Flash! Some OSS business models don't work

For more than a decade, b-school professors have been teaching about business models. However, I suspect sometimes we spend too much time emphasizing how important it is to have or understand a business model, and perhaps not enough about the importance of a good business model. (Regular readers know that I often write about bad business models, broken business models and even the decades-long search for a viable business model).

One important area of business model experimentation has been open source business models. This morning, my friend Matt Asay posted about Monty Widenius, who five years ago sold MySQL to Sun Microsystems for $1 billion, and then bailed out of Sun when the acquisition helped drag Sun down (or failed to lift it up) — leading to Sun’s eventual dismemberment by its new owner.

His opening paragraph sets the stage:

Monty Widenius, co-founder of MySQL and founder of MariaDB, just came to a surprise revelation: most people use open source for free. What's so surprising, however, is not this fact, but the idea that Widenius wouldn't have learned this 13 years ago when he first released MySQL under the GNU General Public License (GPL) and his company's revenues dropped 80%. The lesson here, however, isn't that there's no money in open-source software, but rather that some strategies for monetizing open source are effective, while others are not.

As Matt notes, it’s inherent in offering real open source (i.e. something that conforms to the Open Source Definition) that people can and will use it for free. Widenius' current suggestion is to have semi-open source (called “Business Source”) which might generate revenue but can’t be called “open source.”

I spent almost a decade researching how firms make money off of open source, including one of my favorite (and most-cited) unpublished papers. During that study, it was obvious pretty quickly that you had to give away something useful — so people would adopt your software — and hold back something valuable (e.g. support, add-on modules) so that people would pay you something. The balance was made tricky by the one-way nature of open disclosure of source code: once something was free (as in beer or speech) it was technically and legally hard to make it un-free.

Matt barely contains his snark as he cites all the people who’ve long since figured this out:

Jim Jagielski, president and co-founder of the Apache Software Foundation, suggests that "if your open source project isn't successful with FOSS licensing, it's not the license's fault." Rather, it's a matter of trying to charge for the wrong things:

what's "destroying" open source isn't people not paying for it, but wrong ideas on WHAT they should be paying for

— Jim Jagielski (@jimjag) May 30, 2013

To wit, Facebook, Google, Amazon and others make billions of dollars selling services around open-source infrastructure, while Red Hat mints over a billion dollars annually selling a certified, binary distribution of community-developed Linux. There is plenty of money in and around open-source software. The open-source license doesn't prevent this. It enables this.

Widenius is a smart person. He'll figure it out. It's only surprising that his experience at MySQL didn't already teach him this lesson.

I’m guessing that Widenius has already figured that out, but he can’t see how to get there from here because he’s painted himself into a corner.

(BTW, there’s always been a difference of OSS business models between firms that are givers and takers. A low cost, low risk strategy has been to be a taker — or net taker — by leveraging OSS created by others. It’s the givers that incur the cost of R&D for their free stuff, and thus bear a sizable risk of not being able to monetize well enough to cover that cost.)

One thing I haven’t seen mentioned is the inherent scale requirement for OSS and other freemium business models. As my research continued, it became clear that a revenue model with 1% (or 10% or 0.1%) conversion rate might work with millions of users, but the identical strategy would fail if you only had thousands of users. So copying Red Hat (or MySQL or Sleepycat) was going to fail miserably unless you had a smash hit that would support a 1% conversion rate. This is something that has recently become painfully obvious to all the iPhone game makers who used free games to win adoption and hoped to sell upgrades.

So yes, market leading companies with billions of customers can afford to give away software and monetize off of some small fraction of their customer base. But for new companies trying to launch now — even those run by smart experienced OSS veterans — an OSS (i.e., freemium) business model is at best a risky gambit. At worse, it’s a fools’ errand, because it’s no more feasible to create the next Red Hat or MySQL than it is to create the next IBM, Cisco or Google.

When you've lost Anna and Mikko...

With its market share collapsing worldwide, Nokia has now lost its home market of Finland. Quoting IDC data, Digitoday.fi reported Tuesday that Nokia had a 33% share of the Finnish handset market in Q1 2013, second to Samsung at 36% (Apple is third at 14%).

Unwired View helpfully noted that Nokia had lost the Finnish smartphone market in Q3 of 2012, but sold enough feature phones to keep the overall crown — until now. Nokia’s home market is lagging the rest of the world by only a year. According to IDC data, Nokia lost the global smartphone market share in 2011 to Samsung and Apple, and the overall handset market in 2012.

Apple is also fighting Samsung in its home market, but managed to top the Korean maker in the crucial final quarter of 2012. The two companies are splitting all the net global profits of the global mobile phone market.

As Unwired View concluded:

73% of all phones sold in Finland in Q1 were smartphones. And apparently Finns love Samsung smartphones. That kind of says a lot. When not even patriotism can stand in the way of the Android onslaught, one has to consider what chances Windows Phone (in its current form and iteration) realistically has. You really can’t say that the Finns weren’t willing to give Microsoft’s new OS the benefit of the doubt. Or that they are somehow biased against Nokia, a company once synonymous with Finland in the eyes of many.

All in all, it looks like more rough sailing aboard the S.S. Ballmer.

Note on title: Anna and Mikko are popular names in Finland for girls and boys.

Good (and bad) institutions last for centuries

A report by Stephen Findler from Brussels in this morning’s Wall Street Journal:

The euro crisis is a story of a breakdown in the mechanisms meant to manage national relations within the currency union. Its future hangs on how—and whether—these broken mechanisms can be refashioned.

In a speech to a conference in Munich last week, the Princeton University historian Harold James suggested that one of the central questions is how the 17-nation currency bloc handles its excessive debts.
…
The British-born professor offered a tale of two revolutions: Britain's so-called Glorious Revolution of 1688 and the French Revolution of 1789. The first was peaceful and wealth-enhancing, the second violent and destructive, leaving French society poorer than Britain's for more than a century.
…
So in the British case, not reneging on debts was a principle associated with the development of legal security, representative government and modern democracy—lessons taken on board by the founders of the U.S.

In the French case, the state took on too much debt and then tried to pay at any cost. The state lost credibility and, unlike in Britain, no private market developed to distinguish between risks.

On the face of it, the euro zone combines both these cultures of debt. Germany sees itself as the upholder of a set of rules that attempt to enhance governments' credibility, by limiting their borrowings and placing appropriate risk on the shoulders of private-sector investors.

On the other side of the coin are serial defaulters such as Greece, which according to authors Carmen Reinhart and Kenneth Rogoff has spent more than half of its existence since independence in 1829 in a state of default.
…
His message for the monetary union is that it needs rules—but rules that are interpreted flexibly. He drew some further history lessons for the euro.

Lesson One: Indecision leads to poor choices and policy paralysis.

Lesson Two: Finding a clear answer to a crisis is more difficult when there are conflicts over distribution of wealth and income—as now between northern and southern Europeans.

Lesson Three: Solutions become harder when economic arguments have been used to justify integration. That means when growth falters, the credibility of the project crumbles.

The entire article is well worth reading by anyone who care’s about Europe’s future, free markets or economic institutions more generally.

Latest in a series of outsourced economic commentary in a time of economic hardship

Too late to openness

I saw an interesting comment Wednesday on BlackBerry’s late conversion to openness. VC Fred Wilson wrote:

So RIM has decided that it is time to make Blackberry Messenger (BBM) cross platform. They announced yesterday that by this summer BBM will be available on iOS and Android.

The time to do this was in 2008/2009 when BBM was huge and everyone was on it. The core users were beginning to leave for iOS and eventually Android and if RIM would have let them take BBM with them, they would now own the biggest cross platform messenger out there. BBM is great and everyone knew how to use it and was comfortable with it.

But RIM execs waited four years to make this move. When BBM hits iOS and Android this summer, they will face dozens of cross platform apps that people use to message each other, one of which is in the USV portfolio. My bet is this won't help RIM or BBM much at this point.

Even when I was consulting to Symbian from 2006 to 2008, people were speculating when BB (then Research in Motion) would license or partner with its email platform. (Its BlackBerry Connect mail client was available for a few Nokia phones during that time). RIMM held strong market share in the US until 2009, when it began its unchecked fall towards zero.

As someone who studies the strategic use of openness, I’ve seen this tendency to put it off openness until too late, across a wide range of companies, product categories and decades. Wilson attributes this to The Innovator’s Dilemma, which I interpret as an unwillingness of firms to cannibalize their own high-margin business with low-margin (or low price) business.

Yes, cannibalization is hard. Yes, Clay Christensen made an important observation why such cannibalization is so hard. But having studied these sort of choices over and over again, I think “Innovator’s Dilemma” is too pat an answer: sometimes it explains why a firm can adapt, but it’s rarely the complete explanation.

It often happens that the managers know exactly what they're doing — increasingly likely after the publication of Christensen’s book.. I’d split this into two subcategories. One is that it’s a rational choice — milking a cash cow to the end and using that cash while it lasts to do something else. (For example, from 1999-2002 I took the rents from my printer driver business and used it to finance a shift to a new career).

The other variant is that the managers get it but the owners do not, a classical principal-agent problem. If I’m getting commission on sales (or stock options on current capital appreciation), why do I care about company performance 2, 3 or 5 years from now? It may be perfectly rational for me as CEO to get while the getting’s good, even if I know it will eventually all come crashing down. (I call this the Ceaușescu theory of management, given the predictably unhappy end to the Romanian ruler’s reign.). As such a CEO, I hope to be lucky enough to be I’m retired to my Maui estate before everything falls apart)

Finally, what I think the most common explanation is Da Nile (that river in Egypt). I’ve worked with, for and competed with a wide range of companies that just can’t recognize — or can’t admit — that the competition is a serious threat. Christensen identified conditions where this happens, but often the explanation is much simpler one: arrogance or hubris. (In marketing, we say “they’ve come to believe their own propaganda.”) Certainly BlackBerry/RIM has had this problem for years.

Intel’s once great founder-CEO (now Stanford business professor) had it right: only the paranoid survive. But having escaped Hungary after Soviet tanks invaded the country to crush a popular uprising, the former András Gróf lacks the complacency common among highly successful US business leaders.

Aboard the S.S. Ballmer

Microsoft’s success has always been about its alliances: Bill Gates lining up Basic licensees, the 1980 deals with IBM and Seattle Computer Products and (most importantly) licensing the IBM-funded DOS to all of Microsoft’s competitors.

With declining PC revenues, Microsoft is using its $50+ billion cash horde to buy friends. The Redmond company has created alliances with Nokia and Barnes & Noble in hopes of gaining a footprint in smartphones and low-end tablets. But into doing so, both companies have (for better or worse) paced on their platform bets on Microsoft’s (thus far) losing hand.

As part of my studies of Nokia’s smartphone strategy, I’ve been following the Microsoft-Nokia deal for several years. Tomi Ahonen has done a great job of covering how badly thinks have gone since Nokia threw away its (declining) smartphone lead and cast its lot with Microsoft.

However, the Barnes & Noble story is a different one. It has been searching for a viable tablet strategy for years. When it signed its surprising $300 million deal a year ago, it was losing its decade-long battle fight with Amazon over books, online sales, tablets and every else. The original 17.6% equity investment in the B&N spinoff of Nook Media was supplemented by a promise of $305 million in other payments.

Last week, rumors surfaced that Microsoft would pay $1 billion for the remaining shares of Nook Media. Barnes & Noble shares jumped on the news.

This would be the only good outcome for B&N: Microsoft gets a portfolio of online assets to fight Amazon, Apple and Google, and B&N gets some cash to prop up its dying retail business. To quote Steve Miller: “Go on, take the money and run!”

In the meantime, both Nokia and Nook Media are aboard the S.S. Ballmer without a lifeboat. Microsoft has known for 15 years that it needs a viable mobile strategy, and despite billions in R&D (and funds for products and alliances), has been unable to break single digit market share on either phones or tablets.

It’s not for nothing that Ballmer was named the worst CEO by Forbes a year ago, saying “"Without a doubt, Mr. Ballmer is the worst CEO of a large publicly traded American company today”. Ballmer was merely second worst in CNBC’s 2012 rankings. Both were before the recent Windows 8 fiasco exploded in the company’s face.

On Sunday, Al Lewis of Dow Jones cited yet another Ballmer critic:

Former Microsoft executive Joachim Kempin released a book timed to the Windows 8 launch last fall, called "Resolve and Fortitude: Microsoft's Secret Power Broker Breaks His Silence." In it, he, too, says Mr. Ballmer should be fired.

"He has no clue about technology," Mr. Kempin said in a telephone interview. "All the guys around him agree with him or they get fired."

Because of his long friendship with America’s second richest billionaire, his job has been secure thus far. As long as Ballmer remains at the helm, Microsoft (and Nokia and B&N) shareholders should expect more of the same.

Adobe jumps off a cliff, leaves parachute behind

Adobe announced Monday that it was moving all its professional graphics arts users from a package software purchase model to a subscription model. This is certainly a bold — if not risky — move, but so far I can’t tell if it’s a sign of strength or weakness.

Package software is how Adobe was started — as was true for nearly all 20th century software companies. The company would develop a major new release, sell it as a product, provide free bug fixes for a while and then start over. Adobe was unusual — or perhaps a trend-setter — in that it never tended to give much of a discount for previous owners to buy the new copy. Adobe also got in the habit of bundling packages in “suites”: for example, I once was a Dreamweaver user, but the suite pricing forced me to find another alternative (currently the open source SeaMonkey) when an OS upgrade rendered my 8-year-old copy of Dreamweaver obsolete.

Under the new plan, the flagship “Creative Suite” will become “Creative Cloud.” Fortunately for users, the "cloud" term is somewhat misleading: it’s not a Cloud in the sense of Google Docs or webmail — with all the apps running in the cloud — because the latency of such interactions would make Photoshop or Illustrator unusable. Instead, Creative Cloud is more like the Apple model with apps on the PC and document synchronization between a PC (or other device) and Adobe’s servers. In the 1990s, we called this groupware, although obviously things have gotten better since then.

The big difference is that instead of paying for releases, Adobe wants users to pay for subscriptions. The migration will be enforced by orphaning the old products, which gradually will become obsolete and irrelevant.

Usually when you make such a dramatic transition, you run the two business models in parallel. In Monday’s presentation, Adobe’s CFO Mark Garrett said that the subscriptions have topped 500,000. At $50/month, that’s $300 million a year; with annual revenues of $4.5 billion, that’s meaningful but not overwhelming. Their 2012 10-K stated:

We continue to derive the majority of our revenue from perpetual licenses. However, our subscription revenue, as a percentage of total revenue, has increased to 15% in fiscal 2012 from approximately 11% and 10% in fiscal 2011 and fiscal 2010, respectively, as we transition more of our business to a subscription-based model.

So the ability to make this shift suggests strong pricing power by Adobe. As Garrett said:

So our end goal, from my perspective, of faster revenue growth for this business and more recurring revenue is now even clearer than it was before, and these announcements today really reinforce that.

Garrett said that beyond the core audience of beyond full-time “creative professionals,” it’s targeting three other groups: marketing staff at small/medium businesses, SOHO photographers/hobbyists, and education.

All of these problematic. When I ran a small business, we wouldn’t spend $600/year/seat for anything, nor would I as an individual. Even at a reduced pricing of $360/year, the price seems too rich for the education market (“one of our most important vertical markets” according to Garrett).

Various commentators have questioned this pricing model, including Karl Denninger on Seeking Alpha and Lori Grunin of CNET. People are grumbling, but of course nobody likes a price increase — so the real question of pricing power is whether customers have any realistic alternative. (Adobe’s 89% gross margins suggests most of their customers are stuck).

On the other hand, the shift to seek revenue growth through a new business model — rather than creating new products — could be seen as a sign of weakness. It takes me back to my second software more than 30 years ago, developing minicomputer simulation tools. In our case, once the software was mature it became difficult to provide major new features that would excite customers. We used monthly (or annual) service contracts to provide a steady revenue stream when we were unable to provide major new releases that people would buy.

Adobe’s new pricing model does not appear (yet) to cover low-end consumer products such as Photoshop Elements. My guess (just a guess) is that if the professionals cooperate with the subscription model, Adobe will attempt to shift consumers to the subscription model within 3 years.

One thing going for Adobe is that most of its rivals among professional software companies have pulled back or (as with Aldus and Altsys) been bought up. Open source alternatives are not viable competitors to the Creative Suite apps. However, Adobe faces challenges in the low-end consumer market from App Store apps that sell for $30 or less as new customers seek convenient, affordable alternatives.

IP, BTE and funding startups

In running the @KeckGrad business plan competition this week, I was struck by how different our students’ life science startups were from the retail or IT startups that are common at other colleges. In most cases, our students needed $5 to $50 million in outside funding to jump through regulatory hoops and generate initial revenues.

It seems like this also reflects a fundamental difference in IP strategy — how a successful startup discourages entry or imitation, and how that ties back both to their funding needs and their IP strategies.

The retail startups have a brand, and locations, and perhaps a little bit of internal process trade secrets. Seed funding is available, but (shy of an IPO or acquisition) any subsequent growth tends to be organic and self-funded. Whether restaurants or clothing, these sorts of startups take years to build up, and the margins are generally thin.

The IT companies rely on copyright and trade secrets to protect their implementations, and hope to build network effects or switching costs to discourage entry. A hot property attracts plenty of money, because the scale is small and (if successful) the TTM and thus the payback time is quick. Still, a well-funded, well-run competitor could catch them. Many startups hope that the differentiator is the vision and positioning: for example, MySpace had years to respond to Facebook, but somehow never did.

Then there’s the life science companies: they need spend (and thus raise) huge amounts before ether generate revenues and — given mandatory regulatory disclosures — give rivals plenty of time to see what they are doing. The only way this works is if you have a patent, that gives investors an ironclad assurance of exclusivity for some period of time.

I'm not exactly sure what the model is for cleantech — but maybe there isn’t one. Certainly renewable energy — such as solar or biofuels — the hope is to leverage economies of scale to attain cost advantages in producing commodity energy. Given the hope of scale as a BTE (or BTI), many companies bulked up quickly, leaving a lot of dead companies strewn along the way. China’s Suntech was once world’s largest solar company — the first to sell 2 gigawatts of solar panels in one year — but is now shrinking and bankrupt.

If we look at older, mature industries, scale is never enough. Scale has reduced (but not eliminated) competition in electronics, steel and autos, but has done nothing to provide barriers to imitation to protect HP, US Steel or GM from subsequent entrants. If anything, the race for scale has led to overcapacity and thus price wars — in steel, DRAM, LCD panels, solar panels.

Dirigisme wins, French entrepreneurs lose

By now, the whole tech world has heard the story first reported Tuesday afternoon in the Wall Street Journal about Yahoo’s failed effort to buy Dailymotion. As the story opened:

Dailymotion was on track to be the first big acquisition for Yahoo Inc. YHOO +2.76% Chief Executive Marissa Mayer, after her company signed a provisional deal to buy control of the online-video website from France Télécom FTE.FR -0.59% SA. Then Ms. Mayer's No. 2 executive met with French Industry Minister Arnaud Montebourg.

At an April 12 meeting in Mr. Montebourg's Paris office, the minister told Yahoo's chief operating officer, Henrique de Castro, and France Télécom's chief financial officer, Gervais Pellissier, that he didn't want 75% of a rare French Internet success story to be sold to an American Web giant, according to people briefed on the meeting.

"I won't let you sell one of France's best startups," Mr. Montebourg told Mr. Pelissier, his voice raised, according to people briefed on the meeting. "You don't know what you're doing."

Facing an uproar, the minister clarified:

“The minister has expressed his desire that a partnership between Yahoo and Orange should be built on an equal base, mutually beneficial to both companies,” his office said in a statement.

It was widely reported that the government was willing to let Yahoo get 49% — or maybe even 50% — but not beyond.

This has so many fascinating implications. First, Yahoo is back to the drawing board in trying to build up its video capabilities.

Second, are the policies of the socialist government — after five years of crypto-Gaullist Sarkozy — going to hurt trade and investment with France. From the New York Times:

The government’s intervention has alarmed entrepreneurs in France, who say it sends a bad message to foreign investors, especially at a time when the country is seeking their money to help jump-start its economy.

“I’m sure France will be downgraded in foreign investors’ eyes because they will think it is too complicated,” said Frédéric Montagnon, co-founder of OverBlog, a blogging platform.
…
The move to block a takeover by Yahoo comes even as France has been stepping up its efforts to attract foreign investment — much needed, analysts say, to pull the country out of a slump in which gross domestic product declined by 0.3 percent in the fourth quarter of last year.

Or, as the headline on the Financial Times proclaimed: “Dirigisme dies hard in France”.

The rebuff to Yahoo comes after Montebourg feuded with other foreign capitalists. From the London Telegraph:

But it is not the first time Mr Montebourg, on the Left flank of President Hollande’s Socialists, has been accused of damaging the country’s business image.

Last year he threatened to nationalise an ArcelorMittal steel plant in Floranges, north-eastern France. More recently he got into a spectacular public spat with American tyre tycoon Maurice Taylor, calling the Titan International CEO “extremist” after he pulled out of talks to buy a Goodyear factory over worker demands.

“The extremists are in your government, who have no idea how to build a business,” Mr Taylor fired back.

But what I think is most important is the message it sends to French entrepreneurs, who know that for the next four years (at least), they can’t build an economically significant firm and sell it to the highest bidder. From Business Week:

“It sends a very bad signal to the outside world, saying that because you aren’t French, we prohibit you from being involved,” says Christophe Chausson, managing partner of Chausson Finance, a Paris-based venture capital group. “To develop startups, you have to do the opposite of what the government has done. Dailymotion needs a lot of capital, hundreds of millions of euros, to develop and buy rights to content.”

The same article noted that the decision hit home for the company’s founders:

Perhaps the most poignant reactions to the collapse of the Yahoo deal came from Dailymotion’s co-founders, Benjamin Bejbaum and Olivier Poitrey, who started the company in Poitrey’s Paris apartment in 2005. “It shouldn’t have been THEIR decision,” Poitrey posted on his Twitter account on April 30. He recently moved to Silicon Valley to head a team that’s developing Dailymotion’s mobile offerings.

Added Bejbaum in a tweet today: “On Monday, there was hope. On Thursday we freaked out. The French economy is not a toy.”

Like Poitrey, some expatriate French are thriving in Silicon Valley. But I see a huge opportunity for French-speaking Switzerland (with access to capital and home of a first-rate technical university) or Belgium (already home of French tax refugees) to create entrepreneurial clusters and attract the best and the brightest minds trapped in President Hollande’s workers’ paradise.