In this article, we examine seven open source strategies that can give your company a competitive advantage:Â
1. The Optimization Strategy
2. The Dual License Strategy
3. The Consulting Strategy
4. The Subscription Strategy
5. The Patronage Strategy
6. The Hosted Strategy
7. The Embedded Strategy
 Open source presents a large potential competitive advantage for hardware and software vendors, and vendors of complementary or substitute services. Linux has contributed greatly to the adoption and success of OSS. Companies such as IBM, HP, Red Hat, Oracle, and recently, Novell, have invested in, and legitimized the use of Linux for enterprise applications -- including datacenter operations.
Linux-related services deliver more than $1 billion in annual revenue to both IBM and HP. Oracle strongly promotes and likewise derives revenue from the Linux platform, with the so-called "unbreakable Linux" guarantee. In an attempt to catch the Linux wave, companies such as Computer Associates and Peoplesoft are porting their applications to Linux on ambitious timeframes.
In this article, we examine seven open source strategies that can give your company a competitive advantage. (Editor's note: Each of the following links will take you directly to a particular section of the story.)
1. The Optimization Strategy
2. The Dual License Strategy
3. The Consulting Strategy
4. The Subscription Strategy
5. The Patronage Strategy
6. The Hosted Strategy
7. The Embedded Strategy
Individual and enterprise users of software today have many options for satisfying their computing and networking needs. Open source software (OSS) is one of them, and it is often selected because of the broader choices OSS can deliver. For instance, OSS offers enterprises the opportunity to be more self-reliant through source code modification. It allows incremental project and upgrade schedules, free rein in integration decisions, and direct interaction with the OSS community. It creates the opportunity to implement projects in a way that is consistently mindful of enterprise goals, rather than the goals of a proprietary software vendor. OSS allows enterprises to select from a broader range of hardware and software vendors and service providers than proprietary solutions. For these and other reasons, the pace of Linux and OSS adoption continues to accelerate.
Open source presents a large potential competitive advantage for hardware and software vendors, and vendors of complementary or substitute services. Linux has contributed greatly to the adoption and success of OSS. Companies like IBM, HP, Red Hat, Oracle, and recently Novell, have invested in and legitimized the use of Linux for enterprise applications, including datacenter operations. Linux-related services deliver over a billion dollars in annual revenue to both IBM and HP. Oracle strongly promotes and likewise derives revenue from the Linux platform, with the "unbreakable Linux" guarantee. In an attempt to catch the Linux wave, companies like Computer Associates and Peoplesoft are porting their applications to Linux on ambitious timeframes.
There are many strategies around open source platform applications and utilities aside from Linux or an open source solution stack. These strategies include substantial marketing and service alternatives that are creative and highly competitive. An open source initiative, for instance, may establish an industry standard. A relatively straightforward and simple open source marketing decision may reposition a company or product. For example, using the "patronage" strategy, IBM embraces and extends open source software with refinements that may help them pursue new markets or position themselves against established competitors more effectively. While some open source strategies are fairly obvious, others may have hidden agendas such as monopolizing a software segment or leveraging a patent portfolio. Likewise OSS creates product strategy and business model challenges for many traditional software vendors. Companies like Sun, BEA, and Wind River currently feel the impact of OSS on their business as OSS threatens to commoditize parts of their software portfolio.
The companies in the graphic below illustrate some of the OSS strategies being used to create product value, attract customers, and generate revenue. Each of these strategies and models is explained in greater detail in the following pages.
The Optimization Strategy
The optimization strategy is an open source manifestation of Clayton Christensen's "law of conservation of modularity." In the OSS application of Christensen's law, one layer of a software stack is "modular and conformable," allowing adjacent software layers to be "optimized." The modular and conformable layers are commodities, and are unprofitable or only marginally profitable software businesses. The Linux operating system is an example. The disruption caused by a modular and conformable operating system such as Linux serves to erode margins for other operating system vendors like Sun, Wind River, and Microsoft. Winners under Christensen's law are the adjacent, interdependent layers of the software stack, the layers where applications are optimized to achieve greater value, and where, correspondingly, better pricing power exists. Oracle provides an example of an optimized adjacent layer, as an ROI assessment by Mainstay Partners illustrates.
In this case study, Electronic Arts needed fast, reliable servers for its online version of the popular "Sims" game. Oracle proposed the Linux version of its Oracle9i Real Application Cluster (RAC). Oracle has a long history of supporting multiple operating systems. In fact, cross-platform portability was one of the early competitive advantages of Oracle. Portability created an implied assurance that customers would not get locked into a single hardware and operating system vendor.
To compete on the project, Oracle leveraged its database solution with commodity Linux and server hardware, optimizing the Oracle RAC product for Linux clusters, and thereby allowing Oracle to price its software at a higher margin. Hardware for the Oracle Unix (non-RAC) solution would have cost $2 million more, with no better performance than Linux on commodity hardware. Oracle could deliver the Linux RAC solution at an $800,000 premium, while still saving Electronic Arts more than $1.3 million.
The Dual License Strategy
Under the dual license strategy, a software company offers free use of its software with some limitations, or alternatively offers for a fee commercial distribution rights and a larger set of features. In the dual license approach, free use carries certain conditions; typically, any modifications that are distributed must also be made public in source code form, and companies cannot use the free version as a component of any product or solution they commercialize. This prevents third parties from developing improvements that would rival the original open source software.
The dual license approach is not typically one integrated license. It is a business policy that permits a customer to choose one of two licenses: either the commercial license or, typically, the General Public License (GPL). So what is the incentive for dual license vendors to license software without charge? A free option facilitates new business in a number of ways, including improved customer awareness and faster adoption, stronger competitive positioning, and a large base of users to find bugs and recommend improvements to the software.
The dual license allows interested prospects a pain-free path to application development and testing. Developers experience no business complications in exercising the software in a trial project. The right to use software internally for free, without disclosure of their modifications, is more than a money-back guarantee. Competitively this creates a wide advantage over highly supervised trial licensing practices.
Any commercial license requires a metric by which the customer is charged. For the MySQL database, the commercial metric is a per-server fee. It doesn't matter to MySQL who pays -- the distributor or the user of the application. In the case of the Sleepycat commercial database license, the software can be used in one application on any platform. Unlike many OEM licenses, this application-only limit by Sleepycat creates a highly favorable and uncomplicated metric for OEM licensee adoption and redistribution. Both MySQL and Sleepycat incorporate a tiered approach by charging higher fees for more functionality.
The dual license strategy delivers complementary revenue streams of a traditional commercial software model, through maintenance offerings or services that earn consulting or training fees. A dual license strategy can capture a large user base. Free software often generates high numbers of downloads and broad awareness. By comparison, there have been, and still are, hundreds of software companies which have invested, in aggregate, billions of dollars, only to each gain a mere handful of customers, some paying and some not, in the end. The dual license strategy provides a powerful tool to build a strongly defensible market position. Many companies and VCs with shelved software projects might consider re-evaluating the worth of their proprietary software as open source, especially where it can be leveraged to attract a larger prospect base to an already profitable business.
The Consulting Strategy
In an article he wrote in 1999, Clay Shirky said:
30 years ago, every IT department in this country was in the business of building custom products, and the software industry grew up around that assumption. Now, open source suggests an almost pure service model, where the basic functionality costs nothing, and all the money is in customization.
Indeed, an internal McKinsey Consulting study cited in 1999 suggested that enterprise solution fees are 30% license and 70% implementation. According to a 2000 U.S. Department of Commerce report, not since 1962 has packaged software investment reached 30% of total software investment. So Linux or not, software licenses are earning a smaller portion of information technology (IT) investment, while consulting and services continue to rise.
One company in the open source consulting space, 10X Software, provides enterprise integration consulting for popular open source software including MySQL, Apache, JBoss, Tomcat, and Eclipse. 10X customers include major corporations running mission-critical applications. 10X partners with JBoss, to improve and accelerate middleware migration from proprietary software like BEA Weblogic to open source solution stacks. According to Red Hat, the operating system comprises only 4% of the overall revenue of a Linux-based solution. Delivering a customer solution involves integration of hardware, software, and maintenance: middleware integration is one place where high margin consulting business can be won. With increasing frequency, custom application consulting is performed by system integrators and value-added resellers (VARs), the vendors closest to the customers. These vendors have seen the advantages of OSS, making existing VARs and resellers of Microsoft, BEA, and Oracle, prime converts to broad OSS-based solutions. Linux certification programs from Red Hat, Novell, and from Sun for JBoss greatly reduce the support concerns that customers previously raised about OSS. Applying commodity servers, Linux, OSS databases, Web servers, and middleware as Clay Shirky predicted, system integrators like 10X Software see the opportunity to remove nearly all licensing costs from a proposed solution, and create winning bids for customers, at both lower prices and higher margins.
The Subscription Strategy
According to Culpepper, "revenues from services -- both maintenance and consulting -- increase in proportion relative to revenues from licenses. Move out to the 20-year mark, and the typical software company will have $2 of services for every $1 of licenses."
The table below illustrates this trend in the case of Novell, and introduces the subscription strategy being applied by many OSS companies. The strategy explains why Novell acquired SUSE, supplier of one popular Linux distribution. Red Hat, also shown in the table, is rapidly growing its maintenance revenue for the Red Hat Linux distribution. Unlike the NetWare software product from Novell, the Red Hat Linux distribution generates no license revenue for Red Hat. But clearly Red Hat maintenance revenue is increasing at a faster rate than Novell maintenance revenue. The SUSE acquisition puts Novell in a position to supplement its dwindling NetWare maintenance revenue with maintenance revenue based upon the rapid growth of the Linux market. Novell may also recognize the opportunity to update a portion of the two million aging Windows NT-based servers with the Linux OS, including maintenance.
The table to the right compares financial percentages of Red Hat (past 9 months) with Novell (past 12 months) from reports in Q1 2004. In the table, Red Hat "subscription" revenue reflects what most companies report as maintenance, as quoted from the Red Hat quarterly report: "The base subscription entitles the end user to one year of maintenance, which entitles the end user to configuration support and updates and upgrades to the technology, when and if available, during the term of the subscription[s] (sic)." Below is how Red Hat defines services: "Enterprise technology services are comprised of revenue for enterprise consulting and engineering services, and customer training and education."
Aside from Novell and Red Hat, there are many other open source segments and markets being addressed using the subscription model. Covalent, for example, has built a subscription and support business around the popular OSS combination known as LAMP (Linux, Apache, MySQL, and PHP). Sun is offering StarOffice and much of its developer and enterprise software using the subscription model, acknowledging that developers prefer subscriptions and memberships. Lindows provides access to a large library of open source desktop applications for an annual subscription fee. EJB Solutions provides distributions on a subscription basis to more than 100 open source projects.
The Patronage Strategy
Why would a company like IBM, or any company for that matter, contribute time, energy, developers, and code to an open source organization? There are a number of strategic reasons. IBM does it to drive standards adoption and crack entrenched markets. When a company contributes open source software to an independent organization, it anticipates that a de-facto standard and supporting community will converge around that contribution. A company may also use the patronage strategy to commoditize a particular layer of the software stack, eliminate competitors that are extracting revenue from that layer. For example, IBM, as a major corporate patron of Linux, seeks to commoditize the x86 operating system, eliminating server fees for Microsoft Windows and Sun Solaris. This creates an opportunity for IBM to offer value higher up the stack through clustering, availability, provisioning, security, and management software.
To succeed with a patronage strategy, the patron must deliver more than just source code. There must also be leadership and consistency. Mozilla is an example of a project that failed in this regard. In January 1998, with 60% of the browser market, Netscape was losing market share to Microsoft. On April 1, 1998, Netscape publicly released the source code to what ultimately became Mozilla. Clearly Microsoft had picked an easy target. The Mozilla project continued to deliver buggy, late releases, and by January 2004, Microsoft had gained 95% market share, with Mozilla falling to a mere 2% share of the browser market. Contributing software to the open source community alone was not sufficient to save the successor to the Netscape browser.
Another interesting case is the Apache Web server. IBM dropped its own offering, which had loyal support within IBM but few synergies outside the company. At the time, Apache had about 50% of the Web server market, and Microsoft was steadily gaining share. By adopting Apache, IBM prevented another episode like Netscape, where Microsoft seized control of the browser platform. Apache continues to accelerate in popularity, with 70% of the Web server market today. IBM's patronage strategy successfully prevented monopolization of the Web server market by Microsoft.
When IBM open-sourced all of its Eclipse code with a contribution valued at $40 million, it rearranged the integrated development environment (IDE) landscape. Since Eclipse lets developers target Linux, Java, or Windows, it potentially replaces Sun or Microsoft with a standard cross-development framework in which IBM can better integrate its Rational tools.
Aside from IBM using Eclipse to develop its own software, Eclipse potentially levels the field for IBM across a large development community. By commoditizing the framework, IBM can add value higher up the development tool chain. IBM licenses tools that customers will purchase if integrated well in a development platform. Furthermore, since Eclipse is free, programmers are likely to learn Eclipse as part of their education. Once they are experienced with the Eclipse IDE, they are lifelong prospects for robust software tools from IBM's Rational product line. IBM might have pursued business development through university licensing programs. Instead it made a long-term $40 million dollar investment in open source software available to everyone in computer science and engineering education worldwide. According to data from the Eclipse community group, there are more than 10,000 download requests per day and more than 450 Eclipse-related projects. From that effort will emerge a stream of prospects for Rational tools from IBM. But, like many other large software providers, IBM must carefully manage the potential open source competitive threat to its software franchises such as Rational, Websphere, DB2, and Notes. In the relatively near future open source will infringe on those domains, and IBM and other independent software vendors (ISVs) will have to look to other areas to add value.
IBM has been very focused on where it applies its open source energies. The company has an Open Source Steering Committee that has approved many OSS initiatives. IBM's OSS initiatives are clearly vested in server strategies as opposed to the desktop. As a result of such focus, IBM has succeeded in commoditizing the Sun Solaris operating system and in slowing down Microsoft server adoption in the datacenter. It has made no headway yet, however, in breaking up the Microsoft Office desktop monopoly.
Most major original equipment manufacturers (OEMs) and software providers have adopted the patronage strategy to some extent. Today HP supports more than 60 open source projects that provide tools, utilities, and solutions that make it easier for customers to deploy or customize their products. SGI supports numerous open source projects that are focused upon their high performance computing market.
The Hosted Strategy
In a January 2004 interview with Java Developer's Journal, Scott McNealy gave the following prediction:
Software licensing and deployment models will be radically simplified. 2003 was the year we saw a bunch of companies finally get the service provider model right. Companies like Salesforce.com, eBay, and Google, are in the software business, but they don't sell their software, they let you use it or rent it. You're going to see a lot more activity in this space in 2004.
Similarly, at the March 2004 Open Source Business Conference, Tim O'Reilly discussed what he called the "Open Source Paradigm Shift," advising companies to look for "hidden service business models." He pointed out examples like "Google and Amazon, whose APIs treat Web applications and their data as programmable components."
In looking at open source business models, it is apparent that service providers have much to gain from OSS. They can use GPL-licensed software internally without restriction and without the obligation of sharing their code modifications. This allows them to leverage open source, and incur little or no competitive risk. The GPL license allows them to own and keep secret the intellectual property modifications they create, and as long as they don't distribute the software, they don't have to publicly share the modifications. Using open source allows them to lower costs, while delivering extremely reliable enterprise-quality services.
For example, in June of 2003, Salesforce.com CTO Dave Moellenhoff disclosed to LinuxPlanet that his company used open source Eclipse and Linux. Salesforce.com, an application service provider (ASP), provides a net-native customer relationship management (CRM) application based on a monthly per-user subscription model. Netsuite, another ASP with both financials and CRM applications, also makes heavy use of OSS for delivering its services to customers.
Consider also Amazon, through which billions of dollars of consumer transactions flow each year. Amazon is a large user of OSS. CNET a few years ago discussed Amazon's SEC filing, where Amazon attributed millions of dollars in savings to "migration to a Linux-based technology platform that utilizes a less-costly technology infrastructure."
Google even more impressively bootstrapped its business using Linux and commodity servers, saving Google millions in server infrastructure costs. Sergey Brin, co-founder of Google, gave the 2002 keynote presentation at LinuxWorld, describing how Google runs Linux on more than 10,000 servers, generating advertising revenue through a search service that is known for speed and relevancy. Google is now rumored to be running more than 100,000 Linux servers, and laying plans to leverage its server infrastructure in ways that extend far beyond search.
Computerworld reported in 2002 that financial services companies, often the leaders in IT adoption, were rapidly deploying Linux servers. One major example is E-Trade, a successful Internet-based banking and securities trading service.
What do these companies all have in common? They are hosted service companies using OSS as a cornerstone to their IT platforms.
The Embedded Strategy
Linux is the operating system used in more than half of the embedded systems market. It has been used in consumer products such as TIVO and in devices large and small, from servers to cell phones. Throughout the world it is rapidly becoming the operating system of choice for many low-cost communications products.
It is well known that hardware vendors adopting Linux gain a platform that is functional, extensible, and quickly implemented with minimal capital outlay. A hardware vendor starting a new project should encounter few complications using Linux to get started with design and feasibility testing. And because Linux runs on generic hardware, engineering, prototype, and demonstration hardware costs are a minimum. For a hardware vendor, these advantages free up budgets for potentially better uses in creating value for the customer.
Michael Tiemann, CTO of Red Hat, offered a technical strategy in a May 2002 editorial in Linux Devices. The key, according to Tiemann, is viewing open source as a platform, not merely using Linux as a product to replace a proprietary operating system. "The fact that Linux can be licensed free of charge changes the equation almost not at all." Hardware vendors should utilize standards and commodities, including Linux, as a platform strategy, and move up the chain by developing software that actually creates value. Set-top vendors, for example, might be more viable businesses today if they had pursued truly open platforms and standards. But companies continue to waste their development dollars on software functionality that is otherwise free and available through open source. They persist in buying third-party proprietary platforms or creating their own proprietary development platforms that deliver marginal product differentiation and limited value to customers.
In contrast, Linux and other open source software deliver great value in the embedded market. The inherent technical advantages of Linux for embedded systems include stability, small footprint, and networking. Through the IPv6 implementation, Linux can address thousands of embedded devices. The Linux kernel is well-known for its stability. Linux has relatively low latency, and is generally capable of driving hardware across the embedded device spectrum. Where embedded applications present a real-time performance challenge, the Linux kernel can run as a task under a real-time OS. Linux includes well-documented device drivers. A large support community exists, deeper and potentially more responsive than many proprietary vendors can field. Development tools for embedded Linux are improving.
In a December 2003 article, Business 2.0 illustrated the powerful potential of embedded Linux and open standards. Linux running on commodity hardware allowed network device developer Neoteris to concentrate on creating value-added software. Neoteris delivered a product with more features, months before the competition and at lower price. The strategy clearly paid off in October 2003, when Netscreen acquired three-year-old Neoteris for $265 million in stock and cash.
The bottom line: Determine your own path
There are a number of ways to chart successful open source business strategies. Open source provides a powerful tool for getting a business on a faster revenue trajectory, for improving value, and for out-maneuvering the competition. Some of the business models in this discussion parallel traditional commercial software; others invoke new services or businesses. Examples like Amazon, Google, and Neoteris demonstrate that Linux and other OSS can even help companies that are not strictly in the software business achieve tremendous growth and profitability in a relatively short time.
Business managers should understand open source business strategies and determine which strategies are useful for their companies to adopt. Investors should consider the models here when evaluating companies they may be considering for their portfolios. Identifying trends quickly and taking action can be a powerful advantage. Hopefully this article provides a clear introduction to the open source business dynamics that are permanently changing the software industry.
John Koenig is the founder of Riseforth, Inc., management consultants to software and service businesses and electronics manufacturers. He has worked at Fortune 500 companies General Electric and Tektronix, and at startups Mercado and Myrio. He served for six years as corporate counsel and an officer of nCUBE and more recently led regional business development for Zuken, one of Japan's largest software companies. Contact him at (650) 726-7775 or
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