Free as a marketing gimmick is not new -- Gillette created a demand for disposable blades by giving away the razors for free in 1905.  There are different ways of incorporating free into your business -- free samples, a free gift with purchase, free shipping, wooing evangelists with free stuff -- then there's the "freemium" model: give your product or service away for free to gobs of people and entice a small percentage of the users to upgrade for premium access and functionality.
Freemium in the social media age is the inverse of the free-sample standard. Rather than giving away one cupcake in order to sell 12, you give away 12 memberships in order to sell one. You have to be careful with samples, they have a cost. But digital media is next to free, so the concept goes, so you can give an infinite amount away!
But next to free still has a cost, and the cost may include a negative perception of the value, or practical issues like an increased need for staff and support.
Free is seductive and intoxicating both for the consumer and the business person like you and me. So be careful. Free is a strategy and the freemium model requires constant adjustment in order to be financially viable and to maintain the integrity of your product or service.
If you are considering a freemium business model -- particularly a freemium membership subscription model -- beware the challenges.
The most obvious challenge is revenue & profitability, but profitability can be adjusted in other ways, so let's get this one out of the way first. If your premium fees cannot support your business, revenue can be supplemented with things like affiliate marketing, special events, products, or advertising (though that's a maybe -- and a different conversation). You can sell the personal data of your customers (ahem, like Facebook) and the powers that be may value your company at 100 b-b-billion dollars.
The more critical challenges are related to the impact a freemium model has on the perceived value. (Especially with a freemium membership community). Thus Challenges 2, 3 & 4.
When your community is small, people will pay to be at the top of the list. As the community grows, there's still value at being at the top, but if the percentage of premium users grows at the same rate, the top of the list gets very crowded.
It's like paying for access to a VIP lounge. One of the principle attractions of the lounge is the exclusivity. Those outside the lounge see who's inside the lounge and aspire to join them. When the lounge grows to the size of a football stadium and no one stands out any more, it diminishes the value of the lounge.
You can create niched-lounges, but then there's...
Some people will stop paying for the VIP lounge because the VIP lounge is too crowded. Others will stop paying for the VIP lounge because they see a large mass of people who seem to be satisfied with not being in the VIP lounge.
The influence of a group en masse, grows as the group grows. When gobs of free users turns into gobs and gobs, you eventually get a large group of free users negatively impacting the value of the premium service but influencing the paying customers to question what they're paying for!
Before long, your percentage of paying customers could shrink because the premium users will see a lot more folks getting nearly the same perceived value without paying, and that perception is infectious.
Remember, value is a perception, which leads to...
We don't always disrespect things we get for free, but our psychology shifts when we spend something, anything, because that 'thing' reflects our investment.
Take the study of the Hershey's Kiss.  Research subjects were presented with two kinds of chocolate and asked which of the two they preferred: one was an all-American chocolate-flavored Hershey's Kiss; the other was a piece of premium-quality Swiss-made Lindt chocolate -- equal in size/weight to the Kiss. (Yes, I did just refer to the Hershey's kiss as "chocolate-flavored." It's not really chocolate, you know.)
When the Lindt chocolate was priced at $0.15 and the Kiss was priced at a penny, more subjects said they preferred the Lindt chocolate. But when the Lindt chocolate was priced at $0.14 and the Kiss was free -- the price differentiation between the two was identical -- more subjects said they preferred the Hershey's Kiss.
That study suggests that when you charge something for everything, the perception of the premium service increases in value. It turns out, the perception of value is also higher for everything. When you pay $1 for a "trial" you've invested something. You'll make more of an effort to use the trial before it expires, than if the trial was free.
If you're implementing a freemium model as a way of offering a free trial, then this is vitally important for you. When there's no skin in the game, there's little incentive to get started. You'll even hear naysayers claiming your service doesn't work. Guess what -- a gym membership doesn't work either if you never step into the gym. (And how many gyms do you know offer free membership?)
Naysayers are one thing, a hoard of abandoned membership accounts and profiles is another. Now we're getting into the practical side of things, covered by Challenges 5, 6 & 7.
With no barrier to entry, spammers, gamers and SEO companies will take advantage and run amuck of your feel-good strategy, creating phony profiles stuffed with keywords. This contributes an added burden to communities with a freemium membership model because one of benefits you're selling is a community of others to engage with.
No barrier to entry also subjects a community to users who can't or won't commit but are vocal with complaints about the effectiveness of the service when their lack of commitment doesn't pay off. This added noise is a distraction and an irritant for those who can and do commit with premium membership. If you've got a community, increase the value for your paying customers, filter out those who for whatever reason aren't able to commit to the community.
The risk of added noise and irritation is part of the free territory. Your job is to diminish the impact the noise and irritation has on your premium users by creating filters that protect the paying customers.
You can insert filters like captchas or require an invitation from a current member, but that doesn't cover...
Support costs money. As you grow, your free user-base grows too. When you're successful at getting gobs and gobs of people to sign up for your service for free, you must provide support for those gobs and gobs of people.
If you're keeping the premium fees reasonable and affordable, then your loyal, enthusiastic and dedicated staff will have less time to support the premium users. If you don't or are unable to grow your staff, then diverting too much of your limited resources on supporting free users who have no intention of ever converting is not just bad business, it's neglectful of your paying customers.
Ultimately, it all comes down to...
The freemium business model has three parts that require constant attention and modification: a) building a stream of new users, b) encouraging recurring activity of existing users, c) converting free users to the premium service.
The practical challenge is juggling the adjustment of all three simultaneously. Every vibrant business requires a stream of new customers -- a freemium business model is dependent on free users turning into paying customers. Conversion into premium only occurs if the free users are using your product or service. Therefore, bumping up activity is crucial for the viability of the business, but so is an enticing stream of incentives to upgrade, paired with a funnel full of new users experiencing the ultimate value of the service
Where does that leave us...
Freemium with or without additional revenue support from advertising and affiliate sales has challenges.
To preserve the integrity of your product or service be sure to evaluate the impact your free offering has on the value perceived by the paying customers.
To maintain the viability of the model, pay careful attention to the practical challenges that impact staff and the paying customer's experience.
The 80/20 model reminds us that if 80% of our revenue comes from 20% of our customers, then good business dictates that we focus 80% of our time, energy and resources on taking care of those 20%.
The standard conversion rate for the freemium business model is 1-3%. That means that if 99% of your revenue is coming from 1% of your customer base, then -- while the steady flow of new users is crucial -- your focus needs to be on taking care of the 1% and manipulating the conversion dial to keep that rate from slipping.
Could freemium work for you? It might. Wordpress, Vimeo, Flickr (& Biznik) are making a pretty good go at it.
But before you start giving stuff away for free... Look at it from all angles. Run the numbers. Calculate the ROI. Figure out your resentment number -- the minimum you must charge in order to provide the product or service without resenting your customers.
If the cost of managing, supporting and improving your product or service can be covered by 1% of your users paying a premium, and your premium users will not be negatively impacted by the growth of a free user base, then you've got a fair chance of making a freemium model work.
In the end, there's no magic in free. If you give something away for free, the money to nurture that 'thing' has got to come from somewhere.
 &  Anderson, Chris: Free: The Future of a Radical Price (Hyperion, 2009)