Building a profitable Open Source business from Cross Subsidisation

Aug 07, 2013

Table of contents:

1. Open Source as a business model
2. What are the advantages of a Cross Subsidised business model
3. Conditions for Cross subsidisation
4. The risks of Cross Subsidisation
5. The evolution of Cross Subsidisation
6. Conclusion

Cross subsidisation is where a company deliberately sells one product at a loss in order to increase the future sales of more profitable goods. Loss leadership is a common strategy in a wide array of different industries. Supermarkets for example usually sell many different types of goods, such as bread or milk, at a loss. This enables the supermarket to sell much more profitable goods to the same customers as part of the same transaction.

A similar strategy is widely known as “The razor blade strategy”. This is where companies like Gillette sell their razors at or near cost in order to promote the sale of consumable bladesOpen Source project benefit in the future.

An interesting application of Cross Subsidisation on the Internet is through Open Source software. In this case, the software is distributed openly as Open Source software. The company who is supporting the Open Source project is then able to charge for premium services, support or additional functionality. Two of the best examples of this are Automattic who create WordPress and Canonical who provide additional services to the Ubuntu operating system.

In this post I’m going to look at the business model of Open Source software, how you can build a cross subsidy business model, what are the advantages and what are the pitfalls to avoid.

Open Source as a business model

Open Source projects are, for the most part, started and maintained by individuals or collective groups who work on the project not for profit but because it is their passion or they want to see it exist in the world. However, there are many examples of Open Source projects that have either been started, or that have grown through the support of a for-profit business model.

One of the best examples of this business model at work is Automattic, the creators of WordPress. WordPress was initially started as an Open Source project by Matt Mullenweg. Automattic now supports the Open Source project, but is able to generate revenue by offering premium services such as Akismet and Vaultpress.

Whilst many Open Source projects benefit from widespread adoption and an active and engaged community, many companies are reluctant to use Open Source software in a mission critical part of their business if there is no established company behind the project. Discourse is a interesting Open Source project that has actually raised institutional investment in order to create a cross subsidised business model.

So it should be pretty clear how this business model works. You basically invest time and money into building an Open Source project that you give away for free, and then you offer premium services, features and support in order to generate revenue.

What are the advantages of a Cross Subsidised business model

Despite sharing your entire source code, there are many benefits to creating a business model around Open Source software.

Free marketing

The first big opportunity is that the majority of all your marketing is going to be essentially free. If you build an Open Source project that is highly sought after, you will likely find that interest and adoption of the project is widespread.

This is similar to the world of freemium business models, but even more extreme. Freemium is a business model where the cost of user acquisition is invested in allowing access to the entire product to a certain segment of users for free. If the product is compelling enough, and it solves a problem, high usage users are likely to upgrade the the premium plans. By having a free price plan, the number of people who at least try your software will be greatly increased.

The same theory can be applied to Open Source software. With your software being freely available, you will have far more people trying your software to see if it meets their needs.

This in-turn creates the opportunity for other people to write guides, tutorials or reviews of your software which will significantly increase inbound marketing. When you can inspire people, you will find that they will act on behalf of your project without asking permission.

Low cost customer acquisition

A direct result of free marketing is low cost customer acquisition. When a user becomes familiar with an Open Source project, or the project becomes accepted as the de facto software for solving that problem, user acquisition becomes much cheaper.

Open Source projects already have the direct viral loop of current users inviting new users to experience the project.

Contributors creating direct value

For just about every piece of software, there will always be features that are required by a small segment of the user base. As a private development company, it would be impossible to answer every feature request that was raised by the customer. And even if you could, the end product would be atrocious.

This is not a problem in Open Source software because individual contributors can extend the platform to add new features for specific use cases.

WordPress is one of the best examples of this. The WordPress plugin market is one of the most comprehensive marketplaces for Open Source plugins. If you can think of a feature that you want to add to your WordPress installation, it has probably already been created.

Conditions for Cross subsidisation

Of course, Cross Subsidisation isn’t as easy as just giving a product away and then reaping the benefits of charging for premium services. In order to make the model work, there are a couple of conditions that must be in place.

Price sensitivity of the initial product

The first condition is, there should be price sensitivity for the initial product. This is important because if there is no price sensitivity, then the customer won’t care that you are giving it away for free and so there is no benefit. If the customer is insensitive to price, you may as well make profits on both the software and the premium services.

Open Source software meets this condition perfectly for small businesses. A small business is unlikely to have the resources to make the initial investment in software to make the purchase, but would be willing to invest the time to trial a product, or get hands on immediately to see if it meets their need.

Price insensitivity of the profitable good

Once a company has “invested” in a piece of Open Source software, the sensitivity to price of security and reliability drops. A small company that invests time and resources into a product will want to ensure that the product continues to meet their needs.

For example, if a company invests considerable time entering data into an Open Source project management application, they will want to ensure that they won’t lose all of their data if their server is compromised. This would be a good opportunity to sell a premium back up service.

A strong connection between initial product and the profitable product

In order to convince users to pay for your premium services, there must be a strong connection between the initial product and the profitable product.

For example, in the razor blade strategy, Gillette has to ensure that consumers purchase the profitable razors from them instead of being substituted for a low cost alternative. Gillette is able to do that by showing how their razor blades are better quality than competitors and how they will work better with the actual razor.

In Open Source software, any provider has the opportunity to offer premium services around a project, even if they are not directly sponsoring it. It is therefore up to the sponsor company to ensure that it is well known and perceived as the best choice in premium services for that project. The sponsor company should ensure that it has the majority share of all premium services and that it actively promotes the project to the wider audience.

Barriers to entry for the profitable good

And finally there should be some barriers to entry for the profitable goods. Again, for Open Source projects, this is going to come down to marketing rather than any actual technical propriety barriers.

Whilst there are many ways to obfuscate premium plugins or services for Open Source software, there will always be ways to create alternatives. A much better defensible strategy is to be well known as the best possible source of quality and service. As the project sponsor, you should be in prime position to do just that.

The risks of Cross Subsidisation

If you are unable to create a well known company around the Open Source project, you face the risk that are inherent with Cross Subsidisation. This is a risk when the premium services you offer are also supplied by a lower cost provider. When users of an Open Source project don’t value you as a premium provider, you face the risk of supporting the project without being able to generate revenue through premium services.

Of course, with any open market, and in particular Open Source projects, you will always have competing services. Having competing services is usually actually a good thing because it gives authority to your project and your company.

Vertical integration is also a inevitable risk of Cross Subsidisation. In the backup example given earlier, it would not be difficult for a technical team to set up their own backup solution to avoid the cost of the premium service. Whilst the majority of customers won’t be this technically inclined, it is also important to create premium services that are beyond the expertise of even the most technical teams. When you focus on a particular problem, you will be able to create solutions that are not easily replicated, like spam prevention or security.

The evolution of Cross Subsidisation

Cross Subsidisation is not a static business model as products and customer requirements are constantly evolving.

Say for example you created an Open Source application that utilised the latest web technology. In the early days, it would be unlikely that the mass market of your customers would be able to set up the required technology stack themselves. The rise of WordPress can partly be attributed to the ubiquitous nature of PHP and MySQL.

However, overtime those technologies might also become easy to set up or widely available through third party hosting companies for a low monthly cost. If this becomes the case, your premium hosting service is not going to be nearly as attractive as it was at the outset.

It’s important to constantly monitor the evolution of technology and your customers requirements in order to anticipate where certain profitable services are dying and where new opportunities lie.

Conclusion

I’m a huge advocate for the online business model behind Open Source software. By creating and supporting Open Source software, you make the world a better place for everyone. But in order to create software of a high standard, there often needs to be a sustainable business model behind the work.

Automattic is one of the best examples of Open Source software companies and I really like what Discourse is doing. Automattic shows that you can create a global growing company through Open Source Software.

As I mentioned above, Open Source software gives you a huge advantage in marketing and customer acquisition over pure for-profit companies who hide their source code as intellectual property. Creating an Open Source business is very different from a traditional product company, but once you know the advantages and the differences in the model, you can reap the rewards of being a contrarian in your industry.