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Free vs. Cheap: It’s NOT About Shrinking a Market

Josh Kopelman of First Round Capital, an early stage investor in many Web 2.0 emerging leaders (including Wikia, Mashery, and Odeo), posted an excellent article on the emerging business models across many industries:

“Here at First Round Capital, we see a lot of business plans for consumer-facing internet services. Most assume a significant portion of their revenue comes through advertising — but almost all of them have a “premium/subscription” option. Typically that subscription revenue accounts for 20-40% of total revenue, and is based on a very low ($1-5/month) subscription fee. However, that is rarely how things play out. Most entrepreneurs fall into the trap of assuming that there is a consistent elasticity in price - that is, the lower the price of what you’re selling, the higher the demand will be. It happened in music. It happened in movies. And it’s happening in directory assistance. Now I’m looking for other industries that are going to be converted. If you’ve got a plan that uses the free model to get that first penny and disrupt an industry, I’d love to hear about it. It’s a great way to shrink a market.”

When reading this, IT folks think, “open source.” Looks like that’s exactly what is happening in enterprise software. Open source vendors play the price elasticity game in the demand/price equation. Commercial open source vendors are sizing down their markets by offering free to low-cost solutions where the buyers get far more value for the dollar. But that’s only on the surface.
What I would like to describe is why open source/free software is not about shrinking the markets. Of course, there will be many cases when market leaders will have to step down.

Middleware

IBM has $2B running on WebSphere. Looks like for every dollar of revenue JBoss made, it took two dollars of revenue from BEA and one from IBM. JBoss made its fortune from shrinking the middleware market.

Data Integration

Informatica SOLELY DEPENDS on license revenue from ETL tools.
IDE Tools Borland has had its IDE business on the auction block for a while and is realizing it’s not easy to find a buyer for a sinking ship. Did Eclipse play a role in replacing Borland IDE tools? Sure it did.
For Informatica and BEA to transition to cheap/near-free subscription and OSS is a systemic shock that might literally kill them.There is no doubt that the existing software leaders would have to shrink their appetite significantly, since the disruptive newcomers have totally different cost structure and distribution business models. When you look at the drivers of the seismic shifts going on in many markets, the disruptive business models are not about shrinking markets. It’s not about “evil communists” dreaming about getting the behemoths of the software business to die. I don’t think they will.

What really happening is that new value is being created in the marketplace. Open source is so successful because it’s creating new markets. That’s the key for a true market disruption.

Just a few years ago JBoss, now a RedHat company, and MySQL were not going after the Fortune 1000 enterprise market. They are best at enabling underserved customers who previously could not afford expensive proprietary software. Now, JBoss is a part of a public company, MySQL is VC-backed, and they both have external shareholders. The latter demand returns on their investment thus pushing portfolio companies into a replacement business where the money is. But what these companies are best at is not a replacement business.

Open source is so powerful that it can destroy a license-driven software business. But the truly disruptive businesses are successful as long as they create new markets in the first place, not shrink the existing.

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4 comments to “Free vs. Cheap: It’s NOT About Shrinking a Market”

  1. John "Z-Bo" Zabroski said:

    The same ideas covered here are covered elsewhere. Linux Journal had one of its editors write about the same thing. The author there put together a much better article. I recommend reading it.

    Searl, D. 2006. Linux for suits: Greater goods. Linux J. 2006, 152 (Dec. 2006), 14.

    I also found your critique of Borland rather simplistic and underdeveloped. Show some statistics that show year-over-year Borland was impacted by Eclipse. Show some statistics that show Borland’s problems are not due to dead-end product lines, like Borland C++ 5.0 which was axed right as the standards were being ratified in 1998. What effect did events like this have on the bottom line? From a cost accounting perspective, is the whole IDE to blame? Are certain parts of the IDE causing thinner revenue margins? If so, which parts?

    What do we know about microeconomics that explains this phenomena in a rather simple way? What microeconomic strategy did IBM pursue in order to widen its revenue? IBM is a “behemoth” but they are funding this work. For this reason, I found your comments about “seismic shifts” and “disruptive business models” very buzzword-oriented and lacking real analysis. IBM does not pursue risky business models. They have shareholders that want good quarterly earning reports. Why are they, this “behemoth”, funding open source?

    What is a good leading indicator for a market-place dominated by fee-based software licenses to be uprooted by open source software? What are the trailing indicators? Hypothetical scenario: I am a shareholder in a proprietary shrink-wrapped/close source software firm… what metrics can I use to determine my revenue model is going to be threatened by open source? What sort of business model is going to stack itself on top of me by funding the development of open source software? Can I beat that business model to the punch, and if so, how? How long does my company have to convert its business model? Are we better off selling the company to another firm and exiting the industry? In other words, at what point are we only going to be making a normal profit?

    Open source opens the doorway to a purely competitive marketplace. In fact, it is beginning to open the doorway to monopolistic marketplaces (Oracle, Windows). However, the place we see the effect of open source the fastest is in monopolistically competitive markets. A fee-based license is not a value-add. It adds complications for the customers to worry about. An example of a value-add is when a company like Microsoft or Oracle takes advantage of its world-wide sales force power and does the things necessary for customer loyalty and thus brand differentiation… elevating it above a purely competitive marketplace.

    Also, you said, “Open source is so powerful that it can destroy a license-driven software business.” No. Open source *is* a license-driven software business. Your comment here is dangerously misleading, because it understates the fact open source software *is* license-driven: the ability for two people at opposite ends of the globe can collaborate on a project without having to retain power of attorney is a very powerful concept.

  2. Renat Khasanshyn said:

    John,

    Thanks for your comments, I’ve found the article here http://www.linuxjournal.com/article/9344. With all due respect to your feedback, my blog post was no attempt to re-invent the bicycle. Doc Searls is, perhaps, one of the best journalists focused on Linux and Open Source. And I agree, should I have the numbers on Borland, it would be a value-add to the post.

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