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WiredMany websites and web applications today use the “freemium” model to provide services at a certain level free of charge, then offer more advanced functionality, additional storage or bandwidth, elimination of advertising banners, or other new capabilities, but at a cost.

Similar to the shareware model of the 1980s, freemium services offer something to try or use without out-of-pocket expenses. These days, the freemium business model is used for applications, games, and services, often delivered via the web. Freemium as a business model can work, but there are some issues to consider whether it’s the right model for you as a user or customer.

The first problem is that in reality, the numbers often don’t add up. Similar to the shareware business model, people are often satisfied enough with the free version to never upgrade to a paid version. Either the feature set with the free version works well enough, or putting up with advertising or repeated sales pitches aren’t intrusive enough. For services and applications we often use freely (e.g., email services), many of us have trained ourselves to simply ignore the space where ads appear.

Also, people can be highly creative and change their behavior to fit a limited feature set, making do with what is available. The statistics on the number of people who actually pay for a freemium service can be extremely low — conversion rates range from 1-2% to maybe 5% of the entire universe of users. Some may be able to claim higher numbers, but they seem to be outliers. Ideally, the marginal cost of adding users is low, but doing the math, you’ll see that you’re going to need a lot of free users to generate sustainable revenue.

The second issue I see with a freemium model is that the growth of the service can be a double-edged sword. During the dot com boom in the late 1990s/early 2000s, “getting eyeballs” was an often-cited goal — often because of advertising opportunities, but really it just provided a stable of people who could be a target market. Today, many freemium services focus on additional functionality, bandwidth, or storage space to entice users to upgrade. As the number of free users grows, service providers have to build out larger data centers with more servers, storage, and bandwidth in order to handle the increase in demand. This can be a costly proposition.

As Box prepares itself for its IPO, it is generating revenue, but it is spending money even faster, and unless it really ramps up more paid users (or increases the price, which could negatively affect the conversion rate) it will not be able to cover the gap. The few people who do upgrade and pay for additional features end up subsidizing those on the free version. And because the conversion rate from free to paid can be so low, it’s either unsustainable and the service shuts down, or the paying users end up disproportionately paying more to cover the free users.

While freemium may work for consumer products and services with a low-touch sales model, enterprise/B2B customers often want to talk to a real person to understand requirements, make sure they will receive business-class support, work through the various anomalies that are inevitable in a large corporate user group, and build a real relationship and partnership with their vendor. This higher touch sales model can also add to costs.

Freemium services certainly can work, but there can be obstacles to success. Companies transitioning from a B2C freemium to a B2B freemium model may find it more difficult. A company that has always focused on the B2B space may have better sales and support infrastructure, but may also find that the burden and cost of maintaining a large free customer base can result in an unprofitable service.

Perhaps a better alternative is to offer services at a reasonable price where people feel their economic value exceeds that price and where the service provider can sustain its business and continue providing those valuable services for a long, long time. If the application or service is valuable enough, solves a thorny problem, or improves the efficiency of an existing process, people will be willing to pay for it. That’s a truly win-win situation.

Bill Ho is President of Biscom.

http://insights.wired.com/profiles/blogs/is-freemium-really-free#axzz30xo2qsoN