BUSINESS 2.0:

Why It Pays to Give Away the Store

Investors are abuzz about 'freemiums' - services that lure users in with a basic product, then charge for more features.

By Katherine Heires, Business 2.0 Magazine

(Business 2.0 Magazine) -- Once upon a time, in the bad old days of business, giving away a product without charge was unheard of. Sure, Estée Lauder (Charts) gave samples to celebrities and Gillette sold its razors cheap and made money on the blades.

But free didn't become a serious option until the Internet gave us low-cost online distribution. Adobe (Charts) did it with its PDF Reader in 1994, Macromedia with its Shockwave Player in 1995. Both became the industry standard, and those companies were able to make money by selling the products' authoring software.

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Running starts: Companies like Six Apart and MySQL are following the example of MySpace and Skype by offering a free basic product and charging for premium service.

In these days of Web 2.0 services that rely on quick customer adoption, the strategy has become so common that VCs have coined a term for it: freemium.

We're talking about companies like Six Apart, which offers its LiveJournal blogging platform for free and has sold 2 million of its customers a premium version, which costs $20 for a one-year subscription.

When the service is free, word spreads

Danny Rimer, the London-based venture capitalist with Index Ventures, has been an enthusiastic investor in freemium-type businesses since 1999. His firm led an $18.8 million investment in Skype, which resulted in a handsome return after the $2.6 billion buyout by eBay (Charts).

Freemium works because "you reduce the main stumbling blocks of product adoption," Rimer says. "Web-based users who don't have to pay for it will often start evangelizing the benefits to others."

Right now Rimer has several freemium-style businesses in his portfolio. He's an investor in music information service Last.fm; MySQL, a provider of open-source database software that has become the second-largest open-source software firm after Red Hat; and Stardoll, a digital doll creator and online community that attracts a largely preteen following.

How can you make your freemium service soar? Here are nine tips from venture capitalists and entrepreneurs.

1. Have a product or service that truly stands out. Its performance, ease of use, and reliability should be superior to those of current offerings.

2. Know your upselling plan from the beginning. Before you even go into beta, make sure you have at least one paid, add-on premium service up your sleeve. Better yet, have more than one.

3. Once you've decided that a product will be given away for free, don't change your mind. "The fundamental 'what's for free' and 'what's for pay' divide needs to be set early," says Adeo Ressi, CEO of Game Trust, a startup that hosts 45 free games and sells enhancements online. If you make changes, Ressi says, you risk alienating customers accustomed to getting your product for free.

4. Access to your product should be just one click away. The fewer time-consuming plug-ins, downloads, and registration forms required, the better. Otherwise people may get bored or frustrated and abort.

5. Make sure the major bugs have been exterminated. Your product can be in beta, Rimer says, but not "so much in beta that it doesn't work well."

6. Harness the collective intelligence of your users. Mårten Mickos, CEO of MySQL, says customer suggestions can help speed up product improvements or inspire ideas for premium services.

7. Keep improving the product to give users more reasons to stick with it. "The reality is that offering a product for free can be far riskier than if you actually charged for your product," says Howard Anderson, a lecturer at the MIT Entrepreneurship Center. "Only one in 10 companies will succeed at pulling this off."

8. Identify a range of revenue sources. The Epocrates service, which offers medical professionals both free and premium access to reference material via PDAs, doesn't charge just for the premium information. It also charges fees to pharmaceutical firms for surveys it conducts of Epocrates customers. Similarly, MySQL makes money from customer service as well as from fees charged to firms that redistribute the software.

9. Timing is everything. Make sure that revenue from your premium service soon covers the cost of your free service. Otherwise, cut your losses and move on to the next startup.

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.