The Open-Source Business: What’s Tomorrow’s Dominance Worth Today?

“Futureshock:  The dizzying disorientation that accompanies the premature arrival of the future.”
– Alvin Toffler
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It took a long time for the concept of open-source to build to such a broad awareness that the mainstream media would write about it.  But it’s happening more than ever, and today the NY Times published an interesting piece about open-source business models and the strategic value of the entities and their respective technologies.

The author, Ashlee Vance, is a long-time and respected reporter in the technology industry.  Two of his key observations come together to create a puzzling effect:  First, that an open-source company’s revenues are a small fraction of their software downloads, and second, that the market value of the entities is tremendously outsized compared to their revenues.  He’s right on both fronts.  What’s not obvious is why these things are true.

A large handful of major open-source companies have been acquired for anywhere from 20 to 500 times their trailing revenues — astronomically high compared to other acquisition price ranges.  Here’s the key:  Not one major open-source acquisition has ever been initiated by the proprietary incumbent. Instead they were acquired by a company in an adjacency (e.g., Xen by Citrix, SpringSource by VMWare, MySQL by Sun, JBoss by Red Hat, etc.)

This is the dynamic caused by the constant shifting of technology markets:  Stand still and other vendors will morph around you, surrounding your offering and reducing your industry power.  Aggressive acquiring companies push this envelope, crafting strategies that are missing a key component – one that is unfortunately the property of another proprietary software company.  They covet that missing piece, so they choose to acquire the open-source inheritor of the space — and in the process, pay a large strategic premium.  It’s that simple.  (The same kind of “inheritor’s premium” is calculated in the public markets:  Red Hat’s P/E ratio is 60, while Microsoft and Oracle are at 19.)

So yes, the multiples are tremendous.  Meanwhile the open-source software is flowing like water around the world.  What gives?  It’s the combination of forward-looking investors and brutally efficient markets.  Under the right conditions, open-source will eventually dominate a category because it is the most economically efficient software model in the world. And smart investors (and acquirers) know that.

So what are the key conditions for open-source hegemony?

• Attacking very large markets, not niche ones.
• The average customer’s technical requirements are over-satisfied by the incumbent.
• Standards are broad enough to reduce vendor pricing power and induce commoditization.

With the proper business model, an open-source vendor can exploit these conditions to make their software “go viral.” The vendor wants their software to be ubiquitous so that users get comfortable with it, test it in labs, and begin to fold it into their longer-term IT strategies.  The primary goal is a worldwide user community.  What capitalists often miss is that every free download is not a lost sale; it’s an advertisement on steroids, a deeply powerful method of engaging a sales prospect.  And it was free of marketing cost.

Downloads are a future indicator of sales trending.  If the numbers are high, smart investors recognize this as a preamble to long-term growth.  But there will always be free users too, and cagey acquirers consider the competitive benefit of denying their competitor a sale for any reason.  If you can’t leave an impression, leave a mark.

But in the beginning the open-source vendor must grow their own sales.  This is dependent upon the buying patterns of the industry it’s attacking.  Valuable areas like expensive proprietary infrastructure have long replacement cycles.  So it’s no surprise that Red Hat has the largest open-source revenues:  they began inheriting the Unix market fourteen years ago.

The open-source business model works.  It’s just measured very, very differently.  And by the way:  Vyatta is now at half a million downloads in only three years 🙂