Open source as competitive weapon proves to be bad investment

Oliver Alexy of Technische Universitat Munchen (TUM) Business School has written an interesting paper titled "Putting a Value on Openness: The Effect of Product Source Code Releases on the Market Value of Firms." The research traces the impact of open source on company market valuations from January 1, 1999, to April 30, 2007. The research is hampered somewhat by a lack of private-company data, but it still offers up some useful conclusions.

Alexy tracks open source through the pre-bubble era (mostly hype leading to outsized but highly transitory investor returns) to today, where open source is becoming the de facto way of building software businesses. You can see the rise, then fall, and subsequent rise in the graphic at right.

Along the way, he suggests, investors have grown wiser as to what kind of open-source business models make sense.

Intriguingly, the early bible for would-be open-source capitalists (Martin Fink's The Business and Economics of Linux and Open Source) turns out to have offered up mostly wrong advice, so far as investment returns go. Using open source as a competitive weapon to batter competitors yields paltry returns, according to Alexy:

When looking at the business model the firm chooses, I find that firms that use OSS (open-source software) merely as a competitive weapon see a significantly worse investor reaction than those firms following one of the other three business models. I maintain that the reason behind this negative market reaction is that the business models cost or risk reduction, dual licensing, and sale of complementary goods or services are usually introduced together with a clear revenue model, which enables the company to appropriate value from its OSS engagement, and that the capital market values this more highly than the usually uncertain long-term benefits of the competitive weapon model. The correlation table also hints in the direction that R&D-intensive firms tend to rather use the competitive weapon model, whereas firms with lower R&D-to-sales ratio rather choose the sale of complementary goods or services. (20)

In other words, if a vendor is more worried about pulverizing its competitors than it is in serving its customers, the investment markets recognize this and punish its stock. While I personally love the competitive effects open source can have, it's a secondary benefit. Customer value should always come first.

Alexy's comment about higher R&D with "competitive weapon" companies is telling. It suggests to me that these companies invest a lot of R&D dollars in their proprietary technology and invest considerably less in their open-source products. Why? Because they view open source as something to throw away so as to subvert a competitor, rather than as something to invest in for customer value.

Alexy thinks that there may be long-term benefits to the competitive weapon model that investors aren't recognizing, but I think his initial hunch is right. A business based on beating competitors will lose every time to one focused on helping customers. (This is one reason that Microsoft needs to remember that enterprises buy its products for their value--they don't buy Microsoft's anti-open-source FUD. Not one penny goes toward installing FUD.)

What's the takeaway from this research? Open source is a positive force for customer value. Treat it as such, and the market will reward you. Think of it as a way to shore up one's proprietary business while undermining a competitor's proprietary business, and prepare for your stock to drop.