During the Dot Com Bubble, the most popular business model was spend like hell to drive growth and buy million dollar Super Bowl ads. The focus was not on business models. After the rash, we endured a lull. But now, a new breed of Internet company exploded onto the scene, a movement most know as Web 2.0 (more accurately, social media).

Although accelerated growth still remains the dominant goal of most Internet startups, they have avoided many of the mistakes of Dot Com Bubble companies. They have paid special attention to building business models, primarily advertising-based ones. But now that model has come under fire, and a newer model is gaining in popularity: the freemium business model. I want to talk a little about its rise and the future of freemium in online business.

The Woes of Internet Startups

Recently, the problem has not been overexuberance, but the inability of many Internet companies to build sustainable profits. Many social media websites rely on advertising dollars to generate revenue. Advertising is the primary source of income for Google, Digg, Facebook, and almost all blogs. But for a lot of these companies, advertising has not been enough.

An example: the social media powerhouse Digg is still unable to amass a profit after four years. It incurred a loss of nearly $5 million in the first three quarters of 2008. Powerhouse Facebook faces these challenges as well. Its value has plummeted from a $15 billion dollar high to a speculated $3.7 billion because of monetization concerns. And with the economy (and advertising eCPMs) sinking like a boulder in a lake, venture capitalists have ratcheted up the pressure on their companies to turn a profit or shut down.

A great deal of discussion has occurred on social media channels over the best business model for companies in the Internet industry. More and more, companies are turning away from advertising-based business models and turning towards the freemium model. In the freemium model, you offer a free or trial version and a paid, advanced version of your product.

The Rise of the Freemium Model

Freemium isn’t a new business model – people have offered free trials and multiple versions of the same product for centuries. But freemium is relatively new in the world of online business. Very few companies operated under the model during the Dot Com Bubble. The most notable exception is 37signals, a vocal proponent of the model. In fact, the term wasn’t coined until 2006, during a conversation that followed a blog post by Fred Wilson of Union Square Ventures.

And while few companies utilized the model back then, many do now: Flickr, Skype, StumbleUpon, 37Signals, and more. It’s becoming more and more popular. And it’s easy to see why:

• Freemium creates immediate returns – you don’t have to wait for high growth (i.e. Twitter) before attempting a monetization method
• It’s a consistent source of income, especially if you have monthly plans
• It isn’t dependent on and up-and-down advertising market

Of course, freemium comes at a price – you will not grow as quickly when people have to pay for the “full” version of your product.

Is the Freemium Model Better?

David Heinemeier Hansson of 37signals seems to think so, and he makes very compelling points (he also gives a great presentation). It only takes a couple thousand customers to make a million dollar business. But getting to that point is incredibly difficult, as David concedes. Freemium isn’t easier or harder than advertising models – just different. Freemium’s success depends on a userbase being willing to pay in a bad economy. Advertising models depend on advertisers being willing to pay in a bad economy.

And unless you’re the best in your field, you’re going to have price competition.

Know your product, know your users, and know your competition before picking a business model. There are more business models than just freemium and advertising – and you don’t have to pick one exclusively.

But remember, your goal in starting a business is to make money. Not solve world problems, not make a cool product, but to make money. And freemium often gets you to that goal faster than advertising-based models. Because of that, the rise of the freemium business model will continue.

- Ben

image credits: NixonMcInnes of flickr