Josh Kopelman put up an interesting post this weekend over at Redeye VC called The Penny Gap. In the post, he discusses the substantial gap in the demand curve for a product when the price is free versus when the price is one cent. His demand curve chart is spot on, in my opinion.
This snippet is a great, rational summary of why plenty of folks are monetizing their new online services via advertising:
At some point, the cost to acquire a paying customer is so high, it makes sense to consider shifting from a pay model to a free model. In these cases, asking “who would pay to reach these consumers” (or “who can subsidize these users”) creates an opportunity to build a more valuable business through the combination of exponential growth and targeted advertising.
Here’s the way I think about this: do you want 1M pennies or $10K? If you’ve got a user base of 1M users, do you want to collect a penny from each of them indirectly (advertising) or do you want to convert 1% of them to pay you $1 each (upsell)? What’s your cost to acquire? What’s your cost to convert? What’s your liftetime revenue per user? What are your increased support costs for upsold users?
And which is more valuable to investors and/or potential acquirers? 1M pennies or 10K dollars? Which is more leverageable for the company long-term? Does your service or product have a network effect, which might impact your decision?
I’m a big believer in extracting all the revenue under the curve. As such, I believe freemium services are important and should be pursued, when feasible, along with advertising. But entrepreneurs and investors really do have to be thoughtful about whether they’re economically rational, and intellectually honest about the costs involved.
Tip of the hat to Will for the link (Josh is in my blogroll, but I’m behind in my reading!).