Denice R. Preston
Open-source software is a catalyst for growth and change in the IT industry, and one can’t overestimate its importance to the sector. In recent years, there has been a surge in venture capital dollars pouring into the industry. In this article, we analyze whether current valuations make sense and whether the open-source model lends itself to the returns profile that venture capital investors look for.
OSS Monetization Models
By definition, open-source software is free. This, of course, generates obvious advantages for consumers. In fact, a 2008 study by The Standish Group estimates that “free open source software is [saving consumers] $60 billion [per year in IT costs].”
While providing free software is obviously good for consumers, it still costs money to develop. Very few companies are able to live on donations and sponsorships. With fierce competition from proprietary software vendors, growing R&D costs, and ever-increasing marketing requirements, providing a “free” product necessitates a sustainable path to market success.
As a result of the above, a commonly seen structure related to OSS projects is the following: A “parent” commercial company that is the key contributor to the OSS project provides support to users, maintains the product, and defines the product strategy.
Latched on to this are the monetization strategies, the most common being the following:
Extra charge for enterprise services, support, and consulting. The classic model targeted large enterprise clients with sophisticated needs. Examples: MySQL, Red Hat, Hortonworks, 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. For example, Cloudera provides the basic version for free and charges the customers for Cloudera Enterprise.
SaaS/PaaS business model: The modern way to monetize the OSS products that assume centrally hosting the software and shifting its maintenance costs to the provider. Examples: Elastic, GitHub, Databricks, SugarCRM.
Historically, the vast majority of OSS projects have pursued the first monetization strategy (support and consulting). Still, at their core, all of these models allow a company to earn money on their “bread and butter” and feed the development team as needed.
The influx of VC Dollars
An interesting recent development has been the huge inflows of VC/PE money into the industry. Going back to 2004, only nine firms producing OSS had raised venture funding, but by 2015, that number had exploded to 110, raising over $7 billion from venture capital funds (chart 2).
Underpinning this development is the large addressable market that OSS companies benefit from. Akin to other “platform” plays, OSS allows companies (in theory) to rapidly expand their customer base, with the idea that at some point in the future, they can leverage this growth by beginning to tack on appropriate monetization models in order to start translating their customer base into revenue, and profits.
At the same time, we’re also seeing an increasing number of reports about potential IPOs in the sector. Several OSS commercial companies, some of them unicorns with $1B+ valuations, have been rumored to be mulling a public market debut (MongoDB, Cloudera, MapR, Alfresco, Automattic, Canonical, etc. ).
With this in mind, the obvious question is whether the OSS model works from a financial standpoint, particularly for VC and PE investors. After all, the venture funding model necessitates rapid growth in order to comply with their 7-10-year fund life cycle. And with a product that is free at its core, it remains to be seen whether OSS companies can pin down the correct monetization model to justify the number of dollars invested into the space.
Answering this question is hard, mainly because most of these companies are private and, therefore, do not disclose their financial performance. Usually, the only sources of information that can be relied upon are the estimates of industry experts and management interviews, where unaudited key performance metrics are sometimes disclosed.
Nevertheless, in this article, I take a look at the evidence from the only two public OSS companies in the market, Red Hat and Hortonworks, and use their publicly available information to try and assess the more general question of whether the OSS model makes sense for VC investors.
Red Hat
Red Hat is an example of a commercial company that pioneered the open-source business model. Founded in 1993 and going public in 1999, right before the Dot Com Bubble, they achieved the 8th biggest first-day gain in share price in the history of Wall Street at that time.
At the time of its IPO, Red Hat was not a profitable company, but since then, it has managed to post solid financial results, as detailed in Table 1.
Instead of chasing multifold annual growth, Red Hat has followed the “boring” path of gradually building a sustainable business. Over the last ten years, the company increased its revenues tenfold from $200 million to $2 billion with no significant change in operating and net income margins. G&A and marketing expenses never exceeded 50% of revenue (Chart 3).
The above indicates, therefore, that OSS companies do have a chance to build sustainable and profitable business models. Red Hat’s approach of focusing primarily on offering support and consulting services has delivered gradual but steady growth, and the company is hardly facing any funding or solvency problems, posting decent profitability metrics when compared to peers.
However, what is clear from the Red Hat case study is that such a strategy can take time–many years, in fact. While this is a perfectly reasonable situation for most companies, the issue is that it doesn’t sit well with venture capital funds, which, by the very nature of their business model, require far more rapid growth profiles.
More troubling than that for venture capital investors is that the OSS model may in and of itself not allow for the type of growth that such funds require. As the founder of MySQL, Marten Mickos put it, MySQL’s goal was “to turn the $10 billion a year database business into a $1 billion one.”
Hortonworks
To further assess our overarching question of OSS’s viability as a venture capital investment, I took a look at another public OSS company: Hortonworks.
The Hadoop vendors’ market is an interesting one because it is completely built around the “open core” idea (another comparable market being the NoSQL databases space with MongoDB, Datastax, and Couchbase OSS).
All three of the largest Hadoop vendors–Cloudera, Hortonworks, and MapR–are based on essentially the same OSS stack (with some specific differences) but, interestingly, have different monetization models. In particular, Hortonworks–the only public company among them–is the only player that provides all of its software for free and charges only for support, consulting, and training services.
At first glance, Hortonworks’ post-IPO path appears to differ considerably from Red Hat’s in that it seems to be a story of rapid growth and success. The company was founded in 2011, tripled its revenue every year for three consecutive years, and went public in 2014.
Immediate reception in the public markets was strong, with the stock popping 65% in the first few days of trading. Nevertheless, the company’s story since the IPO has turned decisively sour. In January 2016, the company was forced to access the public markets again for a secondary public offering, a move that prompted a 60% share price fall within a month (Chart 5).
