I’ve had this blog entry saved as draft for a month, and Tom Buck’s post earlier today titled “Failure: Building a $50/month web app” inspired me to post this. He remarks in his post “My mistake quickly became obvious: I had built a tool for an audience that didn’t like to spend money.”. Here’s my take (and my verbatim draft from a month ago):

“The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” — Friedrich von Hayek

Hayek’s wonderful quote captures both the wisdom and arrogance of economists and their field, so consider it my caveat for the observations below.

The canonical example of adverse selection comes from the industry that invented the term: In the insurance industry, customers who are more likely to die tend to buy more life insurance. Because the insurer doesn’t have all information on the health of buyers, life insurance as a product tends to select the wrong customer i.e. customers who are less profitable because they die sooner.

In the online world, “Free” is a popular model for gaining “Traction”, meaning access to many customers. The assumption is that a reasonable percentage of those free customers will at some point become buyers. Therefore success is gauged by growth in the population of a company’s free customers because at any time a company can pull the “revenue lever”.

The problem and a realization I had during the last year, is that “Free” can adversely select against paying customers.

Customers who use many free products online are less likely to pay for a paid service. Conversely, customers who have recently paid for an online service are far more likely to pay for other online services. And what you may view as incentives to upgrading may be further selecting against customers who will pay in future.

One might argue that this is simply the old sales adage that customers who are most likely to buy something from you are those that just bought something from you. But I’d argue that this works across company boundaries e.g. if a business refers customers who recently bought their service to another business, those customers are far more valuable than referrals from a free service – because they’re the kind of customer that pays.

Adding disincentives to using your free product (or incentives to upgrading if you flip it around) strengthens the adverse selection problem because those who adopt your free product, presumably prior to upgrading to paid, have a strong desire to never pay. Their desire is so strong that they will tolerate whatever irritant you’ve introduced in the free product which makes the likelihood of them upgrading to your paid product even less.

So is Free useless? No it’s not and it can be a method of establishing a relationship and trust provided you target free customers where other criteria qualifies them as likely to pay in future and the free product doesn’t disqualify them.

For example, you could choose to only provide your free service to customers who have recently paid for an online service somewhere else. In addition, the free product must not adversely select against those customers once you’ve recruited them e.g. Your free product must be something that a paying customer is more likely to use and like, rather than a gatekeeper that irritates until the customer either leaves in frustration or upgrades.

Free works, provided it targets the correct customer and continues to incentivize them on their journey to becoming a future paying customer.