Excerpt (with edits) from The Common Characteristics Of Successful Freemium Companies by Tom Tunguz:
Startups should consider freemium when four conditions are met:
1. The number of potential free users numbers in the tens of millions. Freemium conversion funnels tend to be very lossy. On average, 1-4% of users convert to paid. 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.
2. Free distribution is a competitive advantage in the market. 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.
3. The product used by a free user has a simple and straightforward value proposition. 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.
4. The marginal cost to serve a user is 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.
(1) On conversion rates, see These benchmarks can tell you whether your business plan is viable.
(2) Cf. The 3 conditions of a great freemium business.