Subject: RE: "I've got more programmers than you"
From: "Larry Augustin" <lma@valinux.com>
Date: Fri, 5 Oct 2001 17:10:55 -0700

In order to understand free software business models, we first have to
understand business models.  Let's look at the business models for two
mature, successful companies in the services and software businesses.
Here are the business models for EDS and Microsoft:

			 EDS		Microsoft
Revenue		100.0%	   100.0%
Gross Margin	 18.5%	    86.9%

R&D			  0.0%	    16.4%
S&M			  4.6%	    18.0%
G&A			  4.5%           4.6%

Operating Margin	  9.4%	    47.9%

Net Income		  5.5%	    41.0%

These are June 30, 2000 fiscal year end numbers.
 
MS's gross margins are typical of a large, successful software company.
90% is a good rule of thumb.  MS is a little bit below 90% because they
have some non-software businesses mixed in with that.  MS spends 16.4%
on R&D, and 18.0% on S&M.  Both numbers are a bit below what most
software companies spend.  MS can get away with that because they are so
big and so dominant.  It wouldn't be unusual for those numbers to be 10%
higher (each) in a smaller software company (e.g. I think Autodesk or
Oracle is about 10 points higher in each category).  MS has a 47.9%
operating margin, which is huge.  A 20% operating margin is considered
good.  Most software companies would be lower in the 20% to 30% range.

EDS is a great example of a pure services play.  EDS does a lot of IT
outsourcing, managed services, support, etc.  EDS is what I would
imagine a free software services business to look like.  Gross margins
are 18.5%, low in general, but not unusual for an IT services consulting
business.  EDS spends nothing on R&D (they don't have a product).  4.6%
goes to S&M, and EDS returns 9.4% in operating margin.

One of the things to take away from this is that EDS has very thin gross
and operating margins.  Further, if a free software business based on
services wants to do some development and contribute back, that R&D line
is going to have to go up to at least 1% or 2%.  That's going to reduce
operating margins to 7.4%.  At 7.4%, investors are going to be tough to
attract.  Remember, that's operating margin.  Net income is going to be
3% to 5%.  Double tax-free municipal bonds are 5%.  Why would an
investor put money into a company (where there is risk), when they could
put that money into low-risk munis and get the same or better return???
Further, why invest in a business like EDS at all when MS returns 41%
net income?  This is why MS is a much more valuable company.

Dell, BTW, has a model similar to EDS except that R&D is 2% and G&A is
less than 1%.  Dell can lower G&A costs because they don't have the
overhead of managing all those bodies that an EDS has.  The result (for
Dell) is a low gross margin business that works with about 10% operating
margins.  But if Dell were to invest more in R&D (for example, by
directly supporting Linux development), Dell would be less profitable,
possibly to the point where investors would walk away.  This implies
that Dell is unlikely to invest in Linux development, since that
investment would lower their profitability to the point where investors
would walk away.

This makes for an interesting point.  Companies like Dell and EDS that
are the most likely supporters of free software (because it does not
compete with them) are also the least likely to have money to invest in
free software R&D.  Proprietary software companies like Microsoft have
lots of margin to invest in R&D, but are unlikely to invest in free
software.  :-)

Any discussion of free software businesses has to happen around the
business model.  What gross margin are people willing to pay?  What are
the costs in R&D, S&M, and G&A associated with running that business?
Is the bottom line return large enough that people will invest in that
business?  Answer those questions about any proposed free software
business and we'll be a lot closer to understanding how to build one.

Larry

Larry M. Augustin, CEO, VA Linux
Tel: +1.510.687.7029      Fax: +1.510.683.8680
Web: http://www.valinux.com

 

> -----Original Message-----
> From: Karsten M. Self [mailto:kmself@ix.netcom.com]
> Sent: Friday, October 05, 2001 10:03 AM
> To: fsb@crynwr.com
> Subject: Re: "I've got more programmers than you"
> 
> on Fri, Oct 05, 2001 at 07:07:47PM +0900, Stephen J. Turnbull
> (turnbull@sk.tsukuba.ac.jp) wrote:
> 
> >     Zimran> software world could you gripe about a 20%
> >     Zimran> margin being slim. Most industries would kill for
> >     Zimran> margins that fat.
> >
> > Most industries also don't have to worry about a Finnish college kid
> > with no financial backing at all kicking their whole raison d'etre
out
> > from under them.  A 20% margin on products that make it to market is
> > nowhere near good enough in software development, any more than it
is
> > in drug development.  That margin has to pay for all the failures
you
> > never admit even got started (not to mention the ones that got
> > announced and you blew a wad on marketing before they got killed).
> 
> ...which is fine if you're arguing his words, and well considered.
> 
> The facts though are that Microsoft tends to get about a 30% profit on
> all operations.  Margin on product is likely higher.
> 
> Peace.
> 
> --
> Karsten M. Self <kmself@ix.netcom.com>
> http://kmself.home.netcom.com/
>  What part of "Gestalt" don't you understand?              Home of the
> brave
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> free
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> Geek for Hire
> http://kmself.home.netcom.com/resume.html