It is impossible to overstate the importance of open-source software in the IT sector. Venture capital has poured into the IT sector in recent years. This article analyses whether current valuations are reasonable and whether the open-source model is suited to the return profile that venture investors seek.
OSS Monetization models
Open-source software is, by definition, free. This has obvious benefits for consumers. In fact, according to a 2008 Standish Group study, “free, open-source software saves consumers $60 billion per year in IT costs.”
Even though it is obvious that providing free software benefits consumers, the development of such software still costs money. Few companies can survive on sponsorships and donations. Fierce competitors from proprietary software providers, increasing R&D costs, and ever-increasing market requirements make it necessary to provide a “free product” as a way to achieve sustainable success.
In light of the above, a common structure for OSS projects can be described as follows: A commercial “parent” company, which is the main contributor to the OSS, provides support to the users and maintains and develops the product.
The most common monetization strategy is:
Additional charge for enterprise support, consulting, and services. The classic model is aimed at large enterprises with sophisticated needs. Examples include MySQL, Red Hat Hortonworks, and DataStax.
Freemium. (advanced features/products/add-ons) A custom-licensed product on top of the OSS might generate a lavish revenue stream, but it requires a lot of R&D costs and time to build. Cloudera is an example of a company that offers the free version and charges customers for Cloudera Enterprise.
SaaS/PaaS Business Model: A modern way to monetize OSS software by centrally hosting it and shifting the maintenance costs onto the provider. Examples: Elastic, GitHub, Databricks, SugarCRM
Historically, OSS projects that have been successful in monetizing their work (through support and consulting) have followed the first monetization model. However, at their core, these models allow a business to make money from their “bread-and-butter” and provide the necessary funding for the development team.
The influx of VC dollars
The huge inflow of VC/PE funds into the industry is an interesting development. In 2004, nine companies that produced OSS raised venture capital funding. By 2015, this number had exploded, reaching 110 and raising more than $7 billion in venture capital funds.
This development is based on the huge addressable market from which OSS companies can benefit. OSS, like other “platforms,” allows companies to expand their customer base rapidly. The idea is that, in the future, they will be able to leverage this growth and start converting their customer base to revenue and profit.
We’re seeing more and more reports about possible IPOs within the industry. Several OSS companies, including unicorns valued at $1B+, are rumored to be interested in a public market debut. These include MongoDB, Cloudera MapR Alfresco Automattic Canonical, and others.
In this context, it is obvious to ask whether the OSS works financially, especially for VCs and PE investors. The venture funding model requires rapid growth to meet their 7-10-year fund life cycle. It remains to be determined whether OSS companies will be able to find the right monetization model for a product that is free at its core.
This question is difficult to answer, mostly because these companies are privately owned and do not reveal their financial performance. The only reliable sources of information are usually the estimations of industry experts and sometimes management interviews in which unaudited key metrics are disclosed.
In this article, I examine the publicly available data from Red Hat and Hortonworks to assess whether the OSS business model is a good investment for VCs.
Red Hat is a good example of a company that was the first to adopt an open-source business model. They were founded in 1993, and they went public in 1999, just before the Dot Com bubble. At that time, their share price was the eighth-largest first-day gain on Wall Street.
Red Hat did not have a profit at the time of its IPO. However, since then, they’ve managed to achieve solid financial results, as shown in Table 1.
Red Hat chose to build a sustainable company over chasing annual growth. In the last decade, Red Hat has increased its revenue tenfold, from $200 million up to $2 billion. Operating and net profit margins have not changed significantly. G&A expenses and marketing costs never exceeded 50% (Chart 3).
This shows that OSS businesses have a good chance of building sustainable and profitable business models. Red Hat’s strategy of focusing on support and consulting has led to gradual but steady growth. The company faces few funding or solvency issues and is posting good profitability metrics when compared with peers.
The Red Hat case study shows that such a plan can take a long time, many years, in fact. This is an entirely reasonable scenario for most businesses, but it is not acceptable to venture capitalists, who, by their very nature, require a much faster growth profile.
The OSS model, however, may not be able to provide the growth required by venture capital funds. Marten Mickos stated that MySQL aimed to “turn the $10 billion database business into $1 billion.”
The open-source approach, in other words, limits the market from the start by focusing on only enterprise clients who can pay for support and excluding revenue from SME and retail customers. This may explain the less-than-exciting stock price performance of the company post-IPO (Chart 4)
If this conclusion is true, it would be a problem for those OSS firms that have raised large amounts of VC money along with the funds that have invested in them.
In order to further evaluate our question about OSS’s viability in terms of venture capital, I looked at another publicly traded OSS company.
It is interesting to note that the Hadoop vendor market is built entirely around the idea of ” Open Core.” Another comparable market would be the NoSQL database space, with MongoDB and Datastax OSS.
Cloudera, Hortonworks, and MapR, the three largest Hadoop vendors, are based on the same OSS stack but have interestingly different monetization methods. Hortonworks, the only publicly traded company, is the only one that offers all its software free of charge and only charges for support, consultation, and training.
Hortonworks, at first glance, appears to have a different post-IPO journey than Red Hat. It seems like a story about rapid growth and success. The company was established in 2011 and tripled its revenues every year for three years in a row. Then, it went public in 2014.
The stock soared 65% within the first few trading days. Despite this, the story of the company since its IPO has been decidedly sour. In January 2016, the company had to re-access the public markets in order to make a secondary offering. This led the share price to fall 60% within a single month.