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Pandora is the Internet’s most successful radio service. As of May 2014, it had over 250 million registered users (200 million of which access the service via a mobile device) and 77 million active listeners. Pandora now accounts for more than 70% of all Internet radio listening hours and a 9% share of total U.S. radio listening (both traditional and Internet).

At Pandora, users select a genre of music based on a favorite musician, and a computer algorithm puts together a personal radio station that plays not only the music of the selected artist but also closely related music by different artists. A team of professional musicians listens to new songs each day and classifies the music according to more than 450 musical criteria. These criteria are used in a computer algorithm to classify new songs into various genres. Within each of these genres are hundreds of subgenres. Altogether, Pandora has a database of over 1 million analyzed songs from over 100,000 artists.

Pandora’s founders, Will Glaser and Tim Westergren, launched Pandora in 2005.Their biggest challenge was how to make a business out of a totally new kind of online radio station when competing online stations were making music available for free, many without advertising, and online subscription services were streaming music for a monthly fee and finding some advertising support as well. Online music illegally downloaded from P2P networks for free was also a significant factor, as was iTunes, which by 2005 was a roaring success, charging 99 cents a song. The idea of a “personal” radio station playing your kind of music was very new.

Facing stiff odds, Pandora’s first business model was to give away 10 hours of free access, and then ask subscribers to pay $36 a month for a year after they used up their free 10 hours. The result: 100,000 people listened to their 10 hours for free and then refused to pay for the annual service. People loved Pandora but were unwilling to pay for it, or so it seemed in the early years.

Facing financial collapse, in November 2005 Pandora introduced an ad-supported option. Subscribers could listen to a maximum of 40 hours of music in a calendar month for free. After the 40 hours were used up, subscribers had three choices: (a) pay 99 cents for the rest of the month, (b) sign up for a premium service offering unlimited usage, or (c) do nothing. If they chose (c), the music would stop, but users could sign up again the next month. The ad-supported business model was a risky move because Pandora had no ad server or accounting system, but it attracted so many users that in a few weeks it had a sufficient number of advertisers (including Apple) to pay for its infrastructure. In 2006, Pandora added a “Buy” button to each song being played and struck deals with Amazon, iTunes, and other online retail sites. Pandora now gets an affiliate fee for directing listeners to Amazon where users can buy the music. In 2008, Pandora added an iPhone app to allow users to sign up from their smartphones and listen all day if they wanted. By 2009, this “free” ad-supported model had attracted 20 million users.

Still not giving up on its premium service, in late 2009, the company launched Pandora One, a premium service that offered no advertising, higher-quality streaming music, a desktop app, and fewer usage limits. The service cost $36 a year. This time around they met with much more success, so much so that Pandora went public in June 2011. By 2013, it had over $600 million in revenue with about 80% coming from advertising and the remainder from subscriptions and other sources. However, Pandora has not yet shown a profit, and does face competition from services such as Spotify, which also is using the freemium strategy.

Pandora is an example of the freemium business strategy. A freemium strategy is based on giving away some products or services for free while relying on a certain percentage of customers to pay for premium versions of the same product or service. As Chris Anderson, author of Free: The Future of a Radical Price, has pointed out, because the marginal cost of digital products is typically close to zero, providing free product does not cost much, and potentially enables you to reach many more people, and if the market is very large, even getting just 1% of that market to purchase could be very lucrative. There are many other examples of successful freemium strategy companies. Other notable success stories include LinkedIn, a social network for career-oriented and job networking that offers some basic services for free, such as creating a profile and making connections, but which charges for premium services, and Dropbox, a cloud storage and file sharing service that provides 2 gigabytes of cloud storage for free, but charges for additional storage. Freemium has been the standard business model for most apps, with over 65% of the top 100 apps in Apple’s App Store using a freemium strategy. But it won’t work for every online business.

While freemium clearly has worked for Pandora, LinkedIn, and Dropbox, there is ongoing debate among e-commerce CEOs and venture capitalists about the effectiveness of the freemium strategy. The crux of the issue is that while freemium can be an efficient way to gather a large group of potential customers, companies have found that it’s a challenge to convert eyeballs into those willing to pay. Absent subscriber revenue, firms need to rely on advertising revenues.

MailChimp’s story is both a success and a cautionary tale. The company lets anyone send e-mail to customers, manage subscriber lists, and track the performance of an e-mail marketing campaign. Despite the powerful tools it gives marketers, and its open applications programming interface, after 10 years in business, the company had only 85,000 paid subscribers.

In 2009, CEO Ben Chestnut decided that it was time to implement new strategies to attract additional customers. MailChimp began giving away its basic tools and charging subscription fees for special features. The concept was that as those customers’ e-mail lists grew, they would continue using MailChimp and be willing to pay for enhanced services. These services included more than just the ability to send e-mails to a greater number of people. Clients would pay to use sophisticated analytics to help them target their e-marketing campaigns more efficiently and effectively.

In just over a year, MailChimp went from 85,000 to 450,000 users. E-mail volume went from 200 million a month to around 700 million. Most importantly, the number of paying customers increased more than 150%, while profit increased more than 650%! Sounds great, but there was also a price to pay. The company also saw a significant increase in abuse of its system. As a result, they were forced to develop an algorithm to help them to find and eliminate spammers using their service.

For MailChimp, freemium has been worth the price. It currently supports more than 6 million subscribers worldwide, sending about 10 billion e-mails a month. However, Ning, a company originally founded to enable users to create their own social networks, tried freemium and came to a different conclusion.

Marc Andreessen, co-author of Mosaic, the first Web browser, and founder of Netscape, launched Ning in 2004. With his assistance, the company has raised $119 million in funding. Despite being the market’s leading social network infrastructure platform, Ning was having a common problem—converting eyeballs into paying customers. While 13% of customers were paying for some premium services, the revenue was not enough. The more free users Ning acquired, the more it cost the company.

In May 2010, Ning announced the impending end of its freemium strategy. The company shed staff, going from 167 to 98, and began using 100% of its resources to capture premium users. Since shifting to a three-tier paid subscription model, Ning has experienced explosive growth, increasing the number of paying customers from 17,000 to more than 100,000 and growing revenue by more than 500%. By September 2011, Ning had more than 100 million registered user social profiles and its social networks reached more than 60 million monthly unique users. In December 2011, Ning was acquired by Glam Media, a leading social media company, for $200 million. In March 2013, Glam relaunchedNing as a personal blogging platform for brands and individuals to bring all of their social media followers together in one place. This version of Ning will attempt to intertwine content publishing with community. Glam intends to charge users a fee, rather than returning to a free or freemium strategy.

So when does it make sense to include freemium in a business plan? It makes sense when the product is easy to use and has a very large potential audience, preferably in the millions. Using a freemium strategy can be a very success marketing tool, because free features can help attract a user base, and are more attractive to most consumers than 30-day free trials that require a cancellation process. A solid customer value proposition is critical. It’s helpful if a large user network increases the perceived value of the product (i.e., a dating service such as Match). Freemium may work when a company has good long-term customer retention rates and the product produces more value over time. An extremely important part of the equation is that the variable costs of providing the product or service to additional customers for free must be low.

Companies also face challenges in terms of determining what products and/or services to offer for free versus what to charge for (this may change over time), the cost of supporting free customers, and how to price premium services. Further, it is difficult to predict attrition rates, which are highly variable at companies using freemium. So, while freemium can be a great way to get early users and to provide a company with a built-in pool for upgrades, it’s tough to determine how many users will be willing to pay and willing to stay.

A freemium strategy makes sense for companies such as Pandora, where there is a very low marginal cost, approaching zero, to support free users. It also makes sense for a company where the value to its potential customers depends on a large network, like LinkedIn. Freemium also works when a business can be supported by the percentage of customers who are willing to pay, like Pandora, especially when there are other revenues like advertising fees that can make up for shortfalls in subscriber revenues.