Open-source companies chase steady money

Start-ups specializing in open source are speeding up an industrywide shift to subscription-model pricing.

Martin LaMonica Former Staff writer, CNET News
Martin LaMonica is a senior writer covering green tech and cutting-edge technologies. He joined CNET in 2002 to cover enterprise IT and Web development and was previously executive editor of IT publication InfoWorld.
Martin LaMonica
5 min read
When entrepreneur Byron Sebastian started his company last year, he set his sights on the business software industry's ultimate cash cow: maintenance contracts.

Rather than charge large up-front fees for a product, his company, SourceLabs, will try to siphon off some of the millions of dollars corporate customers earmark for support. Like a growing number of start-ups, Sebastian's weapon of choice is open source.

The spread of open-source software, which generally is freely available, allows smaller companies to compete for maintenance money that until now has been locked up with incumbent software vendors, he said.


What's new:
In the absence of software license fees, open-source companies are adopting a services-intensive business model, accelerating an industrywide shift toward ongoing, rather than up-front, revenue.

Bottom line:
Established software companies often tout the benefits of subscription-based revenue models, but it is unclear whether smaller open-source outfits will be able to grow their businesses effectively.

More stories on open source

"Open source creates a competitive market for support and maintenance contracts," Sebastian said. "For the first time, you can build a successful business by being great at that, rather than just being mediocre."

Many industry veterans argue that open source is accelerating a shift that has been going on in the software industry for some time: Rather than hinge their business on big-ticket license contracts, software providers increasingly rely on recurring maintenance revenue.

And because most open-source tools don't have license fees attached to them, commercial open-source companies are often forced to build their businesses around services revenue, in the form of support, up-front installation or training.

With this model, purchasing software is more like committing to a yearlong cell phone contract--and less like buying a car with a large cash outlay and making regular payments later.

Although upstart open-source companies are relatively small and untested, the services-led business model reflects how more value is being attached to follow-on services than the actual the software, analysts and industry executives say. In fact, this week, industry executives at the Open Source Business Conference in San Francisco will consider the impact of open-source products on how software is acquired.

Unearthing support money
Once a backwater of the industry, attention is increasingly being paid to the amount of money spent on support and maintenance.

Chief information officers report that as much as 70 percent to 80 percent of information technology budgets are consumed by maintenance, rather than new initiatives. The recipients of much of that money are entrenched suppliers.

Database giant Oracle, for example, makes more on product updates and support than it does on license revenue. During an earnings call last year, Oracle CEO Larry Ellison touted the company's maintenance as an "extremely high-margin business."

"(The subscription approach) allows you to focus on strategic issues."
--Matthew Szulik
CEO, Red Hat

James Goodnight, CEO of analytics software provider SAS, said that Oracle's acquisition strategy, which has included buying PeopleSoft and making a deal to buy Retek, is a play at existing maintenance contracts.

"Larry (Ellison) is buying everything he can get his hands on to consolidate the (business applications) industry. He believes that innovation in software is over. It's all about maintenance revenue," Goodnight said.

Compared with other industries, software has very high margins, in excess of 20 percent, said Mark Driver, an analyst at research

company Gartner. "If you can get someone to pay you 15 or 20 percent a year after they've bought the software, it's a really good gig if you can get it."

The commercial open-source business model turns the traditional software purchasing equation around. Customers may pay some up-front fees, but the bulk of costs are in the form of ongoing services.

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With proprietary software products, usually only the software purveyor provides maintenance services. With open-source software, many more service providers can offer support.

For example, JBoss offers support services for its line of Java-based infrastructure software components--the market area that is seeing perhaps the most activity. But SpikeSource, an open-source services start-up headed by Kim Polese, intends to offer subscription-based maintenance services for bundles of products that include the JBoss application server.

Analysts say that open-source software requires an industry of services companies for its adoption to spread. Some open-source products have been created by a relatively small group of programmers and do not have round-the-clock support organizations. Corporate customers require some sort of vendor to rely upon.

Also, a shift in buying habits is fueling interest in annuity-style contracts between providers and corporate customers. Increasingly savvy customers are shying away from committing to large-scale projects that consume millions of dollars and take years to complete.

"Enterprise customers, in particular, continue to be willing to pay fair and reasonable prices for software. The difference with the old days is that they don't want to pay for it all up front," Mitchell Kertzman, partner at venture capital firm Hummer Winblad and former CEO of Sybase, said at a conference in February. "They want to pay for it as they realize the value and get return on investment."

Billion-dollar open-source company?
Of course, regular payment schedules for software are also available outside the services-intensive realm of open source.

Established companies such as Sun Microsystems and Computer Associates International charge for products on regular billing schedules. Sun, for example, charges $140 per employee per year for its Java software bundles. Similarly, software-as-a-service companies, such as Salesforce.com, charge per user per month.

Using the recurring contract model, which has been around for decades on mainframe systems, works better than relying on large license deals, proponents argue.

"From a management point of view, if you do it correctly you can build a better forecast into expenses and revenue flow," said Matthew Szulik, CEO of Linux distributor Red Hat, which relies on subscriptions. Instead of spending the end of every quarter trying to land big deals, the subscription approach "allows you to focus on strategic issues," he said.

Like other open-source companies, Red Hat is regularly questioned about whether it can rapidly grow its business without incurring substantial up-front costs.

Support and maintenance contracts require that trained technical personnel are available to handle glitches that may occur at any time of the day. Increasing that support infrastructure can be difficult without hiring many people and incurring great costs.

Szulik's response is that the company offers services efficiently online and that its gross margins are about twice as large as that of traditional services companies.

Similarly, SpikeSource has developed a "process automation" application that will send out regular updates of software over the Internet to corporate customers. JBoss, meanwhile, has chosen to focus all of its services work on support, dropping other services, such as up-front installation and training.

But even as open-source and other software companies target the substantial amount of money spent on ongoing services, some questions remain over how sustainable and big a maintenance-dependent business can be.

"It's one thing to be a 5, 10, 20 million-dollar company--it's another to grow that to be a billion-dollar services company," said Gartner's Driver. "It can be done, but it's difficult to do and maintain quality."