Freemium + Adverse Selection (a.k.a., The “Groucho Marx” Problem)

Eminently quotable comedian Groucho Marx once sent a telegram to the Friar’s Club of Beverly Hills¬†— to which he belonged — stating:

“PLEASE ACCEPT MY RESIGNATION. I DON’T WANT TO BELONG TO ANY CLUB THAT WILL ACCEPT PEOPLE LIKE ME AS A MEMBER”

This phrase pops into my head at least once a day, usually when I’m talking to an entrepreneur about their business model.

The “consumerization” of enterprise software has shifted a huge chunk of the SaaS market to “freemium” pricing — allowing anyone to use a basic set of features for free and then mining the large free user base to upsell heavier users (or those with special needs) to paid premium accounts.

This is a fantastic and low-cost way to build an initial customer base, and many companies (including several in our portfolio at Founders Co-op) have used it successfully to build their business. But there’s a downside to the freemium approach, and it’s particularly acute for companies that facilitate commerce (think eBay-style marketplaces), promotion (directory, coupon or affiliate marketing sites) or publishing (free blogging platforms like Blogger, Tumblr or Posterous).

Long story short, if you expose a free platform for driving sales leads to the public web, the first people to find it will be the ones you least want as customers: porn sites, link spammers, and snake oil salesmen of all description will beat a path to your door and bring their friends.

In economic terms, this is called “adverse selection“, and it’s one of the harder business and branding problems that freemium companies face. Offering a service that creates economic value for free will tend to attract the most marginal economic players — the ones for whom almost any amount of low quality free distribution is worth the effort to claim.

If these low-quality early adopters don’t impact the overall perception of your service, their negative impact may not be significant…

…but if your customers’ content and activity on the service reflect publicly on your own brand, you may find yourself trapped in a negative feedback loop that’s hard to break out of.

Shady early adopters attract more shady early adopters and infuse your entire brand with shadiness, driving away higher quality customers who might have been attracted by the value proposition, but are turned off by the “company they’d be keeping” by using your service.

There are many solutions to this problem, but all of them require adding some level of friction to your offering. Examples include:

  • Closed beta – Announcing a freemium service but keeping the public doors closed until you’ve amassed a core group of high quality early adopters that reflect the type of brand you aspire to build. Launchrock has built an entire company on the idea of helping startups manage their beta lists.
  • Public / authenticated identity – Spammers don’t usually like to show their faces in public. Requiring validated identity, especially via a “real names” 3rd-party service like Twitter or Facebook, can shine enough light on the person behind the account to limit (but not eliminate) spammers. Oauth emerged as a framework to enable exactly this kind of shared authentication and make the web a safer place.
  • Payment / micropayment – Because most spammers are marginal economic players that rely on volume and automation to make money, adding even a token “registration tax” to participate in your service can weed out an amazing number of junk signups.
  • All of the above – I’m not sure one data point qualifies as a trend, but I was interested to see lightweight authoring tool¬†Mightybell require a $1 fee to access their closed beta – a new and compound twist on the idea of adding friction to freemium to ensure quality.

It’s a bummer to pour cold water on the magic of free, but if you’re building a business — and a brand — for the long term it just might be worth adding a little friction to your funnel.

Agree? Disagree? Have a better way? Please sound off in the comments!

Note: Image at top sourced from Wikimedia Commons