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The Economics of Open Source: Why the Billion Dollar Barrier is Irrelevant

Indeed, I would go so far as to say that very few open source startups will ever get anywhere near to $1 billion. Not because they are incompetent, or because open source will ‘fail’ in any sense. But because the economics of open source software โ€“ and therefore the business dynamics โ€“ are so different from those of traditional software that it simply won’t be possible in most markets.” – Glyn Moody, “Why No Billion-Dollar Open Source Companies?

The explanation of why zero pure play open source vendors have hit the one billion dollar revenue mark has never seemed, to me, particularly complicated. The economics of open source are, as Glyn notes above, fundamentally differentiated from the closed source models that preceded it. Open source as an application development model enjoys many advantages over proprietary, in-house development; distribution and usage among them. But revenue extraction has not traditionally been a strength, for obvious reasons. When payment is optional, as it is with most open source software, fewer users become commercial buyers. Next up, a study proving that objects further away are harder to see.

Faced with this economic weakness in the model, open source advocates will typically cite the value of community participation and user volume, and they are perfectly justified in this. While it is unquestionably true that non-commercial users can still represent massive value to a given project (see our coverage of the three types of customers here), however, they are particularly unhelpful when the metric is – as it is in this case – revenue. This was what led me to argue in 2006 that we wouldn’t see a billion dollar open source pure play any time soon and to reiterate that point three years later. And it is why I am not surprised, in 2010, that we still don’t have a single billion dollar open source entity.

All of this, however, is ground well trod: IBM, Microsoft and Oracle are substantially larger than Red Hat. And? This matters if your’re contemplating starting up an open source software business. Does it, or should it matter to anyone else?

To answer that, we need to look at two questions: first, can open source firms make more money, and if so how? Second, if they can’t, what does that say about the future of open source?

Can Open Source Make Even More Money?

I believe that it can. Whether or not it will depends, in large part, on the creativity of open source commercial vendors. To date, most have showed little inclination to adapt their business models to the differences in open source development models. Revenue is still overwhemlingly a function of support/service licenses, with other mechanisms such as dual licensing or hybrid/open-core packaging utilized in an effort to introduce some of the same purchasing triggers enjoyed by closed source software vendors. With ten plus years of history at our disposal, several things about these models are now clear:

  • They can generate sustainable, viable businesses
  • They can be profitable and generate growth
  • They cannot replicate closed source pricing and/or margins
  • They cannot produce growth trajectories similar to software businesses that preceded it

Part of the challenge for open source software vendors, of course, is the fundamental difference between open source software and proprietary alternatives, not to mention other tangible goods: the primary asset to be sold is (generally) freely available. But it is also clear that most revenue models are misaligned at basic levels with customer needs.

Consider the support and service revenue lifeblood. If open source advocates are correct, and software developed in this fashion is indeed better designed and architected than proprietary choices, the need for support and service must necessarily be less. No software is bug free, of course, but better software should theoretically mean fewer suppot requests. Or take open core style models, which basically replicate the commercial software licensing model with an open source foundation; this erases, for some customers, the benefits of working with open source software. Dual licensing, meanwhile, can not only be unfavorable to customers, it can actually be detrimental to the vendor as well: MySQL, for example, found itself shipping a version of the codebase technically inferior to community distributions due to copyright conflicts with the dual licensing model (coverage).

The question is whether there are revenue models available to open source vendors that better align customer and vendor needs. We suggested such a model four years ago in a piece entitled “Beyond Support/Service: Making More Money from Open Source.” The idea is straightforward: open source excels at distribution and volume, so logically the ideal revenue model should leverage that strength. Data is likely, in my view, to be more profitable longer term than mechanisms such as dual licensing (coverage). Telemetry (coverage) is the obvious next revenue source for open source entitites. Customers share data with the provider on an opt-in basis, and in return they receive a basic level of analytics on the aggregated telemetry across customers for free, with more sophisticated reporting offered on commercial terms. The vendor taps a potential revenue source, and the customer gets access to aggregated analytics that span far beyond the boundaries of their single organization.

This model, perhaps not by accident, looks far more like Google’s than, say, Oracle’s. Which brings us to the second question.

If Open Source Can’t Make Even More Money, Can It Survive?

If open source businesses today can’t replicate the models that made the likes of Oracle successful, what chance do they have? There is a line of thinking currently circulating amongst some in the industry that goes something like this: the MySQL exit aside, valuations of open source commercial entities are in clear decline. Adding insult to injury, legions of entrepreneurs that at one time would have concentrated on building out open source commercial organizations are instead defecting to cloud, software-as-a-service and other commercial entities with more predictable revenue mechanisms. Given this, venture capital investments into open source are in decline, with the end result that there is less oxygen in the form of revenue available to sustain the software ecosystem generally, and open source specifically.

There are any number of issues with this argument, of course; I’m sure many of you have spotted a few already. The most basic to me is this: the entire argument is predicated on the notion that the primary innovations in open source software are coming from vendors looking to sell open source software. It is not at all clear today that that is true. The database space is illustrative in this case: none of Cassandra, Hadoop, memcached, MongoDB, Redis, or Voldemort were written to be sold. They were written instead to solve problems, part of a larger trend which is seeing vendors return to roll-your-own software (coverage), and commercial organizations responded to the demand generated. That these and other innovations in the software space have been the product of organizations not in the business of selling software seems lost on those making wider predictions of a general decline in the relevance of open source software.

The fact is that open source is as healthy as it has ever been. If you’re attempting to measure the health of the ecosystem by the size of those selling it, you’re using the wrong metric. Open source faces challenges, certainly, from the cloud and related trends that obviate areas of customer choice that have traditionally advantaged open source software. But it’s equally clear that open source as a development model for non-differentiating software is gaining steam (coverage). The trend is most obvious in web native players collaboratively developing their infrastructure software, but it’s not difficult to project a future in which large enterprises face similar choices regarding software up the stack. How differentiating, for example, is the ability to provide online banking? Do the economics really justify each large bank separately implementing an online banking application? Or are there opportunities to amortize the development costs for application software via open source?

The Net

Regardless of the answer to that question, open source has a bright future. The question, remember, isn’t whether businesses and developers are consuming and producing open source software. They are, in droves. Nor are there questions as to whether or not the software can be sold successfully on a commercial basis: is is, every day. The only remaining questions really regarding the economics of open source are whether they can duplicate the margins of their proprietary predecessors, and frankly I think most customers hope they don’t. Either way, the lack of billion dollar open source firms is not likely to be at all predictive as long as web native firms and others increasingly turn to open source as a primary development methodology.

Categories: Business Models, Economics, Open Source.

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