There are two projects we can work on. One would be a small free game to try and get our name out/build an audience. The second is our main idea for a first product.
What are the pros and cons of building the small, simple, free game first instead of focusing that time/effort into the main money making project.
Just because a game is "free" doesn't mean you can't monetize it. See this question: What are some common ways to generate revenue from a free game?
In short, "freemium" (namely, releasing a game for free to build up a user base and relying on microtransactions to build up revenue) is one of the better ways these days to make money on smaller games. Which I'm assuming your game would be in order for your studio to be able to stay afloat.
It depends a lot on what the two games are, your distribution channels, and what kind of time/money the team has available.
Ideally, your two game ideas are somewhat similar: close themes, close genres, something. If you get fans based on your great free racing game, then release a fantasy RPG, there won't be much cross over in the audiences. Also, two games with similarities can share code. You won't be "wasting time" making a free game first if you can reuse large chunks of the code and content as the basis for the premium new game.
Distribution is important. A free PC game and a premium Xbox game wouldn't have much crossover. Again, you want to ensure that the audience you build up from the free game would actually be likely and able to purchase your premium offering. Consider your options here too. For a free PC game, you're main distribution is going to be your own website. For a pay game, you may be able to access additional avenues like Steam or other content sellers who will open your game up to a wider audience. If you need something out there to impress these sellers that your company is a good risk, then the free game is going to valuable both as a audience builder AND a resume booster for the company.
An additional note on distribution, if you are eligible for any kind of contests or awards with either game, make sure to enter them. Just being a contestant gets you exposure beyond your own word of mouth. Making a free game is more appealing if you can enter it in an indie game competition and get free advertising for your website.
Finally you have to honestly assess your own time. If everyone involved is doing this as their job, you may need paying work out there now. On the other hand, if the game design thing is a hobby outside of real work, you may be able to use advertising and donation revenue from a free game to help fund work on the premium game.
Some additional thoughts: Let's say your two games are pretty different. Different enough that you can't really share code or lots of audience between them. What else is there to consider?
On the free game, you might also look at how you can charge for it. Is there premium content you can add to that? Can you sell it as a beta on the promise of making it bigger and better in the future? (the "Minecraft model" ) Can you sell a premium "HD" version of the free game later? (EDIT: Tetrad's excellent answer points to some further ways to monetize the free game, making it both an audience builder and a revenue stream for future game development.)
On the premium game, could you spend time working on a free demo or shareware version of it? It might be better to have a demo of your main game out there instead of a free but unrelated game.
It all depends on the games themselves, and the team that's working on them.
If for example the small game is a Breakout clone and the large game is a full-scale RPG, the former won't really help "establish" you to do the latter.
If the small game isn't a project worth doing in its own right -- if it's just a derivative clone or similarly uninspired -- then the only thing it will "establish" is that your team doesn't know how to make a great game.
If your team has not made a game before at all, then it IS worth working on (and completing) one or more small projects, but the purpose of these is not to get your name out there, it's to get experience completing projects. It is very easy to start a large project with grand plans and huge ideas, only to never finish it because the scope is just too large for the team. An inexperienced team would do well to work on a few simpler projects first, whether they are released or not, simply to get a feel for what it's like to work together on a team.
Then there's the question of burn rate. Do you NEED to make money to support yourselves, or do you all have day jobs? How soon do you need to be profitable? Do you have a business plan? Are you actually treating this like a business, or is this just the three-guys-in-a-garage model where it's great if you make money but that's not the priority? If this is a business question, then top priority should be to halt development until you create a viable business plan first, and once you have one, that should answer your question right there.
