Open-Source Startups Follow Red Hat’s Path To Profit

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When database giant Oracle recently announced its intent to acquire Sun Microsystems, a shock wave went around the open-source community. Sun, along with Red Hat and Novell, is one of only three public companies focused primarily on open-source software. Pummeled by the stock market last year and stymied by poor financial results, Sun was identified by many as an acquisition target even before Oracle’s announcement, and there are now many questions surrounding its open-source efforts as it loses independence as a public company. Novell, too, is seen by many as an acquisition target following poor financial performance and a stock market beating.

Among public open-source firms, that leaves only Red Hat to consider. Unlike Sun and Novell, Red Hat has reported quarter after quarter of strong, stable earnings, with a healthy market capitalization of more than $3 billion and more than $800 million in cash. What is Red Hat’s secret sauce, then? The answer may well provide a lesson for both open-source (and maybe even proprietary) software companies going forward in a tough tech economy: Red Hat doesn’t sell software — it sells support.

How Red Hat Works Its Magic

Red Hat offers an open-source Linux-based operating system, middleware, and application software, but it doesn’t generate its revenues from software sales. Instead, the company is focused on support and training for its software, for which many advancements are developed for free by the open source community. As an example, small business and large enterprises alike pay $80 per user per year to use Red Hat Enterprise Linux Desktop, and free community contributions to Linux help improve the software over time. The open source nature of the software reduces Red Hat’s development costs, and users get better software at a lower cost.

It has long been widely accepted that Red Hat’s business model of free software and paid support is a direct, radical challenge to the expensive enterprise software licensing models that made companies such as Microsoft and Oracle titans. That means the company has a need to stay focused on support as fundamental to its business model — a fact that’s not lost on Red Hat’s CEO, Jim Whitehurst, either. Speaking at the recent Open Source Business Conference in San Francisco, Whitehurst said: “Our biggest competitor is not Microsoft, and it’s not Novell. It’s people stopping paying us for support.”

Where Have Sun and Novell Gone Wrong?

As Red Hat retained that focus, Sun Microsystems (which was seeing profit margins shaved on its server and storage offerings) achieved only minor financial success by focusing the company on open-source software initiatives such as MySQL.  Sun offered fee-based support for open-source efforts as well, but not in the focused way that Red Hat has. In Sun’s case, problems in its hardware divisions eclipsed its other efforts and resulted in steep earnings losses.

Novell, like Red Hat, has a Linux business, but it hasn’t been able to generate consistent financial results with it, reporting a 36 percent drop in earnings in its most recent quarter. Novell depends on a partnership with Microsoft to generate new customers for its Linux business, and the company has stated that lack of new deals in the Linux business have hurt it.

It’s also instructive to look at Red Hat’s pricing practices for its support. Consider this data point: In its most recent fiscal quarter, Red Hat renewed each of its top 25 enterprise support contracts up for renewal at 132 percent of the prior year’s value. In other words, the company has such pricing power for its support that it can grow revenues, even without adding new customers or delivering more software. The company thoroughly trains support personnel and emphasizes full-service support for fair prices. Wisely, it also offers customers top-notch training, which reduces the amount of support it needs to provide.

Who’s Learning From Red Hat?

There are many signs that Red Hat’s model has begun to catch the eye of innovative open-source entrepreneurs. Drupal is one of the largest open-source content management software platforms in the world, and publications ranging from InfoWorld to The Onion to OStatic run on it. It’s free, but a young startup called Acquia is successfully offering commercial support for Drupal. Notably, Dries Buytaert, the founder of Drupal, is the co-founder of Acquia, and, although he comes from the world of software development, he saw a Red Hat-like opportunity in providing commercial support for Drupal.

Cloudera is another example of a promising young startup focusing on the free software/paid support model. It offers commercial support for Hadoop, which is a free, open-source software framework able to take advantage of huge clusters of computers to produce fast results for queries. Hadoop underlies Yahoo searches and is used by many businesses, but until Cloudera’s formation last year, there was no structured support available for it. Just as Tom Sawyer’s friends whitewashed the fence for him, the open source community improves the software on which Cloudera’s and Acquia’s businesses are based. Software development costs are a non-issue for Cloudera and Acquia.

Eucalyptus Systems has just launched as a commercial open source company focused on cloud computing. The Eucalyptus project rose out of the Computer Science Department at the University of California, Santa Barbara, and it offers an open source software infrastructure for cloud computing at much lower cost than Amazon and others. As is true with Red Hat’s business model, the Eucalyptus software is free, and Eucalyptus Systems will make money by providing support for it. Benchmark Capital, which has financed other high-profile and successful open source companies including MySQL (acquired by Sun) and Xen (acquired by Citrix), has backed Eucalyptus with a $5.5 million Series A funding round, in conjunction with BV Capital. (On the cloud computing front, note that Red Hat has its own cloud initiatives, which also concentrate on free software and paid support.)

The software industry moved along for many years with the dual assumptions that selling software is a central business proposition, and that expensive development is the only way to move software forward. While the open-source community has proved the second assumption wrong, Red Hat’s success has established a beachhead for this model in the profit-driven public markets. With so many open-source software applications proliferating and maturing, the Red Hat model is likely to have a growing influence on the software industry for years to come.

Sam Dean is the Editor of Ostatic.

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