Open Source Strategies

A blog about open source software and business models, enterprise software, and the opentaps Open Source ERP + CRM Suite.

Friday, April 01, 2005

Open Source and Software Business Valuations

Do Wall Street financial analysts understand open source?

The article Novell Gaffe Costly says:

"because license revenue is a key indicator of new business, while maintenance revenue reflects ongoing payment from current clients, the shift is disturbing."

It also specifically quotes an analyst as saying:

"the leading indicator of Novell's business -- software license revenue -- is caving in faster than previously thought, suggesting more severe market-share losses with NetWare and other products."

But how will licensing revenues continue to be the leading indicator of a software company's business under open source? More specifically, how will licensing revenues continue to be the leading indicator of Novell's business as it switches from proprietary to open source products?

Broadly speaking, software companies make R&D investments to develop products and then sell licenses to users, then follow through with services, support, and maintenance on those products. Licensing is thus a mechanism for a software company to recover its large investments in R&D. Software companies have huge operating leverage because the R&D investments are sunk costs bear no relationship to the number of licenses sold. In this way, developing software is rather like producing a movie. (Imagine that when you look at your programmer friends next time!)

Why do financial analysts focus on licensing revenues? Because, first of all, licensing sales have no marginal costs and thus huge gross margins. Second, and more importantly, licensing is a harbinger of the adoption base for the company's technology. Robust licensing sales indicate that the company's technology is gaining adoption. This adoption base determines whether the software company can derive future revenues from services or new products, and, critically, whether the company and its technology continue to remain relevant.

Of course, I'm sure there are some software companies where the only source of revenue is from licensing. I don't know much about this sector, but video games come to mind right now. For companies such as Novell, though, their products have significant future service revenue streams. Thus, for these companies, licensing is more important as a potential gauge of the adoption base for their technology.

Most open source companies, however, do not have licensing revenues. (Except for the few companies in the "dual licensing" business. My opinion on that subject does not belong here.) So right there, we need a different metric to measure the adoption base of their technology.

What about the high margins of licensing revenues? Does the absence of licensing necessarily imply that open source companies are in low margin businesses? Not necessarily either. First, because they can draw off a larger, open source code base, open source companies' investment requirements in R&D are also smaller. So, in a sense, they do not have to have licensing revenues to recover those investments.

Second, if their investments in open source community R&D help them build a stronger brand name and charge a premium price for services, support, and consulting, then I would argue they are earning very high returns on those R&D investments. If the adoption base of the underlying technology is large enough, they could potentially earn a far higher return on those R&D investments than most commercial software vendors ever could.

I hope this will convince some of my former Wall Street colleagues to sharpen their pencils.

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