SAN FRANCISCO (Reuters) - Start-up companies using "freemium" business models, including Dropbox, SurveyMonkey, Animoto and Eventbrite, are thriving as the cost of computing power and storage falls.
These are among a slew of venture-capital backed businesses that offer some products and services free, then try to lure customers into upgrading to premium versions that cost money.
This approach is known as the freemium business model, a term popularized in 2006 by Fred Wilson of Union Square Ventures.
While it's been around for a while, the model is gaining more notice now because some companies have become profitable growth machines with its help.
LinkedIn Corp may be the highest-profile freemium story. The business-focused social network went public earlier this year and is valued at about $8 billion. This month, the company reported its first quarterly profit, while revenue more than doubled.
It is free to join LinkedIn, but the company charges for premium subscriptions. Revenue from paying members jumped 60 percent to $23.9 million in the second quarter.
Like LinkedIn, SurveyMonkey is profitable and growing quickly. It has 8.5 million users, up from 2.6 million when Chief Executive David Goldberg took over in 2009.
Goldberg credits some of this success to the freemium approach.
"It fundamentally changes the way you think about the business," Goldberg said. "We have no salespeople. Our free customers do the marketing for us."
The company is running about 280,000 online surveys a month and processing more than 33 million responses, up from 166,000 surveys and 20.6 million responses a month in 2009.
A decade ago, such businesses would have struggled to offer free services to lots of customers because the cost of computer servers and storage was so high.
In 2000, the cost of a customer running a basic Internet application through the cloud was about $150,000 a month, according to Marc Andreessen, co-founder of venture capital firm Andreessen Horowitz.
Running the same application today through Amazon Web Services, a unit of Amazon.com, costs about $1,500 a month, Andreessen noted in a recent Wall Street Journal column.
SurveyMonkey's free service lets customers run surveys with ten questions and 100 responses. For about $200 a year, the company offers unlimited questions and responses.
A few years ago, SurveyMonkey used to charge when there were more than 1,000 responses. The company was able to drop that because it costs so little to tap the extra computing power needed to handle high volumes of survey answers.
"The cost of those additional responses is now a lot less than in 1999," when SurveyMonkey was founded, Goldberg said.
The change attracted a lot more high-volume users, which meant the company's surveys were taken by a lot more people, "creating viral marketing for us," the CEO explained.
Still, Goldberg said SurveyMonkey is not defined by the freemium approach, partly because the company's services do not use a lot of computing power and storage.
In contrast, Dropbox, which lets people store and share files, is defined by the freemium model, Goldberg said.
Dropbox, founded in 2007, has more than 25 million users, up from four million in early 2010.
The company offers two gigabytes of storage for free, while 50 gigabytes costs $9.99 a month and 100 gigabytes costs $19.99 a month.
"To offer storage in the cloud, you have to cover your costs of storage and make a margin," said Jeremy Levine of Bessemer Venture Partners. "In the past, it cost a lot to offer a gigabyte of storage and consumer demand was probably the same. Now it costs so little, you can price it a lot more attractively."
If premium services are priced low, it's easier for free customers to decide to upgrade, Levine added.
Converting subscribers into paid customers is the key to profitability for freemium business models, he added.
"For every 100 free customers there is some number between five and one who end up as paying customers," Levine told Reuters. "If there was a business that's converting at anywhere near 10 I would jump at the chance to invest."
Animoto has three million registered users, up from two million less than a year ago. More than 100,000 of those are paying customers, according to CEO Brad Jefferson.
The company is currently converting about 10 percent of the new users it gets each month into paying customers, he said.
But Animoto needs a lot of computer servers to create video slide shows and a lot of storage to keep the content on file for customers.
"Before cloud computing we would have needed to purchase or lease servers with the hope that we guessed right on the number of servers based on our forecast of video creation demand," Jefferson said.
"The cost to implement such a server farm is substantial and was above our perceived fund-raising potential" when Animoto got going in 2006, he added.
Animoto is a big customer of Amazon Web Services. When the company launched a Facebook app in 2008, it was inundated with new customers and went from using about 100 of Amazon's remote servers to 5,000 in four days.
"Before cloud computing we would have been dead," Jefferson said. Still, the extra computing power increased Animoto's costs, so Amazon invested in the company "to help keep things going for us," he added.
Eventbrite adopted a freemium approach by accident.
The company charges a 2.5 percent commission based on the value of tickets sold for events, plus a flat fee. But people started offering events that cost nothing to attend, so Eventbrite collected little or no money.
Initially Eventbrite was concerned. But because running lots of extra events doesn't cost much more in computing power, the company embraced the change, according to co-founder Kevin Hartz.
The more people use Eventbrite's service, the faster it spreads to new customers. A broader array of events also helps because people know they can come to the Eventbrite website to find lots of different things to do.
Freemium failed to work for Phanfare, which archives photos and hosts videos online for photographers. The company started offering one gigabyte of storage for free and unlimited storage for paid users in 2007.
The number of registered users surged, but profitability suffered.
"Customers with less than 1GB but paying our full subscription fee were our most profitable customers," Phanfare co-founder Andrew Erlichson wrote in a 2009 blog. "With those people at the free level, our margins were down significantly."
"Freemium is not a good model when the cost of delivering service to free users is high," he concluded.
Phanfare was sold to Carbonite in June for $2 million and the assumption of liabilities.
Still, Erlichson's aversion to freemium has softened recently.
"If we had wanted to give freemium more of a fighting chance, we might have lowered the cost of providing the service significantly through down sampling and other methods," he told Reuters this week.
Down sampling reduces image sizes, shrinking files that need to be stored and processed.
"Phanfare, at the time, offered only archival original quality, which was one of the reasons our cost position was too high to support freemium," Erlichson said.
Reporting by Alistair Barr; Editing by Tim Dobbyn