Freemium is a business model popular in the digital world, in which a company offers its product or service to the consumer at no explicit cost – for free – and then offers a premium version of that product or service at a cost, understanding that only a percentage of consumers will opt to pay.

Q. So this is an extraordinarily popular business model concept in the digital world. Can you explain it?
A. The term goes back only a few years, but it describes a big percentage of new company business models. The idea, which in some ways sounds trivial, is to give away your core product or service, drive massive usage of it, and then offer a premium service that some % of the users will choose to buy.

Q. OK, and why is it so popular in the digital world?
A. Several answers. First, very obviously, the best way to get people to try your product is to give it away; and in a world where first mover advantage can be so important, time is more valuable than money. Second, there’s the basic economic truth that the per-user marginal cost to these digital companies is almost zero… as compared, say, to a company selling physical goods, where the same idea would be attractive but you can’t afford it. That is to say, you do it because you can.

Q. And, given how popular it is, I guess you’d have to say that it works?
A. Definitely some of the most successful companies have used it. Linked-In is a good example: basic service is free, but then there are several things that you might pay for: premium access to other users, an executive search function. Etc. With these sorts of “Freemium” models, a small percentage of your users winds up generating nearly all the revenue.

Q. And other there other kinds of “Freemiums”?
A. Yes, there are different flavors. For example, sometimes a company will offer free usage up to a given point, sort of getting you hooked, but cap the amount you can use for free. Dropbox is a good example of that. Not a different feature, just a usage limit.

Q. And what are the big problems to look out for, if you’re an investor or entrepreneur looking to use this approach?
A. The so-called “penny gap”. Turns out that the hardest thing is getting a customer to pay you that first penny… it doesn’t matter how cheap the additional service is, getting any conversion at all is tough. There are still an awful lot of “freemium” companies out there with lots of users, looking for the feature the users will actually pay for. So you can’t assume that you’ll “just figure it out” later.