart says. “As users begin to pay, it validates the concept and shows that the service you provide is something users value.”

He adds that by giving away the basic service or product, you virtually block competitive efforts to undercut your price. “Once you gain initial market share, it becomes harder to displace you,” he says.

Freemiums are a natural for online services. “A customer is only a click away,” Wilson says. “If you can convert them without forcing them into a price/value decision, you can build a customer base fairly rapidly and efficiently.”

The model also works well in the editorial arena, Graubart says, citing the case of Hoovers. The longtime provider of information about industries, companies and the people who lead them, landed its early users by giving away basic listings, then charging a premium for more content.

However, using freemiums can backfire if the cost of servicing non-paying users outpaces revenue from your premium offerings, Beisel says. “With startups launching without a clear understanding of the upgrade features or the consumers’ willingness to pay for them, there’s potentially negative consequences from relying on a user-base that has been accustomed to relying on everything for free.”

Graubart cautions startups about thinking of the freemium model as transitional. “That’s a recipe for disaster,” he says. “Never take free features away. You can add new features to your premium version, but users are unforgiving if you start to charge for things they’re used to getting free.”

Jackie Headapohl is a freelance writer for StartupNation.

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