This week I wanted to continue the theme of online revenue models started by Nick in his micropayments post. Rather than looking at emerging trends, however, I’d like to talk about a model that has become a mainstay of online business – the freemium model. The term “freemium” was coined by Fred Wilson back in 2006 and describes a business model where the majority of customers receive basic service for free, while a small percentage pay a fee to gain access to premium services/content. Ideally, the revenue generated by the latter group is sufficient to cover the costs of running the operation, plus a margin to put the company in the black. Examples of the freemium model are plenty across the Internet (think Flickr, Last.fm, Skype etc.), and yet genuine success stories are not easy to come across.

It is this latter issue that I was curious to explore. Why is it that success so often eludes firms seeking to build a business around the freemium model? And what does it take for a company to get the model right? Given that so much has already been said and written on the topic, I don’t expect to break any new grounds here. Nonetheless, here are a few ideas that I was able to piece together. …Just food for thought.

Challenges to the freemium model:

The “free” mindset: In July this year Guy Kawasaki of Garage Technologies ran a panel discussion with young people, ranging from high school kids to recent college grads, on the issue of what they will pay for or may be willing to pay for online. The bottom line – young people are willing to pay for hardly anything on the Internet (including the Internet access itself). With a few exceptions, of course. The two high school kids were keen on keeping their paid Xbox Live access, while all the panel participants said, quite surprisingly, that they would cash out for Gmail but not Facebook. And so it seems that the “digital natives” have grown up with an idea of free Internet mostly as in “free beer” rather than in “free speech”. Now, the million dollar question is whether these attitudes will change as the kids grow up and become “real” consumers, with the spending power beyond their weekly allowance.

Free alternatives: Perhaps, the biggest reason why people are unwilling to pay for online services is that in most cases there exist free alternatives. Let me give you a personal example. A few months ago I was looking for an online project management/collaboration tool to run one of our research projects. I signed up for a Basecamp trial and had become a happy camper for the next 30 days. Towards the end of the trial period, however, I discovered Manymoon, an application that did almost all of the things that Basecamp had to offer but didn’t require me to pay a monthly fee till I reach a threshold of five projects. I didn’t need to manage five projects in parallel and, guess what, Iswitched. This example is also echoed in Guy Kawasaki’s panel discussion. The panelists had agreed that they would consider paying for an online service only if there was no free substitute. …But, on the other hand, they also said that they would pay for Gmail …go figure. I suppose the real issue is in the difference in value propositions between the paid and free alternatives.

Freemium “success factors”:

Value-audience match: Ok, so young people in general are not willing to pay for online services and/or content. But will they pay for anything? As it turns out, yes. According to a recent study by WeeWorld, teens will consider spending their or their parents’ money on (top 3): things that are really fun (34%), things that let them express themselves and their passions (28%), or things that make them look good (13%). Clearly, these drivers will be different for other internet audiences. Consider XING, a professional social network with wide reach in Europe and Germany in particular. XING generates most of its 30 plus million euros in annual revenue from the 5,99 EUR monthly subscription fee paid by its premium members. Obviously, business professional upgrade to premium subscriptions not because it makes them look good but because it allows them to integrate the social networking service into their everyday work in a more efficient and seamless manner. So, in the end we’re back to Business 101 – finding the right value proposition for the right customer or, as Colin Crawford of Media 7 consultancy puts it, “researching the needs of audiences will drive success.”

Process: Going back to the panel discussion, one thing that the panelists had agreed upon was that they would consider paying for an online service only if they first had a chance to try it out for free. Similarly, a recent study of mobile app stores by Admob showed that the top reason for purchasing a paid app was upgrading from the lite version. This, of course, seems like a no-brainer with roots in the “old” marketing idea of giving away free samples. Sure, but nonetheless it is important to consider the psychology and mechanics of free-to-paid conversion in the online context. Consider Wall Street Journal, for instance. Unlike the rest of the ailing newspaper industry, WSJ has been pretty successful in finding ways to make its readers pay for select online content. Its key to success was the gradual process by which the reader is pulled into the “audience funnel” where she progresses from free to registration to subscription to premium subscription levels. This surely sounds a lot more sophisticated than distributing free detergent samples in a supermarket.
In addition, firms need to keep in mind the “stickiness” of many online services. According to Phil Libin, the CEO of Evernote – a successful freemium start-up, the free-to-paid conversion rate for his company goes up from 0.5% after the first month of use to 4% by the end of the first year. In other words, the longer we use Flickr or XING or Evernote for that matter, the greater the value of the service to us and the higher the switching cost. Hence, to increase the likelihood of conversion, firms need to be thinking not only about how to attract new customers to the site but also about how to keep them there for as long as possible, and most importantly – how to keep them active.

Economics: finally, let’s take a quick look at the economics of the freemium model. It seems sensible to suggest that freemium models will not be equally effective across the entire landscape of online business. In fact, in certain cases they may not be suitable at all. This of course begs a question – what criteria should firms be looking at when deciding on whether or not to embark on a freemium business model? According to Michael Mullany of Engine Yard (courtesy of Matt Asay’s post), this decision comes down to evaluating five variables: cost of acquiring paid user, cost of providing service to paid user, cost of acquiring free user, cost of providing service to free user, and the free-to-paid conversions rate. If we assume the latter to hover between 2 and 8%, an optimistic assumption, then for a freemium model to make economic sense, “the cost to serve and acquire a free user has to be from between one-twelfth and one-fiftieth the cost of acquiring a customer under an alternative paid mode” (click the link above for a complete breakdown).

When Google enters a new line of business, it’s a safe bet that this business will get a lot of attention from the technology ecosystem. Micropayments, an already hot trend this year, got a further boost when Google announced two weeks ago that it will offer micropayment services through its Checkout system.

Micropayments are transfers of small amounts of money. Small may mean anything from several dollars to fractions of a cent. Such payments in theory should have a big potential on the internet, where they would fill the gap between free (or advertisement-sponsored) content and things that cost over several dollars. However, several individual areas notwithstanding (iTunes being the most prominent example), they are yet to be widely adopted.

For instance, newspapers are pinning high hopes on micropayments, in the anticipation that they will help the industry get more money for their content. Currently some newspapers run subscription services, while many are advertisement-based. Neither model is fiscally sustainable in the long run, especially as print sales decline. Making online readers pay for each article they read may bring in more money for the newspapers.

The problem with micropayments, though, is that such small sums are impractical for sellers and vendors to deal with. This is because payment processors like Visa or MasterCard charge relatively high fees for each transaction. (For example, for a typical transaction Visa charges about 1.5% of the transaction’s value plus $0.10.) An easy solution is to lump together several small transactions before actually processing them: if a reader views ten articles worth $0.10 each during a week, his or her account would be charged $1 at the end of the week.

While the technical challenge is easily overcome, not so is the issue of ubiquity. A MasterCard is accepted at “millions of locations” throughout the world, according to the company’s sales pitch. By contrast PayPal, an online payment processor that can also handle micropayment transactions, is not widely used outside its owner, eBay. Then there is a problem of trust: would you put your money to an account at an obscure payment processing company?

So Google’s announcement focused attention on the merits of micropayments, Google’s competitive position in this business and the robustness of Google Checkout as it currently stands. On the last count, some issues have been reported with ordinary payments through Checkout. More importantly, Checkout’s market share in online payments is just 11%, compared to 25% each for PayPal and Bill Me Later, another payment processor.

Google expects to give a boost to Checkout by striking a micropayment deal with newspaper publishers. If the deal goes through, it may in a classic blue-ocean fashion give Google access to a newly created market of pay-per-view articles. And why stop there? If Google has its way in a separate deal with book authors and publishers that would allow it to scan millions of books, pay-per-view books may not be far away.

Fundamentally, the advent of micropayments may bring about a new revenue model to the Web. Today advertising remains at the core of business models of many online outfits. Micropayments may offer new ways of extracting money from website viewers and customers—and pricing information along the way. While a pay-per-view Wikipedia is a faint possibility, imagine a medical Q&A discussion board where users ask questions and exchange advice. The most competent answer to a particular question can be priced by the author, who would profit from his or her knowledge. The experience of experts-exchange.com, a programming discussion board that charges subscription fees, suggests that users may be willing to pay for answers to their specific questions.

Now that would make the contribution of micropayments to online business worth more than two cents.