Earlier this week Fred Wilson (with Jarid Lukin) coined the phrase “Freemium” for the business model described:

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 model (a free tier of service upsold to a premium) along with a “pure” ad-supported appears to be the two primary revenue-models for the recent emerging crop of web services. Why is this situation and what do these two models have in common? The answer is that they separate the initial delivery of value to the customer away from the ultimate monetary payment corresponding to that value. This time lag minimizes the risk involved for the customer, thus prompting increased usage.
Take the case of ad supported content and services. Value is delivered to the consumer in conjunction with advertisements. It appears “free” to the user, but a certain percentage of those ads will entice consumers to ultimately make a purchase based on the messages contained within. Thus, the monetary payment (i.e. cash out of the pocket) doesn’t occur until further in future, seemingly dissociated with the initial value-transfer. As opposed to explicitly paying funds ahead of receiving the value (before s/he knows the “true” nature of what s/he is going to receive) or afterwards (when s/he is less happy to do so since the value has already been received), this dissociation both reduces the risk involved in paying up front or the reluctance to do so afterwards.
On the model of “freemium,” the thinking continues along the same lines. Risk is mitigated by the user because s/he isn’t paying up front. It isn’t until the consumer is comfortable with the relationship where s/he is ready to overtly pay to upgrade it. And by this point, the initial value delivery is in the rearview mirror because the connection between customer and service-provider has strengthened in the meantime. Again, the separation of initial value-delivery from eventual payment helps both parties – by alleviating risk for the consumer and building loyalty/allegiance for the business.
One could perhaps take this thinking and apply it to other technology-enabled services outside the consumer-facing realm (i.e. isn’t enterprise SaaS really transferring the traditional upfront payment of technology prior to value-delivery and spreading it further into the future?), but that’s the subject of another (somebody elses?) post.
The theme is the same: with the abundant number of technology-enabled services and content available today, customers want to mitigate risk in the usage and purchasing of them. By apportioning the clear payment associated with the value away from its initial transmission, business which do so address this need, fostering viral spreading, usage, and loyalty of their service.
(Thanks to Mark Withington of the Boston PHP group who inspired and helped generate many of these thoughts in our discussion yesterday.)