Why No Billion-Dollar Open Source Companies?

Last week, I met up with Jim Whitehurst, Red Hat's CEO. He gave a very fluent presentation to a group of journalists that ran through Red Hat's business model, and explained why – unsurprisingly – he was optimistic about his company's future growth.

Somewhat unkindly, I reminded him of an interview he gave a couple of years ago, in which he said:

When I look at the quality of our existing technology, and the incredible brand that we have and the markets we play in, we should be a $5 billion company or more. If you just look at operating systems and middleware--that's nearly a $100 billion business. We're a $500 million business. We have barely scratched the surface.

Well, today Red Hat is a $750 million business according to Whitehurst. But when, I wanted to know, would Red Hat reach that $5 billion turnover – and why was it taking so long?

His answer was a good one. He said that he did think that Red Hat could get to $5 billion in due course, but that this entailed “replacing $50 billion of revenue” currently enjoyed by other computer companies. What he meant was that to attain that $5 billion of revenue Red Hat would have to displace software that currently costs $50 billion. Selling $50 billion-worth of software – even if it only costs $5 billion – is somewhat hard, which is why it will take a while to achieve.

I think this is the first time I've heard someone as senior as Whitehurst admit something rather profound: that open source solutions save money for customers by doing away with the fat margins for existing computer companies – and thus shrink the overall market. Opponents of open source like to paint this as “value destruction” that takes money “out of the economy” - as if free software went around burning down offices and warehouses.

What they fail to grasp is that the 90% savings do not just vanish like the smoke from those supposed conflagrations. That money is still in the economy, it's just spent on other items: free software allows people to use their hard-won money for things other than operating systems, office suites and applications. In developing countries, for example, it might mean more funds available for education or health.

That's why Microsoft's attempts to paint itself as some amazing benefactor to economies everywhere by virtue of the jobs its multi-billion dollar sales create are rather unconvincing. They conveniently overlook the fact that those sales produce large profits for Microsoft, which in the case of Europe, say, are taken *out* of the region and sent to the US.

Contrast that with Red Hat. It too is a US company, and so the profits it makes in Europe cross the Atlantic in exactly the same way as Microsoft's. But as Whitehurst pointed out, open source software typically costs just 10% of the proprietary equivalent, and so the profits – and outflows - are reduced proportionately.

Whichever way you look at it, open source is good news for companies and consumers: they pay less in the first place, and as a result even less leaves the local economies - which means that more can be spent with indigenous companies on locally-produced goods and services.

However, there is a very important corollary to this – the point that Whitehurst made several times. Indeed, practically his opening words were: “selling free software is hard”. A knock-on consequence is that it harder – roughly *ten* times harder - for an open source company to grow to a given revenue level than it is for the corresponding proprietary company.

That means reaching that $5 billion figure is going to be very hard for Red Hat – and that it may well be impossible for any other company that makes money from selling free software (although Google is an open source company in most respects, it is very different from Red Hat and other “pure” free software outfits.)

Indeed, I would go so far as to say that very few open source startups will ever get anywhere near to $1 billion. Not because they are incompetent, or because open source will “fail” in any sense. But because the economics of open source software – and therefore the business dynamics – are so different from those of traditional software that it simply won't be possible in most markets. Red Hat stands a chance because it has (wisely) colonised the biggest sector, that of enterprise infrastructural products - “we are plumbers”, as Whitehurst put it with brutal frankness.

This means that all other open source companies really need to stop chasing that $1 billion dream – the idea that if they try hard enough they will break through the magic nine zero barrier. It isn't going to happen, for the very reason that open source will take over from proprietary software at most levels of the enterprise stack: because it strips away the traditionally high profit margins and leaves the money with the customer.

As his reply to my question indicated, Jim Whitehurst knows that full well, and it's time for the managers of other open source companies to face up to that reality. If they don't, they will set unrealistic ambitions for themselves, disappoint their investors and allow opponents of free software to paint one of its defining successes – saving money - as a failure.

Follow me @glynmoody on Twitter or identi.ca.


Copyright © 2010 IDG Communications, Inc.

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