In a number of internet market segments (gaming, content distribution, security, performance enhancement), participants seek to lower the cost of customer acquisition through giving away a starter version of the product and offering a paid enhanced version. Often the board room debate centers around the cost to provide the service (bandwidth, storage, support), marketing, and the conversion rate to an enhanced version that is a gateway to the paid model.
It's important to differentiate between companies that focus their energies around the conversion from free to paid, vs. vendors who concentrate on 'free' to use, but are advertised supported. The later really support themselves via an attention tax that users pay each time they use the product. The beauty of this tax is that, for vendors such as Google, the tax, when properly implemented is not too obtrusive, and adds to the overall user experience.
Chris Anderson posted an insightful article in Wired that discusses his views, with a link to MMMPOW that cites statistics in the gaming market. Per MMPOW, here are conversion rates from free to paid for select successful vendors in the casual gaming arena:
* Club Penguin: 25% monthly uniques pay, $5/mo per paying user
* Habbo: 10% monthly players pay, $10.30/mo per paying user
* Runescape: 16.6% monthly uniques pay, $5/mo per paying user
* Puzzle Pirates: 22% monthly players pay, $7.95/mo per paying user
These are way higher than my experience in horizontal business segments, which mostly do not have the benefit of strong community (anyone know LinkedIn conversion to paid?), where a 2% conversion rate is considered successful.
For awhile, the software and internet industry went through a phase where vendors placed an 'annoyance' tax on users of the free product by bombarding them with pop-ups and other annoyances as a way to improve the conversion percentage. Thankfully, competitive realities have minimized this practice as building negative brand equity is ultimately a poor practice (I wonder if today GM feels their planned obsolescence was a good thing?).
Overall, many mail vendors have done an outstanding job of striking a balance between value offered for their free products and garnering revenue for themselves. In their business, it takes a tremendous amount of capital to subsidize horizontal and global applications, before the business can generate positive gross margins through advertising and upgrades. So much capital that the innovation bar is now so high that entrepreneurs must really be doing something special to succeed here.
I am intrigued by the free/paid line in the security and performance enhancement market where Anti-virus, firewall, registry cleaners, disk maintenance vendors, amongst others, have mostly embraced a free to paid model. Sort of like going to the dentist for a free cleaning, with expectations that they will garner the later root canal work.