In this series, I'm going to work through my thought process about Open Source businesses and walk you through the steps I followed while building LunaSec. In comparison to traditional business models, Open Source businesses can be non-trivial, non-obvious, and daunting to undertake.
My goal is to help teach others about Open Source businesses by helping you understand the steps involved, the tradeoffs you make by choosing Open Source, and by overall giving you an intuition to help evaluate if Open Source is the right approach for your business.
The series will be split up into a series of different posts, each one focusing on a different part of the process involved with building and launching an Open Source business. In this post, I'll be explaining the evolution of software pricing models, the pros/cones of each, and relating them back to Open Source.
I hope this article helps you kickstart your efforts of launching your Open Source business. At the end of this series, I will also be sharing with you how to best position your business to raise Angel & VC funding based on our experience raising a Seed round.
Part 1: Software Pricing Models
The world of software licensing is evolving.
Over the years, the software industry has evolved and the simple distribution models of yesterday have evolved along with it. Gone are the days of simple brick-and-mortar software purchases, instead having been replaced by more complex pricing models like by-the-hour cloud-based software, per-seat subscriptions, and custom "Enterprise" contracts.
Open Source represents one of the modern shifts in software pricing by bringing a more flexible, more adaptable approach to address the complexity of modern software development practices. It's not all rainbows and unicorns though. There are real tradeoffs to be aware of when choosing to use Open Source for a business.
To help understand the tradeoffs, I will be breaking down the pricing models into a few categories:
- Brick-and-Mortar: The traditional approach to software development, where you purchase a license and pay for the software. Old school and rarely used anymore.
- License-Based: A more flexible approach where you buy a license and, optionally, pay for specific features you use. Often combined with the Shareware and Freemium distribution models.
- Custom/Enterprise: A top-down sales model for software that requires the one-off negotiation of a custom contract, involves a lot of upfront or custom work, and that generally involves a long sales cycle to close customers.
- Cloud-Based: The approach to software development where you purchase a license and pay for the software, but also pay for the infrastructure that powers the software. You don't ever manage the software or the infrastructure yourself.
- Open Source: Distributed for free with no licensing or payment required. Software is delivered without any support or maintenance guarantees unless offered by a company (generally the author of the software). For software to be Open Source, it must not be locked to a specific customer, and be able to be modified, improved upon, and resold by anyone with any restrictions.
Below, I will walk through a brief history of the evolution of software pricing from the early days of the software industry to today. It's not a complete history, nor is it 100% accurate, but it's a good starting point to understand the different pricing models and to help build your intuition for developing your own pricing model.
The First Software Companies
Software has changed a lot...
Many years ago, before the internet, when you wanted to start a software business, you followed a simple set of steps:
- You wrote some code and compiled it into a binary,
- You printed it to a physical CD-ROM disk using an expensive machine,
- And then you sold individual copies of it on the shelf at a store or via the mail.
Sales were usually on a fixed-price basis: Your physical copy represented your license to use the software. It wasn't possible to duplicate the software disks without specialized hardware ($1,000+), so piracy wasn't a major concern. Physical possession was a sufficiently difficult challenge to overcome, so companies just sold boxes of software in stores.
A Windows 95 launch event with boxed software being sold.
Because of this, software businesses were simple and closely represented traditional business models. Software purchases happened like they would for physical goods. You bought a hammer just like you bought a copy of Microsoft Word by simply visiting a store and grabbing it off of the shelf.
This approach is simple and easy to understand, but it has a few downsides.
First: It's expensive to scale. You have to pay to build a hammer every time you want to sell one. That means, to sell 10,000 copies of your software, you also have to create, package, and distribute 10,000 copies. That's a non-trivial amount of work.
Second: Piracy started becoming an issue for companies. It was simple for your friend to give you a copy of their software, thereby hurting the company's sales.
Some companies were able to combat this by adding in copy-protection mechanisms (early DRM), but these would eventually be circumvented by skilled individuals. It was an uphill battle for companies to try to overcome this problem.
Third: Customer Support. It's impossible to authorize users that call in for support when you can't verify that the user paid for the software.
As a company, it's expensive to give phone support to a user because it requires a human to be present. You simply couldn't afford to pay for phone support for a user that didn't pay for the software.
The Creation of Software Licenses
Windows XP relied on product keys that were verified over the internet to combat piracy.
Over time, these became problems with the physical "Brick-and-Mortar" method of selling software forced a new pricing model to be adopted. This new model is often referred to as the "Software Licensing" pricing model.
The idea is still fairly simple: Instead of selling software on the shelf, software companies now started selling codes that allowed you to use the software. Possession of the code was all that a user requires to authorize them as the owner of the software. If a code was shared too many times the code be considered "stolen" and the license would be revoked, and companies could leverage the moment to sell copies of the software to any customers calling in without a valid license.
This license-based model, coupled with the advent of the internet, created new ideas for software distribution like Shareware and Freemium. You could download software from the internet, try software for free, and only buy a license if you liked or needed more features.
This didn't get rid of all piracy -- consumers could just use their friend's keys and call in as in their friend -- but it did remove most of the financial burden for them to provide support to pirate. And, as a second order effect, it also made it harder for companies to get away with buying only one copy of the software for all of their employees to use. Now, for any companies purchasing software, they would have to purchase one copy of the software for each employee or for each computer. They could no longer just buy one copy for everybody to use.
Switching to the License-based model also helped to solve the distribution problem: Businesses could install software on computers using a single disk or downloaded copy, and then they could purchase license keys directly from the software company via the phone. No more physical copies of the software had to be produced every time another copy of the software was purchased, and, because physical copies cost money, the software companies benefited from increased software profit margins.
Segmenting Customers by Price
Redis's Pricing Model shows their method of segmenting customers by price.
As companies continued to grow, and relied more heavily on technology, their needs became more complex too. The software companies selling the software had to manage the needs of varying types of customers, ranging from individual sole-proprietors, small businesses, large enterprises, and government agencies.
Their customer's demands were not always the same, and the software companies had to adapt their pricing model accordingly. A blanket policy would no longer suffice. The software companies would simply be leaving too much revenue on the table. Features that were expensive to implement, or that were not commonly used, would be priced higher than features that were more common.
Large Enterprises, for example, would be able to afford to pay for features like custom integrations with their existing software, a faster turnaround time in the event of a software bug, or a more hands-on onboarding and training process. Even if these features required development cycles from an engineer to implement, they would be able to afford to pay the fees for these features.
This divide in different users' needs, coupled with using nearly-free digital software distribution software, lead software companies to become some of the most profitable companies in the world.
Oracle is a company notorious for their Enterprise sales model.
Over time, for many industries, software companies would begin exist to fill every niche. Some of these companies would cater on to a small number of very large customers, often referred to as "Enterprise" customers. They would create specialized sales teams and onboarding processes that would be tailored to the Enterprise customer's needs. For any companies below a certain size, they would simply be turned away if they were unable to pay the exorbitantly high price.
This posed a problem for smaller companies like startups. They wanted to use the software, but the Enterprise Software companies couldn't justify the expenses of onboarding them or supporting them. It was simply unprofitable to offer support to a small company.
Around the beginning of the internet era, a new company named "Red Hat" would be founded. Their solution to this divide -- of wanting to only sell to large customers -- was to publish their software as Open Source. Anybody would be able to use their software, and they would sell custom support, features, and training to the Enterprise customers separately.
Red Hat went on to become a very large player in this space, and is one of the pioneers of building a business around Open Source software.
The Evolution of the Internet
The Cloud companies are some of the most successful companies in the world.
Fast-forward to the start of the internet era, and the needs of software continued to grow increasingly complex. With the scale of internet traffic becoming larger, there became a need for more specialized software to run along with specialized hardware. No longer would a company just purchase the software, but they would also purchase the hardware that is needed to run it. This hardware was often expensive to produce, setup, and maintain, so buyers would often end up renting it from the software companies instead.
The companies who wrote the software, managed the hardware to run it, and sold it together would become known as the "Cloud" companies. They would sell their software as an internet service and their customers would be able to use their software on any computer that is connected to the internet. The Cloud companies would often be called "*-as-a-service" companies to describe what "Cloud service" they sold. Companies selling Cloud Software became "Software as a Service" (SaaS) companies. Companies selling access to managed servers, providing the "Platform" for others, become known as "Platform as a Service" (PaaS) companies.
Modern software licensing became no longer just selling software but also selling hardware, and this led to a new class of software consumption. No longer did it make sense to simply purchase a license for software, but instead you only "rent" the software based on your usage of it. When licensing Cloud software you might pay by the hour, pay by the second, or pay per API request. The price of the software license, if any, would be baked into the price you pay.
This model of software licensing has been a powerful tool for simplying the steps required to launch a tech company. Many companies, like Netflix and Snapchat, have used cloud services from their earliest days in order to scale to meet their highly erratic scaling needs. Even with the "premium" price of cloud services, it's still worthwhile for them to not "own" their own hardware.
Of course, not all companies have dynamicly changing demand that require a flexible pricing model. There are still many companies that don't want to use Cloud services such as those with strict security requirements that require data to be onsite. If a vendor only sells their software as SaaS, they're often forced choose an inferior product that supports "on-prem" deployments or to build it themselves.
The Proliferation of Open Source
Do you recognize any of these?
Since the earliest days of computer, there has always been a contingent of software professionals that advocated for Open Source software. Much of the software that is run today dates back to these professionals. Most are small tools, libraries, and scripts, but some are large applications that are used by many people. One of the most successful projects is the GNU/Linux project, which is the Linux operating system.
Systems like Linux power the vast majority of computers in the world. It is the most widely used operating system, and is entirely Open Source. By itself, Linux is not directly sold. It is a community of developers, and the community is willing to contribute to the project to continue building it. Cloud companies, like Amazon and Microsoft, are able to run Linux on their servers and then their customers are able to run any software that runs on Linux against the rented server.
Open Source Goes Enterprise
Red Hat, now a part of IBM, was once the largest contributor to Linux.
By itself, Linux is not a product. It is a language. It is a tool. It is a community. It is a way for companies to build and to run software.
Linux is not unique in this way. Many large Open Source projects have taken on similar roles, with projects such as Nginx, Git, and PostgreSQL growing in popularity until the point where they become a foundation for others to build on top of. This approach flies in the face of the traditional belief held about software. That is, for the majority of software history, there has been an assumption that Source Code is what is valuable and that you must protect your Source Code.
Companies like Red Hat were the early pioneers that began to break this assumption by building a business model around Open Source. They showed that it's possible to be worth billions of dollars, even when you freely give away the software that you create. Projects like Linux were never designed to be commercial projects, but the Open Source work that Red Hat did was designed to make money.
They realized, and subsequently taught the world, that Source Code behind the software was not what was valuable, but that it was instead the deep knowledge possessed by the people that created it. That deep knowledge was necessary to fix bugs in the software quickly, to save time setting up and maintaining the software, and to continue developing the software to make it better over time by identifying the patterns across the many ways the software was used.
This insight, that the "secret sauce" was not the Source Code, but instead the knowledge of those that created it, was a powerful tool for the software companies that wielded it. They were able to create a business model that was not only profitable, but that also greatly simplified adoption of the software. Companies leveraging Open Source would be able to distribute their Source Code for free on websites like GitHub, and never have to worry about supporting the usage of the software.
In exchange for giving away their software for free, they would be able to grow the usage of their software more easily by catering their software directly to developers working at companies. These developers would no longer have to deal with a lengthy sales process involving signing NDAs, being given non-editable binary files that they couldn't modify or extend, or getting approval from the Finance department and other stakeholders. When the software was Open Source, they could simply use it more easily than they could other proprietary software.
This was a huge win for Open Source adoption. Companies that used Open Source would be able to build their software more easily and, because of that usage, they would rely on that software. That reliance creates an incentive to pay for help whenever something went wrong or if they needed a feature added.
Where are we now?
You know Open Source is mainstream when even Microsoft wants in...
In 2021, the number of software companies using Open Source is nearly 100%. It's simply too difficult to develop all software in house anymore. At some point, you have to rely on software built by somebody else, and the only way to do that is to rely on Open Source (in some capacity).
Since the days of Red Hat, there have been a number of companies that have been using Open Source to build their business. Companies like MongoDB, HashiCorp, and Elastic proved that Open Source was a viable way to build a business worth billions of dollars. Open Source was no longer a niche belief held by software purists, but it was also a reliable way to acquire customers and grow their mind share.
"Source Available" Software Licenses
Docker failed to create a viable business model around containerizing applications.
Open Source isn't perfect -- Cloud companies, like Amazon, have been known to exploit Open Source software projects to earn a profit without contributing back either source code or sharing revenue. It's legal and fully within the bounds of Open Source for companies to do this -- that's just the risk of choosing an Open Source software licensing model. You do not have control, and sometimes that hurts your business.
In order to mitigate that risk though, there are a number of approaches that attempt to bridge the gap between the proprietary and Open Source by changing the rules of the license to be less "free". These approaches are generally referred to as "Source Available" software licenses, and are not considered "true" Open Source software by the OSI.
Licenses like BSL are designed to let their software be used as Open Source software would, but with a few additional restrictions to prevent other companies like Amazon from deriving value purely from hosting a managed version the software. Redis, Elastic, and MongoDB are examples of companies that have adopted Source Available licenses in response to competition from Cloud companies.
While it's great to see innovation in the software licensing industry, it's also important to understand that using a Source Available license is not a catch-all solution. You're not actually Open Source when you choose a Source Available license, which will hurt your early adoption at any companies requiring that only a permissive software license like Apache 2.0, MIT, or BSD be used.
Even if you choose to be Open Source or Source Available, you still have to think about how you're going to structure the pricing model for your business to generate revenue. It's not enough to just think "We're going to be Open Source, grow, and then figure it out later." Many companies, most notably Docker, have successfully used an Open Source licensing model to achieve traction and explosive growth, but still failed to create profitable business model despite what otherwise seemed like a "slam dunk" to investors.
When to use Open Source for your pricing model
Which path do you take?
There is honestly no way to know if Open Source is the right solution for your business's pricing model. You have to think about it, do your own research, and come up with your own conclusion. That's just the unfortunate reality of building a business: There is seldom a one-size-fits-all solution.
Beyond that cautionary note though, I think there are a few places where Open Source really shines:
- Software Infrastructure: If you're building software that's going to be the "backbone" of somebody's software stack, you probably want to consider using Open Source or a Source Available license. When you're in the "critical path" of somebody's production software, you will win points with developers by being Open Source. Nobody wants to be stuck debugging proprietary software or dealing with an outage because your PaaS is down. If they can self-host it, that's a big win for adoption (even if you end up hosting a PaaS anyway).
- Developer Tooling: If you're building a tool that will be used by developers, you probably want to use Open Source. Developers are a tricky market to sell to because they're often happy to build their own solution instead if something is proprietary (sometimes due to natural curiosity, but also due to debugging requirements for production software). I've run a startup in this industry before, and it taught me some painful lessons. I'll write a post about that soon, if anybody is interested.
- Sensitive Data: I've spoken with enough startups and companies to realize that people are often fearful about trusting others with their sensitive data. It already takes a lot of trust to get somebody to share their data with you, and it takes exponentially more when its sensitive data. If you're building a product that touches sensitive data, you probably want to use Open Source to help earn trust.
- Security or Compliance: These areas are a bit hairier to understand what the right choice is. In general, if you're a security or compliance company, you might want to consider going Open Source. You'll be able to build a more secure product by having people easily vet it, and you'll be able to more easily comply with your customer's compliance requirements by allowing them to self-host it. For HIPAA, for example, it's a lot easier to self-host than to buy a proprietary solution.
- You offer a free-tier: Depending on your business, if you offer a free tier, you might want to consider being Open Source for the functionality in the free tier. With that path, you can still choose to slap on proprietary features for your higher tiers. You might find that certain large customers have different needs, and that their needs are best served by a proprietary solution.
If you don't fall into any of those buckets, then I'll ask you a few questions to help you decide.
- How do you make money?: If you're planning to host the software for your customers, then you probably only want to be Source Available. If you're not hosting the software, then you should consider being Open Source. Even if a Cloud picks up your software and starts hosting it, if you're not losing out on any profits, then does it matter? You might find that you actually gain more value by being available as a Cloud service, so being Open Source is a good choice.
- Is Open Source your only customer acquisition strategy?: If the answer is yes, then you're in for a world of hurt. Open Source is frequently more work than a proprietary solution in order to get your first paying customers. It takes months of effort to polish up your API, set up your CI/CD pipeline, and write enough docs to get people to use it. If you choose Open Source, you should make sure you have other ideas about how you're actually going to drive adoption.
In this post, I've talked about the history of Software Licensing, and I've tried to build up your intuition to determine if Open Source is the right choice for your business's pricing model.
Like I said before, there is no clear answer here. I'd recommend doing your own research on the internet, consulting with other people that have done it before, and reviewing the business models of existing companies that have made Open Source work for them successfully. This space is rapidly evolving, and there is a lot of nuance to it.
I'll be writing more posts in the series soon. Please email me if you found this useful or if you have any questions (free at lunasec dottt io).
And while I have your attention, please throw us a star on GitHub. It really helps us out!
Good luck, and thanks for reading.
Free Wortley, Founder of LunaSec
- Photo a computer programmer from the 70s from here
- The happy man with his copy of Windows 95 from NBC News
- Windows XP Screenshot from Blogspot
- Oracle HQ photo from here
- AWS trade show photo from here
- Redis Pricing screenshot from their website
- Open Source logos from Miro's Medium here
- Red Hat HQ photo from BalfourBeattyUs here
- Microsoft buys GitHub image from here
- Photo of sinking container ship from here
- Cool photo of street signs from here