WHY BUSINESS MODELS MATTER

There are a wide variety of factors to consider when choosing a software platform. Much ink has been spilt comparing the relative merits of the commercial software model, most notably represented by Microsoft, and the alternatives offered by the Free and Open Source Software (FOSS) community.

Various studies with various degrees of rigor have been published showing the pros and cons of each model. The folks at the sharp end of this debate are the Chief Information Officers (CIO), Chief Technology Officers (CTO) and procurement managers of the organizations which ultimately have to choose between these alternatives. Their selection criteria commonly include: total life cycle cost, availability of applications, security, interoperability, relationship with the supplier etc. However, I believe there is one factor which is almost always overlooked and yet, to me, is absolutely critical to defining a long term, strategic platform acquisition strategy. That factor is the core business model of the company supplying the platform.

In my view this one factor illuminates everything you need to know to understand why certain large technology companies are betting their future on FOSS, why Microsoft is not and why it matters to everyone making a strategic platform decision.

Licenses and Services

Within the software industry there area essentially two basic business models: the product sales driven ‘Commercial’ software model and a ‘Services’ revenue driven model. There is of course a wide spectrum of models but they all tend to be variations on, or combinations of, these two.

Revenue in the product sales model is generated by selling a license to use a particular product to a customer. Customer may get a perpetual license which gives them the right to use the product for ever without any further payment to the supplier. An alternative subscription license may be offered which requires the customer to make a payment to the supplier on regular basis (Yearly is normal) in order to be able to continue to make use of the product. In the product sales model the supplier will also, in most cases, offer a maintenance contract which provide ongoing updates and other services during the life of the contract. So even in the purest of product sales models there is almost always a services component as well. 

Under a services model the supplier generates the majority of their revenue by supply a range of services to the customers. This set of services can include everything from bespoke or customer solution development, through systems integration of purchased applications and platforms all the way to full outsourcing of the customers complete IT infrastructure. Services contracts may be charged for on a “Time and Materials” basis where the customer pays based on the amount of effort and time required to complete the project. They can also be charged on a “Fixed Price” basis where the supplier makes a quote a specific service which is fixed irrespective of the final amount of resource a time required to finish. A third variation is the “Packaged Services” contract. Under this model the supplier offers a range of services to be delivered over time for a given fee. This model is akin to the maintenance contracts discussed above where the supplier may provide software updates, security patches and other fixes over time for an application they have written.

Platform Choices

It so happens that the two major competing platforms which customers have to choose between today exemplify either end of this spectrum of business models: The Free or Open Source Software (FOSS) or commercial software models.

FOSS

Any supplier building a business based on FOSS, must depend entirely on a services based business model because a license fee can not be charged for software offered under the GPL. This is not universally the case however. There are very good examples of Open Source Software (Minus the ‘Free’) based companies which offer a commercial software license for their products. The commercial software license from MySQL is perhaps the best example. However even MySQL depends greatly on it’s services revenue stream to sustain it’s business.

Businesses being built on top of the FOSS platform will typically be providing services under one of the three service model illustrated above. It is this service based business model I believe one can look to in order to predict the future strategic direction and focus of the company.

Commercial Software

The other choice open to customers is to acquire solutions and platforms from a commercial software supplier; Microsoft being the prototypical case for this discussion. Microsoft is a complex company composed of seven distinct businesses each running their own P&L. Despite this complexity, the fundamental model underlying these businesses (Excepting MSN which is still a very small net contributor to Microsoft profitability) is extremely simple. It has also remained unchanged throughout the life of the company.

Microsoft makes the vast majority of its revenue by selling a software license to customers granting them the right to use its product. Almost all licenses sold by Microsoft grant the customer the right to use the software in perpetuity; once the customer buys a product license that asset is their for ever. The business grows over time by convincing existing customers to buy a license for upgraded versions of the software they already have rights to use, or by selling new licenses, for new products, to new customers. This model really is this simple and underpins not only Microsoft’s business but also the business of nearly all commercial software companies

[For the sake of completeness it should be recognized that there are two service components to Microsoft’s business model; product support services which provides technical support to consumers and business customers and Microsoft consulting services which provides specialist architectural design and development services for larger enterprise customers. Both of these organizations are driven to price there services in a way which covers the costs of delivering the services and if possible to provide a small net contribution to the company. However, in revenue terms these contributions are very small compared to software licensing revenue streams.]

Complexity and simplicty

The IT environment in most reasonably sized organizations today is just too complex. It is a fact that complexity translates directly into costs for the organization. As complexity rises an ever larger portion of today’s limited IT budgets gets spent on maintenance and operational support. At the same time the demand for new capabilities from IT departments continues to grow rapidly.

In today’s IT environment, CIOs and CTOs value: Security, reliability, manageability, interoperability and several other ‘abilities. However, the most important ‘meta-factors’ are simplicity and ease of use. Only by tackling these issues can budgets be reduced or, even better, reallocated towards value creating new IT capabilities for the organization. It is generally accepted that improvements in these ‘abilities over time will lead less complex and easier to manage and use systems.  

Reducing complexity and costs and increasing the share of budget available to develop new capabilities is the number one strategic imperative facing today’s CIOs. How does an analysis of business models help illuminate these issues when you are making a strategic software platform decision?

Motivation is everything

All companies are motivated to make money. This is how R&D gets funded, developers, sales people and marketers get paid and how the company returns value to its stakeholders. It does not matter whether the business is based on FOSS or the commercial software models; for the people that work in the organization ‘Maslow’s Hierarchy of Needs’ still applies. Companies must generate an income which at least matches their expenses over time. For a company to grow, investments must be made in new resources, R&D, marketing etc. This requires growth in the revenue stream. Growth in the revenue stream comes from convincing customers that you are delivering value which they are willing to continue pay for.

As outlined above, companies building a business on top of FOSS technologies must, by definition, generate their growth by delivering value to customers through the services offered. On the other hand, companies based on the commercial software model drive their growth by delivering value though the products themselves.

Service model motivations

I realize that what I’m about to say is probably the most contentious part of my argument: Simplicity is the anathema of a services based business model! The plain fact is that increasing complexity drives increased demand for services either to keep the environment running or to develop and integrate new capability into the environment. Increasing simplicity on the other hand reduces the demand for services. A services based business will thrive in an increasingly complex environment and will shrink as complexity if reduced.

This is not to say that services based businesses are fundamentally motivated to increase complexity. Obviously not, for to do so would generate negative value for their customers and that would have predictable results on income and profitability. However, I would contend that service based businesses are not fundamentally motivated to reduce complexity either, because to do so would cause increasing challenges to their growth. Service based businesses must navigate the path between delivering value to customers and sustaining a revenue model which is counter to the desires of those same customers.

The intimate relationship between services and the FOSS approach also explains why certain large technology companies have jumped on the FOSS bandwagon. IBM has 240,000 consultants. In 2004, out of a total $96 Billion in revenue, IBM generated $43 Billion from services, $31 Billion from hardware and only $15 Billion from software. Year over year growth in services was 3.1% compared to 0.6% for the software business.

No wonder IBM is funding FOSS development and so eagerly promoting its adoption. FOSS is clearly viewed by IBM as a vehicle to drive growth in its services business. While this might be beneficial for IBM’s growth can the same be said for its customers?

I believe that it’s no coincidence that the biggest corporate supporters of FOSS are those technology companies which depend most on services revenue streams to compliment their other software and hardware businesses.  

Commercial software motivations

Commercial software businesses are primarily motivated to focus their R&D on generating innovation which maximizes value creation through the products they ship. As illustrated above customers place most value of improvements in the ‘abilities, ease of use and reduction in complexity over time.

The net value created by an investment in a solution or platform is always the difference between the total ‘potential’ value minus the transaction costs of implementing, deploying and managing the resulting system. When transaction costs, including all required services, exceed the ‘potential’ value then value is destroyed and costs increase.

In my view well run commercial software companies will always realize that their growth will be maximized when they focus on innovations which maximize ‘potential’ value and minimize the customer’s transaction costs (Complexity.) Being focused in any other way will significantly limit the company’s growth opportunities.

If one looks at where Microsoft is focusing its R&D you will see that the highest priorities are placed on improving the Windows platform’s security, manageability, interoperability, scalability and ease of use. Microsoft’s underlying licensing based business model demands that it invest in areas which will remove barriers to customer adoption. If the company fails to direct R&D in this way then customers will not upgrade, would switch to other platforms and new customers will not be attracted to the Microsoft platform: In short the revenue streams which fund this innovation cycle would dry up all too quickly.

What’s in it for me?

Of course there is a wide spectrum of business models. Few companies are either pure licensing focused or pure services focused. However, I do believe that the clearer the focus and the more pure the underlying model, then the easier it will be to predict future value delivery. Companies with blended models will always suffer from conflicting motivations which ultimately leads to confusion and less value creation for their customers.

If you are an IT decision maker faced with making a choice between FOSS and commercial software based platforms then you will of course be evaluating a wide range of criteria in making your decision. However, I believe the arguments I’ve laid out above delineate perhaps the most fundamental difference between the two options.

Over time, the commercial software model, with its primary motivation to reduce transaction costs and increase value though software alone, will inevitably deliver more customer value than FOSS with its implicit service based business model.