MailChimp posted some interesting numbers on their blog about how their free mailing lists worked out.
The answer is – VERY well – 650% increased profit!
They do add some thoughts on why that might not work for a start-up – the ratio between free and paid users seems to be around 10:1 for the average web service, but that 1 will have to cover all your expenses, and your starting infrastructure might not be up to the task.
Of course, their line of service is particularly good for free samples, since lists tend to increase with time, thus converting those free users to paid users naturally. Plus their free users automatically spread word about their service every time they use it.
A lot of software doesn't have such clear cut transitions, and users can keep using the free version forever.
That said, I do get some free advertising from STGThumb – my photo album generator – from watermarked photos and the HTML generation, however. While I never bothered to quantify this, it does add to a lot of hits over the years.