All web applications can be seperated by the way they charge users into three groups:
1. Free forever - using the application is free, for all the parts of the application, forever. Example: Google search engine.
2. Free to try - using the application for some time is free (usually first couple of weeks/months), then you have to pay to continue using the application. Example: Clarizen Project Management (my previous employer).
3. "Freemium" - there is a free version of the application that you can use forever, and there is one or more payed versions. The versions are distinguished by the features they provide.

The third model is maybe the most common and definitely the easiest to do wrong. That's because the devil is in the details.
The details are how the free version is different from the paying version. Your goal as a developer is to give something valuable to the user for free and make it so valuable that they want even more.
The goal is not to annoy your free users so much that they will pay just to make you stop annoying them. It won't happen.

And most importantly: don't design your differentiation in a way that in the free version it's possible to do everything that the payed version does but in a more annoying way.

The problem is that differentiation in the freemium model is very hard to do right in a service that is narrow and well defined, which is often the case. When your application does just one thing - how can you have different types of users?

Case in point:
Cafe Press, an otherwise great idea, has the freemium thing all screwed up:
They provide a service for people to design their own stuff (t-shirts, mugs...) and sell it in a web store hosted on Cafe Press. They take care of actually manufacturing the products and handling the ordering and shipping against the customer. You just design your stuff and take a percentage of the sales.
It's free to setup a "basic" store and it costs money to setup a "premium" store. The difference is that the "basic" store can only have one design for each product type. So you can sell just one white t-shirt, one colored t-shirt, one hand bag and so on.
But
Any free user can setup as many basic stores.
So, you can sell as many items as you want, just like a paying user, you just have to work harder (basically more clicks) and get more annoyed. The premium store can also have custom designs and better display of items, but that's not as important in terms of features to the user.

The people at cafe press have a great business. They make money from selling t-shirts and they don't have to pay for the designs. In my opinion, they should abandon the paying version alltogether. That will just drive more people to upload designs and increase sales.

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Get in touch: pasha at cohai dot co