UPDATE: We clarified some of the language in an example we outline in the middle of the post. The numbers are simply samples strictly to show an example scenario that isolates the impact of freemium. If you're interested in running through the math with your own data, let us know.

To note: This post was written during a time in which we weren’t a fan of freemium. Our views have since changed and we now recognize freemium as an effective acquisition model. ProfitWell offers a free metrics tool, which you can check out here.

On May 26, 2006 famed VC Fred Wilson posted the following about his favorite revenue model:

"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."

And thus, modern day freemium was born. Of course as Fred mentions, freemium had been around for quite some time in numerous different forms, from the free calls of Skype to the free storage of Box.net (even before the 2000s software developers have been giving away lite versions on CDs since the 1980s). Yet, at the time of this article, the momentum of freemium began to change from novel to mandatory. Everyone bought into the idea of “just get a bunch of people to sign up and drive them up the river of your plans." Revenue slowly became a secondary goal though with musings of, “we’ll figure out the revenue model eventually” or “we’re just not focused on charging customers right now, maybe in a year or two.”

The success of Skype, Facebook, Flickr, and the like didn’t help, painting freemium as the silver bullet to any entrepreneur seeking a billion dollar exit. Of course, this perspective is a bit gonzo in it’s assertion, but after mentoring some early stage companies at a number of events the past few weeks, we’ve lost touch with the one truth about freemium: it’s a marketing strategy, not a revenue model.

In an effort to clear the misconception around freemium's true purpose, let’s explore why freemium potentially kills businesses, uncover where freemium is appropriate (the big asterisk), before going through some healthy ways to implement “freemium like” pricing strategies.

Freemium is a marketing strategy, not a revenue model

In a freemium model, a business is giving away a portion of the value they’ve created: 1. to gain as much interaction with potential paying users, and 2. in the hopes that the value in a premium tier is so enticing to a customer that they can’t help but drop their credit card digits to upgrade. Yet, pushing a customer up to a premium tier takes an extraordinary amount of intimate knowledge about their behavior and incentives, let alone a direction on who that customer is out of the different personas you could be targeting. Freemium will make your pipeline much wider, potentially leading to a flood, but if your customer and business development aren’t guiding the water through proper canals and ditches, you simply have a disaster of support, hosting, and frustration costs for customers that don’t want to upgrade.

This is why companies like Wistia and MailChimp are around for 5 and 10 years (respectively) before they launch a free plan. By that time they’ve figured out what drives their customers, at least to a point where they’re ready to step on the gas. Essentially, freemium didn’t lead them to being a good business. Being a good business drove them to freemium.

When you launch a freemium plan you should have clarity as to the purpose of that plan and how it will lead to an increasing amount of revenue across your bottom line. You should be so excited that your CTO busts out a legendary rap launching the plan (see Wistia below). It should be an event worthy of a ticker tape parade.

Enough with the philosophical stuff, what’s the data show

OK, all of that was philosophical, so I’m sure some trolls will find some exception or tautology to explain how I’m generalizing and completely wrong. As such, let’s do an impact analysis using some sample data. Let’s say you’re a SaaS company with three tiers and your software pricing as follows:

Let’s make some assumptions for this scenario, too. I repeat, we're making these numbers up to outline a scenario to show some data around the impact on freemium. (If you want to test out the impact of freemium on your own product with your own data, let us know.) You’ve done a phenomenal job marketing your $49 product and start with 100 customers (and 0 customer in the other two tiers), growing the base by 30% while churning at a rate of 10%. You’re also able to move your customers to upgrade at a rate of 5% every month from tier 1 to tier 2 and tier 2 to tier 3. (lots of numbers involved in the revenue modeling...email me if you'd like to go deeper :)).

If nothing changes, at the end of five years, you’ll have 1,095 customers and a run rate of $900k. Now imagine we drop that bottom tier to $0 and hold everything the same.

The result: your $900k 5-year run rate just turned into $380k. 42% of what you could have had.

Obviously, there are a number of factors to consider here and all of these levers can be optimized and improved. Yet, look at the real dollar impact on your long-term run rate with all things being equal, in addition to the costs in supporting and marketing to free customers that haven’t proven they’re willing to pay for any aspect of your product.

Simply put, freemium is not an insignificant cost to your business. If you're not able to optimize any of the above metrics, then maybe you should develop your marketing, pricing strategy, customer, etc. to grow into a freemium strategy. Big customer databases are only sexy if they’re ponying up cash.

The asterisk: where freemium works

There’s a huge asterisk that shouldn’t be overlooked. For some companies, freemium is viable from day one. Although, I’d really push anyone on this claim. Very few of you will be a Facebook, and even then, they haven’t figured out their ideal revenue model. If you want to build a platform, then be a LinkedIn, charging the power users of the network from day one. Social applications and other platforms like Smarterer need to grow their free user base to a point where the data is valuable to a paying user base. That’s perfectly fine, but really challenge yourself to think about creative ways you can charge right from the get go.

If you’re trying to figure out your revenue model, the answer is rarely “let’s give it away for free until we figure out how to charge.” Instead, test different revenue models. Iterate the pixeled dollar signs on the page quickly and see which maximizes cash.

Finally, tread cautiously, but if you can figure out how to embed viral growth into your free offering, go ahead and offer one. Dropbox brilliantly offered a negligible amount of storage unless you tweeted, shared, or signed up your friends for the service. All of those actions correlate to an actual dollar amount in customer acquisition spend, making the shares, invites, and tweets from “free” users actually correlate to real marketing dollars. Just be careful, because it doesn’t work for every product.

OK, I get it. What should I do though?

1. Diet freemium - the free trial: If you’re selling a SaaS product, then don’t be afraid of the free trial. They’re exceptionally valuable in giving a potential customer a taste of the value you’re creating, while not giving away everything and the kitchen sink without an upside.

2. Follow business fundamentals: If you practice the fundamentals, your freemium time will come. Double down on finding product/market fit or at least moving as close to it as possible before flooding the business. Take the time to also find out what drives the customers coming through the pipeline. Usage from current customers is exceptionally enlightening. Plus, you'll be able to optimize retention, upgrades, and costs to a point where you'll be making enough cash to seriously consider whether freemium is for you.

The goal of any business is to create some sort of value that someone is willing to buy. Whether weeks or months go into that first dollar of revenue or your cash flow begins trickling in from day one, someone exchanges cash for the efficiency you’ve created. Business at its core is that simple. If no one is buying, then you haven’t justified your value for that price to that particular customer. Of course, if practice were as good as theory, we’d all be driving maseratis right now, right? Developing your customer and your product takes time and energy. You can still move quickly, but don’t be reckless by giving away the farm. Cash is the real validating king.