We’ve all used free online services or applications and have likely thought “how is that a sustainable business model?”. Some are purely for marketing and exposure, and others, like Zynga’s free FarmVille application for Facebook, allows users to fast-track the game by selling virtual currency. Some services, like Twitter, develop customers or an audience and plan to figure out the business model later. A business model that isn’t obvious at first, but makes complete sense is the “Freemium” model. In short, this is giving away a base service and charging for extra features, introducing them to your product and earning their business.

An example of a “freemium” business model is Evernote, a service that serves as a memory aid. Evernote captures and organizes things from everyday life using your computer, phone, and the web. Its services and products are free on a variety of platforms. Unlock additional features with a $5 per month subscription.

As reported by VentureBeat, chief executive Phil Libin reveals how the freemium business model works for them.

The free version launched in June, 2008. The number of users grew gradually and organically. The company expanded it to the iPhone, Mac, Windows PC, the web, and Android phones.

Libin noted that 31,334 users signed up for the service in March, 2008… and …about 11,000 of the 31,334 users became regular users coming back every month.

Those 11,00 users mean that the software has a great ability to retain users. The more you use Evernote, the more valuable it becomes. If you have two years of your life stored within it, and there is no other way to quickly find information, then you will keep on using it. (Libin makes an argument that some users rely on Evernote so much over time that they will consider it to be as valuable  as a car).

“Brand Evangelists” (an important part of online marketing) loved the service and shared it friends and Evernote’s popularity grew.  the The longer people used their service, the more likely they were to subscribe. Libin said that subscriptions grew over time and now generate $8,000 per month. Libin also goes on to say that the key to hanging on to older users is introducing new features.

The company became profitable on a gross profit basis in January, 2009, and now it earns a gross profit of 11 cents per active user per month. This is why the company has been able to raise $22.5 million in three rounds from investors including Morgenthaler Ventures, NTT DoCoMo, and Troika Dialog.

The lessons from this growth: Create a product that has a great long-term retention rate; make something whose value increases over time; keep your variable costs low.

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