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 is 'Freemium', as defined / explained by Fred Wilson back on his original 2006 blog post.

I'm going to start today, breaking down the reasons why companies choose to do Freemium... they are what I like to call the 'Freemium Fallacies'.

Freemium Fallacy #1: Users must have unlimited free access to the product before they will pay for it.

Outside the context of the internet, this sounds completely crazy.  Imagine going to the Mercedes dealership and saying "Hey, I'll need to drive this SL55 around for a few weeks, months, maybe a year before I can *really* know whether I want to buy it"   

You might be thinking, "But hey, my product is not a Mercedes - not to mention the fact that it's not a tangible 'good' that needs to be manufactured".  Well this applies to services too.  Does your dry cleaner wash your suits for free as long as it takes to get you to commit to a 'premium' plan that comes with tailoring?  

Offline businesses have all kinds of great ways to let potential customers 'try before they buy'; test drives, money back guarantees, food samples at Costco (which are so successful that they've inspired this guy to take 1300+ pictures of them and post them on his Flickr) ....

All of the above offline strategies are essentially free trials.  They are normal things.  They work for Ning.  They can work for you.

Ultimately, if your product provides value, people should, and will pay for it.  If your product doesn't provide value, then really, you have no product at all.

Freemium Fallacy #2: Payment is too high a barrier to entry.  If I charge, I won't get enough users.

Let's flip this argument on its head.  Most of your operating cost is going to come from trying to scale.  Large user volume companies like Twitter, and Facebook have to scale and scale.... and scale.  Maintaining this ubiquitous network of distributed systems results in gargantuan operating costs.  Yes, having more users is better for monetization, but it's also a ton more expensive.

One way to look at this is:  You probably want your company to be so huge that it's mistaken for a small moon...  However, building the Death Star costs a ton of money.  And there is a danger in this investment, because while you're focusing on destroying planets you might get taken out by a smaller and more focused attacker.

Ok, so maybe that's not fair.  We're not evil.  We don't want to 'dominate the galaxy' ...  we just want some profit.  

What if you were trying to make a party profitable, but you couldn't charge at the door?  On top of that, you're expecting a massive head count.  You have to feed these people, but you're on a tight budget, so your options are limited.  Additionally, large crowds leave a mess.  How will you even pay for all of this, let alone turn a profit?  

Debt?  Debt can lead to begging, especially if you haven't figured out how to make money yet.  Advertising?  Maybe, but reliance on advertising turns a low barrier to entry into a double-edged sword.  Specifically, in an advertising based business model, your *users* are really your product and *advertisers* are your customers.  As a result, that low barrier to entry you thought was going to be a boon is now diluting the quality of your product!

Believe it or not, there's a simpler way... when all of your users are paying, your *product* is your product, and your *users* are your customers, and you'll need a lot less of them to make the same amount of money (or more!).  Moreover, since you have more money, you can spend it on getting more customers!  Marketing, customer referrals, general hustle.   Invest your time and money in making your product amazing and your customers absolutely ecstatic to be using it.  The rest should take care of itself.

Freemium Fallacy #3: If my product isn't free, I'll never gain market share.

This fallacy is based on the assumption that dropping your price point to zero will tilt the competetive scale in your favor and kill any traditional businesses in your market.  An example that's commonly given is the collapse of Tower Records in 2006.  However, while this diagnosis was made in good faith, it was not made with the perspective of time.  What killed Tower Records in 2006 is the same thing that killed Blockbuster in 2010 and Borders in 2011;  A failure to adapt to technology.  How do I know?  Apple.  Netflix.  Amazon.  Businesses are still making money selling music, movies and books ... but they're doing it online.  For these companies, getting ahead of the technological needs of their customers is what won market share, not giving their products away for free.  Just ask Napster.

Now, we've looked at digital content and media...  what about more traditional offline businesses?

If tomorrow, Reebok started giving away free shoes, putting ads on the sides, and trying to upsell customers to fancy basketball shoes, do you think Nike would follow suit? The answer is no.  If Reebok started offering their product for free with ads and upsells, Nike would rejoice.  Why?

Freemium isn't free (it costs devs like you and me)

Making products and providing services costs money.  Free is not sustainable; Offline companies know that while going free might result in an initial uptick in customers, it would ultimately cause them to crash and burn. This is because the 'free' company would either start nickel and diming their customers, or they would *have* to start charging money outright.  Trust me... users are not fond of compulsory payment for a previously free product.  Why go through that pain?  Just charge them up front for what they're getting.  They and you will be much happier.

Perception of value

When Reebok gives away free shoes, people who really really need shoes and have no money will be very excited.  However, most of their mainstream consumers, and other people who can afford to actually pay for the shoes will instantly have a lower opinion of their product.  After all, how good can it *really* be if it's free?  Let's be honest, wouldn't *you* be skeptical of any offline company who was offering their goods and/or services for free?  You've all had 'Two buck Chuck', right?  Didn't you pretty much get what you were expecting?

The beauty is that perception of value creates a positive feedback loop.  Your biggest hurdle is convincing just *some* users to pay.  Once you start making some money, you can spend that money on improving your product, making your product more valuable.  This in concert with the fact that real people are spending real money on it will increase the market's perception of its value.   The market will percieve your product to be superior, not only because it will be, but also because of social proving...

"Why else would people choose to pay for this one when they could get that one for free?  This one must be better."

Sound familiar?

The end result of this is more paying customers, and the loop is complete.

Ultimately, you can't make a quality product without spending money, and you can't spend money without getting it from somewhere.  Better that 'somewhere' is from your customers.  All they ask for in return is a great product, not advanced ad targeting systems, not 'hockey stick' growth curves, and not interest payments.

Overall, the idea of free sounds great, that's why so many people have done it.  You think you'll be able to get tons of users and make them happy.  You figure, once you've got a huge, happy user base, monetization will take care of itself.  The problem, however, is that there is no such thing as a free lunch.  That's to say, nothing is free - even free things.  Everything comes from somewhere, so be sure you understand your business and market; We're running businesses, not charities after all, so make sure you understand the numbers and that they make sense.

So, we've spent some time talking about why you probably shouldn't go Freemium - let's talk about some reasons why you should go Premium.  I call these the 'Premium Principles':

Premium Principle #1: Paying customers will like you better.

Interestingly enough, folks tend to feel more affinity towards things they own or have purchased, despite their actual comparative value or quality.  There's a fair amount of psychological research to back this up.  Consider this excerpt from a paper in the Journal of Experimental Psychology:

Decades of work on cognitive dissonance theory (Cooper, 2007) has shown that people value what they choose simply because they chose it (Brehm,1956), and indeed, when people choose Alternative X but are led via a clever experimental technique to believe they chose Alternative Y, it is Alternative Y—and not Alternative X—that increases in value (Johansson, Hall, Sikström, & Olsson, 2005).

- From Bad riddance or good rubbish? Ownership and not loss aversion (Morewedge, Shu, Gilbert, Wilson, 2009)

This is the fancy academic explanation for the fact that your uncle keeps insisting his camera is the best, despite there being newer models with better features, or the fact that your dad keeps buying the same brand of car despite the fact that it's constantly in the shop.  This is not to say that your product should suck; On the contrary, if you keep disappointing your customers, enough of them will leave that it will cannibalize your new customer acquisitions, leaving your growth flat or on the decline.  The point I *am* trying to make here is that psychology is on your side... once you can get them to pay.

Premium Principle #2: It pays to make paying customers love you.

One of the best things you can do when your customers *sort of* like you, is to invest in making them *really* like you.  Specifically, you should have legendary customer service.  Great customer service serves three main purposes:

Rewarding Commitment

A paying customer has committed to you in some sense.  They're trusting you with their hard earned money to give them something of value.  This is yet another reason why paying customers are better than free users;  They're generally more loyal and reliable.  Best to make them feel like the feeling is mutual, and that you care about their needs, even if you have to disappoint them from time to time.

High Customer Retention

Customer churn rates are way more deadly than most people realize.  Losing 5% of your customer base per month means you need to grow by nearly 60% over the year just to break even.  Why do customers leave?  The answer almost always has to do with poor customer service.  Stop losing customers!  

Keeping your retention rates high (churn rates low), means a higher lifetime value per customer.  The more confident you are in your customer's lifetime value, the more money you can spend per customer acquisition, and it becomes a self-reinforcing cycle.  The most successful subscription businesses in the world have customer acquisition costs only marginally lower than the lifetime value of their customers.  They can do this because they're super confident in their projections.

Word of Mouth

This is the kind of virality that fills your bank account.  Paying customers being so impressed with your service and product that they actually promote it to others without prompting.  The aggregate result of this effect is a lower cost per customer acquisition, since you're getting some of your customers without breaking a sweat; Directly, anyway.  When free products go viral and scale up, it's great, but you end up having higher costs and you still have to monetize.  When paid products go viral, you have real money coming in that you can spend on servers, engineers, and anything else you need to support your growing user base.

Bottom line:  Every dollar you spend taking care of your customers is a dollar very well spent.

Premium Principle #3: People are happy to pay for value.

From the roof over your head, the car you drive, the devices you use, the TV you watch, down to the the food you eat, and the magazines you read - you pay for things that provide some value to you.  All you need to do is look at companies like Zynga to know that people will pay for things, even virtual things, that they find to be valuable.   But, people don't just pay for "things", they pay for convenience, they pay for peace of mind, they pay for feelings.   While this seems basic and obvious, it's so vital to understand because of what it means.  It means that if *you* can create something that people find valuable in some way, *they will* give you money for it.  

Is your app more valuable than a Snuggie?  Does your service provide more convenience than valet parking?  Does your product make people happier than a singing greeting card?  These are all things that people pay for everyday.  There's no reason they can't be paying you, too.

Once you start viewing your product this way it changes the way you make decisions.  Specifically, every time you change or add to your product, you should be thinking: 'Is this making my product more or less valuable?'.  You'll find that the answer to that question and 'Will this make more money' are almost always the same. The correlation between product changes and your bottom line is a perfect introduction to my fourth and final Premium Principle...  

Premium Principle #4: Your business will be the most successful if you invest in what you can control.

Generally, you should strive to have most of the factors that affect your bottom line under your own control

When you're solely relying on virality and advertising revenue (which only really works at scale), you're kind of out of control.  You'll be frustrated mostly because so much of your money and hard work will be dedicated towards things only indirectly related (if at all) to the amount of money you make.

To put it another way, relying on virality, advertising revenue and scaling for your business to be successful is tantamount to taking your investors' money over to the casino.

Imagine taking your money over to the roulette table and putting it on 00.  Now imagine that the odds are three times as bad, the return is a third as good, and the money is also your blood, sweat and tears and that of everyone who works with you.  Would you take that bet?

Stop gambling with the future of your business!  You can't control what advertisers do, you can't control what users do outside of your product.  You *can* control prices.  You *can* control customer service.  You *can* control your product.  Let *these* be the pillars of your business.