- Proprietary Software Business Model (Research and Development Model)
- Open Source Software Business Model
- Possible Effect of the Open Source Movement on Proprietary Software Businesses
This article discusses the differences between the proprietary software business model that creates "end value" in a closed source, proprietary code, and the open source software business model that creates "user value" in the software developers who write the code. The possible effects of the open source movement on proprietary software businesses are also discussed.
Proprietary Software Business Model (Research and Development Model)
In his May 3, 2001 address to The New York University Stern School of Business, Microsoft Senior Vice President, Craig Mundie, emphasized the importance of the "research and development model" in creating a sustainable business:
"[C]ompanies and investors need to focus on business models that can be sustainable over the long term in the real world economy…. We emphatically remain committed to a model that protects the intellectual property rights in software and ensures the continued vitality of an independent software sector that generates revenue and will sustain ongoing research and development. This research and development model … based on the importance of intellectual property rights [was the] foundation in law that made it possible for companies to raise capital, take risks, focus on the long term, and create sustainable business models…. [A]n economic model that protects intellectual property and a business model that recoups research and development costs have shown repeatedly that they can create impressive economic benefits and distribute them very broadly."
Mundie's "research and development model" – otherwise known as the "IP-rent model" or "proprietary software business model" – seeks to derive revenues from the value of the software as an end product. The model works in the following way. A company, like Microsoft, invests research and development to create the software as a protected intellectual property (a closed source, proprietary code base); then derives revenues by charging IP-rent for access to the software under a licensing agreement. The revenues generated from licensing allow reinvestment in further research and development.
The proprietary software business model has a number of business features that make it attractive to small and large software companies, alike. The IP-rent can be charged independently of any services provided, so a new business can start small but grow quickly. The IP-rent also generates a sustainable cash flow that allows for further reinvestment in the growing company. Best of all, the IP-rent need not bear a proportional relationship to the costs of initial software development. Thus, high profit margins can be leveraged from small reinvestments in research and development. Finally, the model scales well. Increases in the size and complexity of the code base scale proportionately with the size of the IP-rent that can be charged, and thus with the value of the company's stock.
The proprietary software business model also has its shortcomings. There are higher costs in the short term related to the granting of a monopoly. There are also threats to future innovation because the creative abilities of the company's software developers are constrained by the capabilities of the proprietary software's feature set. Finally, by fencing its base code around with IP protection, the company is forced to generate the value of its end product without the assistance of the outside software community. This may not be a major problem for a larger company, like Microsoft. However smaller companies, with their limited resources, are at a disadvantage.
Open Source Software Business Model
In contrast to the proprietary software business model that seeks to derive value from the end product, the open source software business model seeks to derive value from the software developer as an intermediate tool in the development of the end product. The model works in the following way. The company allows users/developers access to its IP, and in return receives assistance with the development of the tool. The open source license provides incentive for this co-operative effort: prohibition on terms restricting use, redistribution and modification of licensed subject matter motivates potential users to contribute to the writing and debugging of the code, which in turn generates a superior end product.
The open source business model also has a number of attractive business features. By allowing access to the source code, the model offers a way around the resource constraints of small business. By acting as an IP donation to the public domain, the model preserves many of the advantages of the academic license. Most importantly, by harnessing the input of a large number of co-developers, the model invites innovation and extension of the capability and functionality of the software, resulting in an improved end product that better meets the needs of the end user.
The open source business model is subject to a major criticism. By allowing free access to their IP, open source licenses appear to eliminate a primary source of revenue for their companies. Craig Mundie opined in his May 3, 2001 address:
"A common trait of many of the companies that failed is that they gave away for free or at a loss the very thing they produced that was of greatest value in the hope that somehow they'd make money selling something else. The Internet, for example, was full of sites producing content for free, in the hope that somehow they'd generate revenue from sources that never materialized, whether it was advertising, subscriptions, or a wing and a prayer."
The arguments above, however, assume that IP assets are only valuable if they can be converted into a revenue stream. Proponents of the open source movement argue, instead, that giving away IP "for free" makes business sense if it creates demand for another product or service provided by the company, or even for the company itself as a licensed brand. The Linux distributions (distros) have shown that it is possible to base a business on the distribution of free software. The IP asset of each distro house is its brand, and the brand may be licensed and trademarked. Red Hat is the premier example of a successful distro house that generates revenue through branding and user loyalty. While many people are knowledgeable about Linux, only Red Hat can provide the services of a "Certified and Trademarked Red Hat Engineer."
Possible Effect of the Open Source Movement on Proprietary Software Businesses
Karen Shaeffer, in her web article "Concepts and Perspectives Concerning OSS and Business: Prospering in the Open Source Software Era", explains the effect of open source software on the proprietary software business model:
"Open source software has the disruptive effect of commoditizing what used to be proprietary property of software vendors. The closed, proprietary source code formed the foundation of the highly profitable software industry of the last quarter century…. From the perspective of the proprietary software vendor, the open source software phenomenon effectively devalues the source code to the price of the media that holds it. Thus, the primary consequence of the growth of open source software code bases will be the proprietary software business model will not be able to sustain the historical profit margins of the past few decades."
Microsoft Chairman Bill Gates commented to similar effect in his March 31, 2003 quarterly address:
"To the extent the open source model gains increasing market acceptance, sales of the Company's products may decline, the Company may have to reduce the prices it charges for its products, and revenues and operating margins may consequently decline."
While this dark prediction of decreased profits for proprietary software vendors has so far failed to materialize, many of the better-established vendors of proprietary software (Apple, HP, Sun Microsystems, SGI, IBM, and even Microsoft) have launched open source initiatives, or have recently released software into the open source domain. These efforts may represent a first attempt to create sustainable open source business models capable of generating a respectable revenue stream in the face of a readjusting software market.
While the open source business model has a number of attractive business features (invites innovation, better meets the needs of the end user, etc.), it is subject to the criticism that it constitutes a flawed revenue model – by licensing the IP "for free," a primary source of revenue is eliminated. But revenue can be recouped if the licensing creates a demand for another product or service provided by the company, or even for the company brand itself. Red Hat is an example of a company that has developed a viable open source business model based on the licensing of the "Red Hat" brand. As the open source movement continues to gain market momentum, traditional proprietary software vendors may need to develop their own sustainable open source business models if they are to counteract a predicted decline in profits from proprietary products.
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