Freemium business models for the enterprise?

It's commonplace for consumer applications, but can it work for enterprise software?

The Freemium business model is normal for consumer applications, but can it work for enterprise software? Freemium usually means a free service with an "up sell" to paid premium subscriptions. Examples include Skype, LinkedIn, Flickr, Ancestry.com, Typepad, Dropbox, and many others. Freemium differs from Free Trial in that a free trial is the fully functional product but only for a limited time. Freemium is always free, but you can purchase additional features or service for a premium price.

Freemium business models usually involve a Free service, sometimes time limited or feature limited, supported by advertising. The ads rarely cover costs. The goal is to convert these free users to paid subscriptions. Most consumer services start with a $10 per user per month subscription and scale up to $20 or $50 per month based on a small, medium, large usage scale. Enterprise software is also using the Freemium model, sometimes with higher prices commensurate with the power and functionality of the product. They all have slightly different measurements and cut-off points, but most have some notion of small, medium, large.

Most companies see a 1.5% to 5% conversion rates, with most of them averaging around 3%. That doesn't sound like much but they are reaching tens of thousands to hundreds of thousands of users...sometimes millions.

Do the math. 100,000 free users convert to 3,000 paid users. If they pay $50 per user per month, that is $150K a month or $1.8M per year. That is an excellent revenue stream for small startups that typically have 3 to 5 employees. And, it is an annuity stream that continues to grow every year. By the 3rd or 4th year these small companies can be generating $5M to $10M a year, still with less than 10 employees. Most of these small companies don't take Venture Capital so they own the whole company. It is a pretty good cash flow business.

Recently at Google IO I moderated an all-star panel of VCs on the subject of Freemium in the enterprise.
 Making Freemium work - converting free users to paying customers - Venture Capitalists, Brad Feld (Foundry Group), Dave McClure (500 Startups), Jeff Clavier (SoftTech VC), Matt Holleran (Emergence Capital) and Joe Kraus (Google Ventures) discussed strategies for building free products that can be upgraded to paid versions.

Some key points from the panel;

• Your initial thoughts about how much customers will pay, and how much they will pay, is probably wrong
• Start collecting usage statistics from day one, even if you don't have time to analyze them. These stats will help you understand which features customers really use, and what they are likely to pay for.
• Customers tend to optimize for "least surprise" so they tend to purchase a service level one above what they think they will need. Think cell phone pricing models.
• Gmail Enterprise is a good example of an enterprise Freemium product based on usage limits. The first 50 users are free, but convert to paid subscription over that.
• Freemium works best where there is a "network effect" or where more free users contributing content or data makes the service more valuable.
• Put your business model in beta at the same time you put your product in beta. Test several business model scenarios to see what works best.
• Consumers don't pay for additional features, turning off advertisements, analytics, etc...but businesses may be very happy to pay for these things
• Google Apps Marketplace is a great channel to get your product to Google Apps business customers.

Watch the video for more details and insight. This group of VCs has built lots of companies based on the Freemium business model. They have some great insights.