Red Hat Demonstrates Subscription Power

Red Hat announced full results for FY06 yesterday, and the results were very impressive. The most notable statistic, in my opinion, was the strength of the renewals. 25 of the top 25 customers and 99 of the top 100 customers up for renewal in 4Q06 renewed their subscription contracts with the company. These renewals are not for some percentage of an initial license sale, but for the full value of the subscription. In most cases, it was probably higher due to an increasing footprint within each customer.

The important lesson here for the rest of the software industry is that getting your product in the door at a reasonable price (i.e. a "pay as you go" subscription) leads to a great business model if you continue to fulfill on the value of the product over time. I was on a call yesterday with Jason Maynard, a CSFB equity analyst, where Jason declared that he was seeing a definite transition to the "pay as you go" subscription model. He claimed that the pendulum of negotiating power was swinging toward the customer, and software vendors are reacting by accepting some of the risk of software success by changing the license terms from perpetual to subscription.

During the early days at Red Hat, it was difficult to sell the customer on the notion that the payment each year was the total subscription value instead of a bigger payment in year one for a license and lower payments in subsequent years for "maintenance." The logic that ultimately prevailed with the customers was that a subscription to the total value of the supplier provides a healthier foundation for a relationship. Customers can consume the technology that works best for them independent of the "version" or "release" because the subscription entitles the customer to the total value stream for a particular product line. Additionally, the supplier has to "earn the value" everyday or be faced with the prospect of cancellation at the end of the subscription term.

One final lesson for the software vendors that are still addicted to the adrenaline rush of the perpetual license model - customers do not replace software that works for them. The switching costs are too high. Lower the barrier to entry, get in the door, do a good job, and maybe you too can build a model that looks as good as RHAT.

Microsoft? or IBM? or None of the Above?

Microsoft's Steve Ballmer poked IBM in the eye this week with the following quote:

"Their pitch is to let IBM help your company with its innovation. Ours is to empower your people to innovate. The two approaches are striking in their contrast"

Steve Hamm wrote a nice article about the spat for Business Week Online. In the article, he detailed IBM's retort, provided by Ken Bisconti:

"Windows and Office attempt to prolong Microsoft's pre-Internet, proprietary, one-size-fits-all computing model. We embrace open-technology standards, which give customers the ability to mix and match the technology they use."

I do not believe that anyone is going to be better empowered to create software innovations because of the new features Microsoft is planning for Windows or Office. I also do not believe that IBM's embrace of open source and open standards is going to be at the center of the next wave of innovative technology businesses. But, in a sense, some combination of their two statements probably leads us to the right conclusion about where the software market is going.

Open source, not Windows or Office, empowers people to deliver software innovations to market more quickly. Survey the market today and take note of the number of software solutions that are being delivered to the market as Linux appliance solutions or as on-demand applications via the Internet. How many of these applications do you suppose are running Windows as their foundation or utilize Office as a key component? My educated guess would be "a negligible minority." How many of these new applications are being conceived, developed, and delivered by IBM technicians? My educated guess, again, would be "a negligible minority."

The freedom of Linux and open source technology empowers talented and motivated developers to get a high performing, integrated solution to market quickly with minimum overhead. Technical talent, a good idea, and a strong work ethic are the table stakes for the next generation of software innovations that will change the world. The Internet provides the distribution channel, and the last piece of the puzzle is the sales and marketing platform. The winning technology businesses will be those that match open source infrastructure with talented developers and a savvy marketing and sales approach. Witness Google, Yahoo, Apple, Red Hat, and salesforce.com. Who will be next?

Caveat Emptor - The Perpetual License

Let's all pretend for a moment that we are a software buyer. Perhaps we wish to purchase an accounting application for our business, and we have begun the process by creating a "punch list" of requirements for the application - mostly functional requirements, some technical requirements. Next, we engage our favorite technology sales person whom we trust because she has dealt with us squarely in the past, and each time she has delivered value commensurate with the value promised (no joke here, seriously, these people do exist and I have had the pleasure of working with some of them).

Upon review of our punch list, she proclaims that the application she is selling does indeed perform all of the "punch list" functions as specified. Furthermore, she provides us with references in the industry who also proclaim that "the punch list is punched" by this application. She also has her fabulous sales engineer install a trial version for us so that we can "take if for a few laps around the track to see that it works as advertised - punch list punched."

Not wanting to negotiate price before we examine the fine print, we ask to see the license terms, which can be summarized as follows:

- Perpetual right to use the object code in the form delivered.

- Media warranty - the media will be replaced with new media if it is found to be defective

- As Is - no fitness for any particular use

- No source code nor any right to decompile, reverse engineer, blah, blah, blah

Everything seems to be in order. Typical language for most software. We ask a few final, simple questions of our trusted sales person:

Q: "So, what is the financial health of the company that develops this code anyway? Are the developers happy? Are they working on the next great thing for my business?"

A: "Well, the company that originally developed this application is defunct and the developers are not reachable in any way, shape, or form. Now let's get down to the business of pricing this perpetual license, shall we?"

How does this story end if you are the buyer? Everything is in order. You have a punchlist that is punched, great references, a trusted sales person, and a typical perpetual license. The perpetual license is the most valuable thing in the software industry, right? It is the item which defines the software sale, right? So, how much do you pay for this very valuable thing which can never be changed by you or anyone else for the life of the "perpetual license?"

Not one thin dime, because the current functionality of the "punch list" is table stakes, and the real game is played based upon a sustainable future - a future where the "punch list" is certain to change. Since its birth with the IBM consent decree, the software industry has largely existed as a failed market because the item for which the buyer pays the most money, "the perpetual right to use the current object code functionality AS-IS with no warranty or fitness for any particular use," is the item the buyer values the least.

What is most valuable to the buyer is the ability to adapt the technology to future needs, whatever they may be. So, in most cases buyers pay for the expensive perpetual license based upon the "promise" of some future maintenance stream. This "promise" is implicitly bundled with the perpetual license in the form of a maintenance contract (which also likely proclaims "no fitness for any particular use"). A market is a failed market when the value a buyer ascribes to a product is grossly different than the value actually delivered by the product as part of the contract, yet the buyer completes the transaction anyway.

The great news is that the market is transforming from a failed market with software vendors wielding too much power to an efficient market where software goods are purchased based upon the real value they deliver to the buyer over the contract term. It's called a subscription. Carpe diem.

Virtualization - A cold reality for the Standard OS

Lots of people and companies are excited about Intel's Vanderpool and AMD's Pacifica virtualization technologies. You hear constant clanging about "higher utilization" in the datacenter and the "cool" factor associated with being able to run Windows on a Mac (which is kind of cool, because you get OSX plus all the apps monopoly power can buy on a beautiful machine). But has anyone stopped to consider what widespread virtualization might do to break the innovation stranglehold created by the "standard OS disease" (SOD)? Most companies and consumers are not even aware they have SOD because they have learned to live with the technical equivalent of chronic fatigue disorder.

SOD is the condition of settling for slow innovation and poor performance while shelling out extra money to make things work together because all new innovations must be filtered through the least common denominator of a "standard OS." The current tonic for SOD is expensive and bitter. For commercial concerns, the tonic for SOD is expensive system techs that constantly fight through "patch hell" to pull together a rack of machines, all running variants of one or more "approved, standard OSes", that collectively deliver the value of some enterprise application. For consumers the SOD tonic has 2 flavors. Flavor one is a semi-annual re-install of Windows to recover from the bloat created by the helter skelter of conflicting application dlls and Windows updates. Flavor two is shelling out the dough to own a couple of machines, with the Windows machine relegated to only the chores that your Mac or Linux box cannot accomplish because some website or app you require only supports Windows (monopoly power has its rewards).

Ultimately, widespread and high performing virtualization is the best tonic for SOD because the application provider can simply deliver to the user their application PLUS whatever fractional OS is required to run the application most effectively. The base OS that accesses your hardware (domO for the techies) is NEVER (or rarely, in the case of a security patch) modified for the life of the machine, and applications run seamlessly together because they simply plug into "guest" sockets on the base OS.

Why does this new virtualization tonic break the innovation stranglehold? Because application vendors no longer need to spend 30 - 40% of their engineering time and money "porting" and supporting the application for all of the variants of "standard OSes" (versions, patch levels, etc) that might be in use by their target market. This time and money can be re-directed to features and performance - things that matter to customers. Beyond getting better applications faster, customers also jettison the bitter tonic of extra machines and extra time currently required to battle SOD.

What happens to the OS vendors? I suppose it depends on their reaction to the new tonic. If they are allergic to the notion of the application provider streamlining their "standard" to better suit the needs of the application, they are in for a rough ride. If they are "flexible" (a rarity for system software vendors), they will probably pick up market share at the expense of their rivals. It should be fun to watch . . .

SaaS and Open Source

How can the popularity of these 2 very different trends be explained? SaaS delivers the value of the application without the complexity of software. Open Source is all about the flexibility of software, and there can be plenty of complexity. Where do these 2 trends meet?

I think there are a couple of good answers to this question. First, the SaaS vendors leverage open source very heavily to deliver the application to their customer. The early crop of on-demand application ASPs failed miserably because they were just re-hosting the same expensive, proprietary solution for the customer. Expensive Unix hardware and expensive software licenses disguised as a lease did not create a better model. The current crop of vendors uses Linux on industry standard servers, they own the application code, and they have created a multi-tenant architecture that allows customers to share the infrastructure. Their efficiency in creating and managing the platform is enabled, to a large extent, by open source infrastructure.

Open source has also enabled another form of SaaS that is labeled and marketed as "appliance" solutions. Does anyone believe the value of a firewall, spam, or authentication appliance is the hardware? Of course not. It is the software, and open source, notably Linux and FreeBSD, have created the possibility for these integrated solutions to be delivered at such great prices to the customer. The value of an application without the hassles of software is the hallmark of SaaS, and vendors such as Barracuda Networks and Imprivata provide software without hassles via an appliance.

As the founder of rPath, I believe another form of SaaS is going to emerge - the software appliance. Similar to an appliance solution, the freedom of distribution enabled by open source creates a platform for an application vendor to deliver a complete software solution to the customer - no integration required. In this case, however, the customer provides the hardware from their favorite industry standard server vendor according to the specifications of the software appliance. The application vendor manages all maintenance for the solution, which the customer receives via a simple web interface -- always tested, never painful.

So open source and SaaS are intersecting at the creation of the solution, and the suppliers and customers are each receiving the benefits that matter to them. The suppliers get a flexible platform free from restrictive and threatening licenses, and customers get an integrated solution free from the hassles of software integration and maintenance.

No Network effect for Novell

Novell reported results for their 1Q06 yesterday, and Linux has done little to lift the company's fortunes. I remember the announcement of the Novell acquisition of SuSE when I was running North America sales for Red Hat. The theory was that Novell's much larger sales team would see more opportunities than Red Hat and therefore be better positioned to convert them into Linux sales. It has not happened. Red Hat is growing subscription revenue at 2 times the rate of Novell from a BIGGER base with a fraction of the sales team. The network effects of market leadership continue to provide enormous benefit to Red Hat while Novell continues to struggle in a booming market for Linux and open source.

It is curious to me that Novell continues to operate their Linux business as a mirror image of the way Red Hat operates their business, but for lower price points and lesser market share. The positioning is the same. The technology is the same. The business model is the same. Something needs to change. If you listen closely enough to your customers and your prospects, they will tell you what to change. We should all find ways to listen a bit more . . . .

Open Source is all about the Network.

I had a call with an equity analyst yesterday discussing why open source is different. One leader in the open source industry tried to convince him that open source changes the dynamics of software distribution, but I do not believe distribution is fundamentally different for open source vs. proprietary products. There are lots of examples of "free for use" proprietary products that are distributed via the Internet. VMware player is a great example.

The big difference with open source, in my opinion, is the value created by the freedoms of "modification, use, and distribution," which are collectively greater in value than the simple freedom of "use." Freedom to modify means more users will use the product because they can adapt it to their needs. Freedom to distribute means more users will offer the product as part of their value, creating yet again more users. These open source freedoms have the potential to create market share faster than any free use scenerio for a proprietary product. Increasing market share leads to network effects, which are the real secret to success in the software industry.

Network effects in the software industry are well documented, and open source provides the best mechanism today for a small company to "break out" by creating network effects quickly and cheaply.