Revision as of 12:31, 16 March 2007

Open Source Business Models: why they make sense

Problems with the older model of IP rents

"Standard business models ... aim to extract economic benefit primarily from the value of tools as end products (ie their value as final goods). The business creates the tool, fences it around with intellectual property protection, and derives revenue by selling the tool or, more commonly, charging frees for access under a licensing agreement.

From a business perspective, this IP-rent extracting model has a number of advantages. The relevant property transactions can be tailored in a range of ways, e.g. to allow for price discrimination. Fees can be charged independent of any services provided, which makes it possible for a new business to start small but grow quickly. Most importantly, the price charged for the product need not bear any proportional relationship with the initial costs -- so profit margins can potentially get very large.

However, because the IP-rent extracting strategy relies directly on restricting access to the tool, it also has a number of costs. From a public interest perspective, the main costs are higher prices in the short term (the well-recognised cost of granting a monopoly) and threats to future innovation in the longer term. In the longer term, of course, the company itself also has an economic interest in ensuring continuing innovation so it can remain competitive as the market changes.

Less obviously, restricting access to intellectual property poses an immediate economic challenge to the company: it alone must generate all of the value offered to its customers. This is particularly hard for smaller companies because their resources - money, people, time - are more limited, but it is a cost for any company, no matter what its size." (http://rsss.anu.edu.au/~janeth/OSBusMod.html)

Advantages of the new model of engaging outsiders

"The open source approach offers an opportunity to address these economic challenges by expanding the resources available to the company to include resources that lie outside the firm boundary. In this model, the company allows users access to its intellectual property, and in return it gets help with developing the tool instead of having to do everything on its own. Open source licences support this strategy in two ways. The first is purely practical: users cannot become codevelopers of a tool unless they have access to that tool in a form that they can understand and modify. In the software context, this issue is addressed by the requirement to provide access to source code; an open source biotechnology licence would also need to guarantee such access one way or another. The second relates to users' incentive to contribute to a co-operative effort: if potential contributors expect to be prevented from using the tool that they helped to create, they will be reluctant to contribute in the first place. Seen in this light, the open source prohibition on terms restricting use, redistribution and modification of licenced subject matter is a way of shoring up the motivation of potential contributors.

Not only do open source business models offer a way around resource constraints for individual businesses, they also preserve many of the advantages (from a public interest/long term innovation perspective) of straight-out donations of intellectual property to the public domain as per traditional academic practice. Importantly, open source licensing of intellectual property does not entail giving up ownership of the property; rather, ownership rights are exploited (through licensing agreements) to harness the input of a large number of users or potential users to create and/or improve the tool. Yet because open source licences allow use, redistribution and modification of subject matter without imposing any fee, intellectual property that is subject to such licences has been characterised in efforts to map the public domain as "contiguous territory".

There is, of course, a downside from the business perspective. Clearly, open source prohibitions on restrictive licensing terms are incompatible with standard "proprietary" business models." (http://rsss.anu.edu.au/~janeth/OSBusMod.html)

Characteristics of successfull Open Source Business Models

For an open source business to work well, a start-up needs a number of attributes that a closed-source software company doesn't, executives said.

In particular, they have to combine their pursuit of profit with active involvement in a vibrant "community" of open source users, some of whom are not paying customers. Not all open source companies are hitting the right balance between commerce and community, analysts and executives said. "Too many of these companies [now forming] are being funded without a community," said David Skok, a venture capitalist at Matrix Partners. "If a community doesn't form and form fast, then they're going to burn through their venture capital, and they're going to be disasters." Open source companies typically give away their software with source code to potential customers and either charge for a more functional version or charge for ongoing support services. Over the past two years, a number of companies have chosen variations on that business model to try to unseat incumbent software providers. The pace of investment in those start-ups has also picked up. Until the end of September this year, the amount of venture money that went to companies with "open source" in their business description was $144m (£81.8m). That's more than double the total for the whole of last year, according to research from the National Venture Capital Association, PriceWaterhouseCoopers and Thomson Venture Economics.

But the business model has its limits, said Skok of Matrix Partners. Skok, who led investment in open source Java software provider JBoss, said he recently passed on funding a business-intelligence start-up. One problem was that it didn't have a sizable open source community behind it. A strong community of users can contribute bug fixes if the product is developer-oriented or provide feedback on desired features, executives said. Perhaps more significantly, an active community of users helps sell revenue-generating products and services. By giving away entry-level products, potential customers can try out the software without a long, complex sales process. That dynamic can dramatically lower the cost of sales and marketing for a provider.

SugarCRM, for example, does not employ direct sales people, who are typically highly paid. Instead, the users of its open source product are the primary source of sales leads, chief executive John Roberts said. A smaller sales and marketing budget allows it to divert its resources toward engineering, he added. There is a drawback. By the same token, open source companies can be slowed if an active group of customers switches to another product, said Winston Damarillo, the chief executive of software developer Mergere. Instead of charging an annual support service fee on a free product as many companies do, EnterpriseDB uses a "plain old software licence", Astor said. The only difference with closed-source providers is that the EnterpriseDB database is based on PostgreSQL, an open source product." (http://insight.zdnet.co.uk/software/0,39020463,39235813,00.htm)

Examples

Overview of the commercial uptake of Open Source software

June 2005:

"And so Linux entered commercial use. Its first, and still most successful, niche was Web servers; for at least five years, the majority of the world's Web servers have used open-source software. Then, several years ago, IBM started to contribute money and programmers to open-source efforts. IBM, Intel, and Dell invested in Red Hat Software, the leading commercial Linux vendor, and Oracle modified its database products to work with Linux. In late 2003, Novell announced its purchase of SuSE, a small German Linux vendor, for more than $200 million. IBM invested $50 million in Novell. IBM, Hewlett-Packard, and Dell began to sell hardware with Linux preinstalled. IBM also supports the Mozilla Foundation, developer of the open-source Firefox browser, and with Intel, HP, and other companies recently created the Open Source Development Labs (OSDL), a consortium promoting the business use of Linux, which has hired Torvalds and other open-source developers. Now, Linux is running on everything from $80 routers to cell phones to IBM mainframes, and is much more common on desktop PCs. Red Hat is a highly profitable $200 million company growing 50 percent per year, and commercial open-source vendors serve many important software markets. For instance, in databases, there is MySQL, which now has annual revenues of about $20 million, doubling every year. In application servers, there is JBoss, and in Web servers, Covalent. In the server market, the eventual dominance of Linux seems a foregone conclusion. Michael Tiemann, Red Hat's vice president for open-source affairs, told me, "Unix is already defeated, and there's really nothing Microsoft can do either. It's ours to lose." Of course, Microsoft, which refused all interview requests for this article, sees things differently. But surveys from IDC indicate that in the server market, Linux revenues are growing at more than 40 percent per year, versus less than 20 percent per year for Windows. Unix, meanwhile, is declining." (Charles Ferguson, Technology Review, June 2005, at http://technologyreview.com/articles/05/06/issue/feature_linux.asp?p=2 )

For the ‘governmental uptake’ of Linux, see http://news.com.com/2100-1001-272299.html?legacy=cnet& (August 2001 overview by CNet’s News.com)

Discussion

Why It Makes Sense to Open Up Software

Jonathan Schwartz, CEO of SUN, explains why it makes sense for companies to open source their software:

Now, I've heard from a few stockholders saying, "What? Sharing? Free Software? What's up with that! Go make some money!" And so I thought I'd put down, once and for all, why we're committed to sharing, to open source, open standards, and eradicating the digital divide. Ready?

Because we're going to make more money. How? It's trivially simple. Why do carriers give handsets away for free? Because they make money on the subscription necessary to receive the handset. Why do banks give away free checking, or free credit cards? Because they acquire new customers. Why do Google and Yahoo! give away free search? Because there's a fortune in the end result. So why on earth would we give our OS away for free? Because it'll ensure those without the economic wherewithal to pay for it will still consider using it. Companies that suffered from piracy a decade ago now know the lesson well - piracy is a good thing so long as the pirates are folks who could never afford your products. So stop calling them pirates, call them users. Free software has no pirates. As I've said forever, there's value in volume, even if you're not paid for it.

Do I worry about enterprises or corporate customers taking OpenSolaris and not acquiring a subscription to someone's (hopefully our) service contract? No, not in the least. Do you really think a hospital, or an air traffic control authority or a Minister from an African nation would run their institution on unsupported software? No. No way. Are we guaranteed to get that business? Nope. But we are guaranteed the opportunity will be greater than if we kept Solaris locked up. And I'd rather get 20% of a business that's planetary in scope, than 100% of a business with 17 customers. Like I said, there's value in volume. (And I haven't even touched upon the impact of open sourcing on innovation.)

To prove the point, the Minister this morning was joined by the head of a bank headquartered in his country. His customers are increasingly coming to him via the network. He clearly recognized that a world in which the development and digital divides have been eradicated is a world in which he grows more customers, transaction volumes and business opportunities. And we both recognized that as the divides are eradicated, he'd find himself... ...buying more infrastructure to support his business. (Just so happened he was a Sun customer - and given that it is Q4, I will admit to giving him a brief update on chip multi-threading and storage containers.)

Sharing is good for our business. Free software is good for our business. Anyone who believes in preserving the old model of software distribution is, at a certain level, fighting gravity. The most popular credit cards are the free ones. The most popular handsets, search engines, and checking accounts are the free ones. Just like the most popular operating systems will be, in the long run, the... Free ones. nd as I've consistently said, and as you'll soon see, there's a lot of value in volume." (http://blogs.sun.com/roller/trackback/jonathan/Weblog/sharing)

The General Public License as an ‘ideal capitalist tool’

“The GPL is one of the most exciting, innovative capitalist tools ever created. The GPL breaks down walls between vendors and customers while enabling strong competitive differentiation. Unlike the BSD, which strikes me as serving an ever-narrowing slice of the development community that shares code simply for the sake of sharing, the GPL takes a hardheaded look at software development (and human nature) and works to maximize choice, control and a free market. From its inception, the IT business has depended on intellectual property. This dependence is enshrined in the U.S. Constitution, Section I, Article 8, which establishes copyright/patent to "secur[e] for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries." This limited monopoly grant has enabled software companies to create exceptional, customer-focused products without inordinate fear that competitors will freely clone their innovations for sale as their own. No other open source license has done more than the GPL to make open source commercially viable. By emulating the traditional copyright format, the GPL facilitates commercial involvement in open source communities, which is important for expediting the spread and depth of open source software. Free market open source, thanks to the GPL." (Matt Asay is director of Novell's Linux Business Office, Network World, http://www.networkworld.com/supp/2005/opensource/070405-face-off-no.html)

More Information

Articles

Open Source Initiative, "Open Source Case for Business", http://www.opensource.org/advocacy/case_for_business.php

Open Source Initiative, "The Open Source Case for Customers", http://www.opensource.org/advocacy/case_for_customers.php

Behlendorf, Brian. 1999. Open Source as a Business Strategy. In Open Sources: Voices from the Open Source Revolution, edited by C. DiBona, S. Ockman and M. Stone. Online version: O'Reilly. Available from http://www.oreilly.com/catalog/opensources/book/brian.html

Hecker, Frank. 2003. Setting Up Shop: The Business of Open-Source Software [Internet]. hecker.org 2000 [cited 21 Jan 2003]. Available from http://www.hecker.org/writings/setting-up-shop.html.

Young, Robert. 1999. Giving It Away: How Red Hat Software Stumbled Across a New Economic Model and Helped Improve an Industry. In Open Sources: Voices from the Open Source Revolution, edited by C. DiBona, S. Ockman and M. Stone. Online version: O'Reilly. Available from http://www.oreilly.com/catalog/opensources/book/young.html

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For a general discussion on how peer production, and free software and open source models in particular, fit in the for-profit economy, see our entry: Peer Production - Immanence vs. Transcendence

Open Source Commercialization: Difference between revisions