Why Freemium Works For Software

(MoneyWatch)  Chris Anderson's most recent crusade, which he makes in The Future of a Radical Price, isn't actually very radical. However, his conclusion -- which is that businesses should embrace "free" as a pricing concept -- has triggered several rounds of arguments among finance writer Malcolm Gladwell, venture capitalist Fred Wilson, fellow blogger Phil Wainewright, and Anderson himself.

Wilson's argument, which is not in dispute, is that entrepreneurs can enter a market with a free offering because the costs of doing business online are relatively low. What's in dispute is how to turn that start into a revenue-generating business -- a process Wainewright equates with something between magic and bait-and-switch. "The trick is to target the right free users to yield a sufficiently lucrative conversion rate," he writes. But Wainewright's point-of-view is skewed from the get-go; he thinks businesses offer free products either

because the idea of asking people for money makes them uncomfortable, or because they haven't the vaguest notion of how to go about building a charging mechanism into their website (vide Twitter, Facebook, etc).

If the latter were really the case, they could simply use Google Checkout.

No, free isn't a liability or a defect -- it's an asset. Now that businesses, especially software businesses, can offer their products online (as a service), they've conquered arguably the hardest hill they have to climb, which is getting their offering in front of potential customers. A great example of how this works is Intuit, which generated $3.1 billion in revenues last year despite giving away a great portion of its software. It offers its QuickBooks accounting software free for up to 20 customers; however, once a business grows beyond that limit, or wants ancillary services like being able to email reports to an accountant or specialized reporting, it has to pay.

Similarly, open source enterprise software vendor Red Hat doesn't charge for the actual application it distributes, but rather for "aggregation, integration, testing, certification, delivery, maintenance and support," which it defines as the true value it provides its customers.

That said, turning free into profitable dollars isn't child's play. Jeff Kaplan, principal analyst with THINKstrategies, noted two requirements to making this work, which can be summarized as: "know thyself" and "keep it simple, stupid." Or, in Jeff's words:

1. "The whole premise hinges of being able to determine what you can give away and what crucial value proposition is going to allow you to convert free customers to paying customers."
2. "Freemium requires a frictionless operational process because you can't be expending a significant amount of labor to power that aspect of your business. So you have to allow customers to self-provision a portion of your capabilities."

Clearly Freemium in high tech wouldn't be so controversial if it didn't directly affect the people writing about the industry. The argument has raged in large part because most of the people doing the arguing have a huge stake in the outcome: advertising revenue, which has subsidized publishing since forever, is slated to drop by 8.5 percent worldwide this year. I doubt that Facebook CEO Mark Zuckerberg or Twitter co-founders Biz Stone, Jack Dorsey and Evan Williams have issues asking for money or even coming up with paying business models. In fact, Zuckerberg recently noted that Facebook has five quarters of EBITDA profitability, generated 70% revenue growth year over year, and will "be cash flow positive in 2010."
But free has always been a part of doing business. ("Doing business" is how we called it until business schools brought us the "business model.") The novelty is how much more use technology companies can make of that asset by using the Internet as a distributor.