Is there a common characteristic of successful freemium companies? Piotr asked this question earlier this week. This is the framework I’ve seen work well for freemium startups.

At its core, freemium is a novel marketing tactic that entices new users and ultimately potential customers to try a product and educate themselves about its benefits on their own. By shifting the education workload from a sales team to the customer, the cost of sales can decrease dramatically. So, freemium can be a huge strategic advantage in a competitive market because those companies that successfully implement freemium can scale faster and more efficiently than traditional sales-driven companies might.

Successful freemium companies do three things:

First, they use free to market, educate and win mindshare. The nature of sales processes is evolving as Daniel Pink eloquently argued in his book To Sell is Human. The Internet enables potential customers to research products much more deeply before engaging with a sales person. Freemium is the ultimate embodiment of that change because customers can use the product before buying it.

Second, freemium startups leverage usage data to improve their product. The large amount of users using the product enables A/B testing with statistical significance, a non-trivial strategic advantage. Marketing teams can sift through the data to understand market segmentation and funnel efficiency, and product management can parse the data to improve the on-boarding experience.

Third, freemium startups gather information about their customer base to prioritize their sales efforts. When customers sign up or download a free product, freemium companies should gather data about the user to understand who they are and analyze the usage patterns of these users. With enough user data, it’s possible to predict with great accuracy which users will become large accounts. Yammer employed this tactic to prioritize leads for the inside sales team, with great results.

The measure of success of a freemium campaign is revenue, aka converting a user to a paid customer. There are many different sales movements, triggers to generate some value from a user. But I bucket them this way:

1. Convert a free user to a paid user in exchange for certain advanced features or more of the product, eg Evernote charges for offline access, Dropbox charges for more storage.
2. Win several users in a team and leverage the social proof to convert a team or department though inside sales. I’ve called this the Two Step Value Proposition, eg Yammer wins the end user and converts the IT admin who seeks control over the app, Expensify wins the expense reporter with a mobile app but ultimately converts the finance team of a company to paid by offering policy management.
3. Leverage one free user to win many other free or paid users. In some cases, lots of free users increase a company’s rank and visibility in the app store, attracting customers. In other cases, incentivized referral programs like Dropbox’s enable free users to continue to free-ride in exchange for driving revenue from others. A nice quid-pro-quo.

Freemium models can be attractive, but they don’t work in every case. Startups should consider freemium when three conditions are met: the number of potential users numbers in the tens of millions, free distribution is a competitive advantage in the market, the product downloaded by a free user has a simple and straightforward value proposition, and the marginal cost to serve a user is negligible.

Freemium conversion funnels tend to be very lossy. On average, 1-4% of users convert to paid, so a startups needs a huge number of users to be able to drive meaningful revenue from a single-digit percentage of users. To reach $100M in annual revenue, a freemium business charging $100 per year with a 4% conversion-to-paid rate would need a total user base of 25M users.

Because the freemium model relies on customers to educate themselves, freemium is best used as distribution advantage in established markets with incumbents who bear large customer-acquisition costs. An ancillary benefit, freemium companies can draft behind the sales and marketing efforts of the incumbent behemoths. Initially, freemium startups often serve a smaller customer segment, but can address them more profitably than the incumbent could as a result of a more efficient sales process.

Because customers are educating themselves, freemium products have a very short window of attention to seize and convince a user to convert to paid. Therefore, the product has to be straight to the point and solve an immediate need or eliminate pain.

Most important, the marginal cost of supporting a free user must be close to negligible. If the cost-to-serve a free user is significant, the freemium model will demand lots of cash to support hordes of free users, and this growth path can be unsustainable if a startup really must acquire 25M users, for example.

Freemium doesn’t work for many different businesses, but deployed the right way, freemium marketing strategies can be a hugely strategic weapon for startups.