The Economics of Open Source

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I’ve operated in the world of technology for the better part of a decade in private and public companies alike. Despite holding positions in business functions, my roles have tended to blend revenue generating activities with technical expertise. Working as a Solution Engineer or Product Marketer, you’re granted exclusive access to product and engineering teams, an elusive bunch — often by choice or for the sake of pure productivity and output. It was among the developer crowd that I first came to learn about open source software (OSS) and its contribution to our modern tech ecosystem. Nevertheless, the concept was puzzling, especially from the vantage point of a well-funded, private company with the means to compensate employees and the potential for huge returns.

As it turns out, I had mis-characterized open source software as “free public goods” generously brought to you by well-intentioned programmers with either bad business sense or an extreme penchant for altruism. While there is a sliver of truth to that assumption, there’s much more than meets the eye. Not only is it a powerful force for progress in the IT sector but, if done well, a unique competitive advantage that can rarely be matched by private organizations. Following a bit of research I was able to answer the following questions:

  • How do you define open source software?
  • What is the history and impact of this development philosophy?
  • How does it work financially & can it compete in a highly privatized industry?
  • Does the economics of open source make it an attractive venture capital investment?
VC investment in Open Source has increased YoY (Source: Battery)

Defining OSS

According to OpenSource.com the definition is as follows:

Open source software is software with source code that anyone can inspect, modify, and enhance.

“Source code” is the part of software that most computer users don’t ever see; it’s the code computer programmers can manipulate to change how a piece of software — a “program” or “application” — works. Programmers who have access to a computer program’s source code can improve that program by adding features to it or fixing parts that don’t always work correctly.

The first thing you’ll notice is that the word “free” is not included in the definition. Although most open source tooling is free of charge (we’ll get to monetization later), the definition centers on the availability of source code and your rights to interrogate it as an independent developer contributing to the project. Open source development really started as a fringe activity, hand in hand with the ethos of the early internet community.

History of OSS

Writing, sharing and tinkering with code became more accessible as networks expanded. Furthermore, R&D in the space was primarily funded through government (re: ARPANET) and academia (MIT & others) meaning there wasn’t a preconceived notion around compensation or return on your time spent on a project. Early projects like the LINUX operating system and MySQL were built publicly with a community of distributed developers fixing bugs, improving the code base and ultimately fostering an ecosystem for growth.

RedHat is the original success story in OpenSource started in 1993 (read the full success story here)

There have been plethora open source success stories, many of which you’ve likely heard of, if not indirectly interacted with (including RedHat mentioned above). Still, open source isn’t the first model that comes to mind when you envision high-growth, fundable business models. It’s inherently counterintuitive: you build a public code base, enable anyone to contribute and then expect, organically perhaps, to monetize said functionality. Yet what is often perceived — at first — as a major weakness, has proven in some cases to be an enormous strength: community. Now, some private companies have co-opted this strategy, namely Apple and Microsoft — but nothing has been able to eclipse the power, passion and draw of the open source developer community. Let’s have a look at why that might be and how exactly it works in practice.

Economics & Competition in OSS

Open Source has always maintained an arm the rebels mentality among developers. Indie hackers who care about a certain project dedicate hours of their life with little expectation in return. The focus is on building something cool and perhaps “sticking it to the man” i.e. a proprietary software company that stands to profit greatly if it weren’t for the open source counterpart. But it’s not all idealism and altruism, the majority of early, defining OSS projects built the tooling and frameworks for the modern enterprise. Infrastructure, analytics, hosting, middleware and data transformation — these functions are essential for the rest of the stuff to “just work.”

Arguably, they were only achievable within the context of open source development: highly motivated and intelligent developers working towards a functional outcome as opposed to a vanity metric. But the fact is, you can’t eat that warm and fuzzy feeling you get from participating in a meaningful project. The ethics and challenges of open source compensation are well-documented. From what I gathered, however, the largest and most successful projects are able to scale, hire, monetize and in some cases even IPO. Let’s examine how exactly this works.

Source: Bessemer Venture Partners, Roadmap: Open Source

According to Peter Levine, Partner at a16z and longtime OSS advocate and leader, there are three phases of open source growth as well as three key differentiators that provide a competitive moat against private/proprietary software organizations:

The Phases

1.Project-community fit, where your open source project creates a community of developers who actively contribute to the open source code base. This can be measured by GitHub stars, commits, pull requests or contributor growth.

2.Product-market fit, where your open source software is adopted by users. This is measured by downloads and usage.

3.Value-market fit, where you find a value proposition that customers want to pay for. The success here is measured by revenue.

The Competitive Moats

  1. Enterprise customers don’t want vendor lock-in
  2. They want to buy from people who have written the code
  3. Big companies don’t have your expertise

The phases resemble an inverted version of what a typical startup goes after. Customarily, a founder looks to identify a problem and build a solution that a customer(s) are willing to pay for. Once they develop the product, they test it out in the market, looking for product-market-fit. Then finally, once they’ve built a stable customer base willing to evangelize the product, they work towards driving community led growth — a subject we touched on a couple weeks back. OSS products and companies are community-first by design. The challenge down the line is less about finding champions and more about generating revenue.

Aside from community-driven enthusiasm, there are a few key competitive moats unique to the OSS model. Perhaps due to their tight-knit relationship with Enterprise companies (OSS having powered the backbone of modern enterprise tooling and all…) there is a clear path to monetization through this channel. Enterprise companies like flexibility (i.e. no long-term contracts), developer-to-developer relationships (fewer sales hoops to jump through) and experts to help implement, maintain and advise. But the preferred method to capture this value has evolved over time.

  • The RedHat case study from earlier was a pioneer in providing free software but monetizing through support and services
  • Later on, this method was trumped by offering proprietary/enhanced functionality, sort of like a freemium model where the roadmap is bifurcated between public and private/paid access to the tool [examples: Elastic, Confluent]
  • Nowadays, most modern open source companies monetize (surprise, surprise) via the SaaS model: handling the hosting, tooling and operations side of things for enterprises leveraging their technology [ex. Databricks]
OSS Pivot to Cloud has scaled faster than any previous model (Source: Battery Ventures)

Successful OSS projects come with a pre-built community (read: subject matter experts, developers who can use the product, and regular updates and documentation releases). This is attractive for any enterprise looking to integrate the source code into their own projects and then hire on developers to oversee it (or expect current developers to adopt it quickly). For OSS companies, it’s a fine balance to strike: your project is visible to everyone. In theory, the community could “fork” the project (clone and separate the source code to build in a different direction) which could pose problems. You live and die by community, but if you can thread the needle you have an incredibly powerful resource at your disposal. Historically, OSS was viewed as a commodity. In reality, it’s become a critical accelerator for commercial activity and business innovation.

Source: Open Source Business Forum (O4B) EU OSS Landscape

The Prospect of Funding OSS

Some have argued that open source is having a renaissance moment. Deeply rooted in developer culture it now also benefits from macroeconomic tailwinds like remote and distributed workforces, a mass migration to SaaS and the resurgence of early internet culture as viewed through the lens of crypto and blockchain communities. The path to exit is somewhat different from a traditional private startup, but the opportunities are there.

Furthermore, open source projects have been known to be key strategic acquisition targets. MySQL was acquired by Sun Microsystems which was then acquired by Oracle; Salesforce bought Heroku and Mulesoft; XenSource by Citrix; RedHat by IBM; Microsoft purchased GitHub. In addition, Open Source projects have expanded beyond the confines of pure play architecture into all the key verticals with major headwinds: fintech, ed-tech, cybersecurity, eCommerce etc. Many of the examples are US-based, but it should be noted that there are tons of great OSS companies right here in our backyard (Europe): Aiven (recently landed a $3B valuation with investment from Eurazeo), AI repository Hugging Face (just hit $2B after a recent fundraise), MariaDB, SUSE, Strapi, Axion IQ, Elastic ($ESTC public ticker) & GitLab to name a few.

Source: a16Z’s Future — Open Source: From Community to Commercialization

As articulated in the beginning of this piece, venture investment in open source projects is increasing year over year. It should also be noted that exit values are increasing as well, with over a 3x increase in IPO & M&A activity between 2019 and 2020 alone. So what have we learned? Well, first is that OSS isn’t simply free software, in fact, successful projects are able to achieve revenue targets and exit with multiples comparable to traditional, proprietary startups. Open source serves as both a philosophy and a go-to-market strategy — one that is heavily developer-centric — and requires careful, deliberate governance and oversight to succeed at scale.

Lastly, it embodies the movement towards transparency, decentralization and building for good that is representative of the current zeitgeist. Even some of the largest corporations in the world are resorting to open source to accelerate R&D progress and experiment at scale (Google has more than 2000 OSS projects!).

While we don’t have a specific mandate surrounding open source applications, we’ll be monitoring the market closely for projects aligned with our own investment thesis and with potential to achieve value-market fit and unlock innovation across commercial products around the world.

Kyle O'Brien