A freemium cookbook for your company

July 15, 2009 | Alex Wilhelm

Business models are a tricky subject. There is an old saying among entrepreneurs that there is no real value to writing down your business model, as it will have changed by the time you commit it to paper. The joke has truth to it; I can personally attest to its veracity. But there is something brewing in the larger world of Internet business models that has wide implications: freemium.

Fred Wilson, famed VC and blogger, originally came up with the general concept of freemium, which he explained this way:

Give your service away for free, possibly ad supported but maybe not, acquire a lot of customers very efficiently through word of mouth, referral networks, organic search marketing, etc, then offer premium priced value added services or an enhanced version of your service to your customer base.

This concept, building an audience, then implementing paid features as later expansions, is slowly becoming the de facto model for online companies. Of course, there are many successful Internet companies today that avoid it entirely. However, they all seem to lose money. Digg, Twitter, and the other media darlings of the Web 2.0 world still live in red ink, even after scaling to mass market size.

This has direct implications for companies today that are migrating parts of their entire business to the Internet. To modify the colloquialism of the Internet that “traffic is the new revenue,” the road to profitability seems instead to be “revenue is the new revenue.” Or, as David Hansson put it delicately to people working on the Internet, “Charge a price!”

This is critical for nearly all companies that have an Internet presence. The building43 site is about helping people succeed online, and if you are attempting to take your company or product to the Internet, I have a few tips on how to do it successfully, a “freemium cookbook,” if you will.

To begin with, a company working from the freemium model does not monetize from day one. Instead, the company, as Fred Wilson said, must first acquire a user base. Do this in the way that best fits your product and market.

How do you know when you have a large enough user base to begin charging? The rule of thumb that I live by is that when your organic traffic (from search engines, write-ups, and direct traffic) is greater daily than your visitors generated by advertising for a full month, you are ready. At that point your product is by definition viral, and you have enough momentum to carry you over the pay wall.

The next step is not to charge for what you already have, but to implement a new round of features, capability, scale, speed, and power to your product. Once you have this second round of features, take about two thirds of them and put them behind a pay wall. The remaining third should be released to your free-user community. Always remember that your free users are the feeder stock for your paying users. You must continue to attract new users to your free service if you want your product to thrive.

The pricing of your first payed tier is difficult to set. My advice is to keep it low when you put in the first paid option.

When he introduced GigaOm pro, Om Malik put the cost at a very affordable $79 per year. You can bet that this price will rise with time. But Om is generating his first paid-user base, with which he can further expand his service offerings to either create a second, higher-paid tier, or enhance his single tier, and charge more for it.

From this point forward, with your freemium architecture that has one or two paid levels in conjunction with the free level, you must continually expand your total product offering. This means that you are in a cycle of continuous improvement. However, once you have had your freemium system in place for some time, you must change your feature concentrations.

Given that a growing percentage of your free users should by this point be converting to your paid levels of service, you must put new focus on paid customer retention. Recurring payments are the best form of cash flow in business, both offline and on, and they must be protected. With that in mind, change your feature releases to 80 percent paid and 20 percent free. This is sufficient to continue to attract free users, but will keep the paying users ecstatic with a constant flow of new capabilities.

At this point, you do not need to be looking for an exit strategy. In fact, you never do. Companies that successfully implement a freemium model have excellent cash flow. The Internet bubble ideology of quick exits is not a realistic goal until you have tens of millions of dollars in revenue. At that point, go for it. Until then, focus on revenue, profitability, and product quality.

Of course, there is no single model or plan for every business, but the general freemium concept of building an audience and charging later for advanced features works. It only works due to a basic component of online business: cheap distribution. Because bandwidth is cheap compared to physical distribution, you can afford to share with the masses, even running your free operation at a loss to get customers for your paid service. With cheap distribution, the losses are small.

Freemium has become the shiny new thing mostly because it works. It combines the inherent advantages of the Internet with the classic business sense of the bottom line. Of course, freemium has its detractors; the recent publication of “Free,” by Chris Anderson, has produced even more advocacy for not charging for your product or service. While in the rare case this is a long-term model, the freemium method uses the best aspects of free, with solid business concepts.

Alex Wilhelm is a technology blogger and entrepreneur. He is a co-founder of Contenture, an online payment platform handling small recurring payments, and blogs at TechGeist.net. Alex can be reached on Twitter @Alex.

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