There is a subtle and incredibly disruptive revolution happening at the intersection of software and capitalism: Freemium.

What is Freemium? In short, StartUps in the 2010s have learned (arguably from Facebook) an explosive way to rapidly grow a business: (1) develop a great and useful product and (2) give it away for free. This enables StartUp, with great product design and social marketing, to grow their user base at ridiculously fast rates, and historically little money. StartUps acquiring millions of users and morphing into $500M companies using less than $5 million in funding – with no or scant revenues – are becoming increasingly common. Here are two good examples: Instagram and Pinterest. There are dozens of others. While there are countless Freemium StartUps that do indeed pioneer new services and products, one common type of Freemium is a knock-off product, which has become part of the teachings of the top incubators (see slide 13.) With the help of the incubators, who act as StartUp boot camps to help young and hungry entrepreneurs build disruptive businesses, Silicon Valley is launching more StartUps than ever, and more Freemium business models than ever.

The Old Guard in the business world, who were trained according to 1950s business school pedagogy and mantra, does not understand Freemium. Whenever the discussion comes up, a baffled look arises in their faces with the eventual question: “How is this Freemium business going to make money when it gives its product away for free?” There are three answers.

1) The StartUp will figure it out later. See: Twitter and Facebook. (I call this the ‘cocaine dealer business model’ – they only monetize after the user is addicted.) Figuring it out later also includes adding a paywall or fees for premium services. See Pandora for example where users can pay a premium to avoid ads.

2) They will add some related product that generates cash. See: PInterest and affiliate links.

3) The StartUp does not even plan to make money from selling its product, and currently has no plan or intent to. They don’t need to. Hunh? This drives the Old Guard nuts. This is a unique disruptive paradigm shift in the Freemium model: a StartUp does not need revenues to build a successful business and make founders rich. See: Instagram, who were bought for $1 Billion USD, making Instagram’s founders very rich.  In yesteryear, executives learned businesses are created for profit and margins. Now? StartUp focus on product development that creates value for customers – regardless of revenue. Then they sell the users/customers. Facebook’s users were gravitating to mobile photos, and Instagram had an inside track on mobile photos and young users (who love the word ‘free’). Facebook now considers paying $1 Billion for Instagram a ‘deal.’ It’s just business in the new world.

These product-centric Freemium businesses can be incredibly disruptive. They are started by hungry and very talented 20-something year olds. Some want to make a lot of money, many want to change the world, others just want to see their free product being used by millions. None of them shed a tear when an Incumbent Company gets destroyed in the process.

Patents as a Defense to Freemium

Freemium products are also uniquely resistant to the patents of an incumbent company whose products and revenues are threatened by the new Freemium product. Let’s explore this in a few scenarios.

A) If the Freemium product IS a new product (such as Twitter or Instagram) then there theoretically should not be a scared Incumbent Company about to be displaced, so there is far less threat of a large Incumbent Company patent portfolio suing on the basis on valid infringement.

B) When the Freemium product is NOT a new product but instead a new, usually better and free knock-off of an existing product. What happens? Hell breaks loose. Here is one example: Mobile Android. In three years, Google went from zero mobile O/S market share to number one in the global mobile O/S market. In the process, Android devoured the market share of Nokia’s Symbian, Windows Mobile, and RIM’s whatever. If not for Apple, Google’s market share would even be higher.

Let’s step back from the patent/business intersection and put Freemium in perspective from a consumer standpoint. When I was an undergrad in college in 1994, I needed a CD player. Here were my choices: a) a top Sony or Panasonic CD player with a 6-disc changer for $300, or b) a cheap knock-off that plays one CD for $89. Now THAT is a consumer decision: a better product for more money, or a crappy product for less money. Most professionals pay the $300; most students and other cheap people pay the $89.

Operating systems?  Choice (a) costs $100, has about 47 apps, and crashes more frequently than a drunk driver.  Choice (b) is free (FREE!), has 150,000 apps, performs faster, and never crashes. What is the rationale consumer behavior in this instance? The better product for free, of course! Only a fool buys a crappier product that costs more money.

Microsoft’s initial response to Chrome and Android: sue Google and use Microsoft’s phenomenal patent portfolio to put an end to … wait a second…

This won’t work. Courts are less and less granting injunctions for patents. EBay was just the beginning. Instead, courts are now handing out larger damages or using FRAND for essential patents with even weaker damages awards on compulsory licenses. However, with Freemium, court awarded damages do not work. The exercise of finding a percent for damages on an infringing product is moot there are no revenues on a Freemium product. Any royalty percentage (e.g., 2% of revenues) times zero (revenues) equals zero in damages. With Injunctions becoming increasingly rare, Freemium thus undermines damages, and neuters the patents. (Whatever happened to using “irreparable harm when damages alone will not suffice”?)

So as the courts continue the trend of making injunctions a thing of the past, and Freemium continues to grow in popularity for young fast StartUps, then some F500 company’s patent portfolios are about to get collectively disarmed, and we will watch a major company die as customers rationally rush to get for free that which they used to pay for.

Are there other fallback possibilities for the incumbent company and its large portfolio? Sometimes… But the answer better come fast: once customers get a product for free, they don’t like paying after that.

Microsoft got a little lucky in its Freemium war. The lucky break is that Android needs a revenue generating partner to carry the O/S – the smartphone, which introduces revenue bearing products (and damages) into the fray. Deftly and desperately, Microsoft approached and licensed the smartphone manufacturers and now makes more from Android than Microsoft’s own mobile O/S sales. Newsflash: this attack-the-partner-fallback has some serious limitations. First, those Microsoft patents will eventually expire. Second, and worse, when it comes to the word ‘free,’ customers-who-change-to-a-better-product-to-avoid-paying are as predictable as gravity.

If there is no revenue generating partner to a Freemium product, then damages will not suffice, and the patents are neutered.

So, as long as courts are pushing injunctions into extinction, then Freemium presents a very dangerous threat to any Incumbent Company and existing product revenues.

In Part 2, I will go into what companies can do.