Tuesday, April 27, 2010

The Financial Physics of Free Software

In the Internet age, does software have value?  Of course software is valuable in the sense that it provides service and is useful, but does software have monetary value?

If one looks at the law of supply and demand, the fact that software, like all other forms of digital content, can be endlessly reproduced and distributed at virtually no cost negates its value because software distributed this way lacks scarcity.  Digital content is simply not a scarce resource.  This hasn't stopped people from trying to impose artificial scarcity on digital data through the use of digital restrictions management (DRM) and draconian imaginary property laws but these approaches have had only limited success.  This is not surprising as attempting to create an artificial shortage goes against the physical nature of the Internet and of computers themselves.

The Proprietary Model

If you have ever checked out my resume, you know that I spent the greater portion of my career in the proprietary software world and was, at one time, a big supporter of proprietary software.  I was fortunate to have spent all of my years in the software industry working for small companies where one could wander the halls and learn every aspect of the business.  In addition to being a technical manager, I had number of marketing and sales assignments as well.

Software development in the proprietary world is speculative.  Typically, a product manager or marketing director is given the assignment of coming up with the "next big thing," a product that can sold to many customers at a profit.  The reason that it has to be big is because proprietary software development is fantastically expensive. The product manager will present ideas to management and get approval for some personnel and a budget based on the product manager's forecasts for delivery dates and sales targets.  After approval, the software development process begins,  In some companies this process is very formal including requirements specifications, design reviews, test plans, etc.  At the end of the process, the software product goes to market.  This involves a number significant expenses including marketing, advertising, trade shows, etc.

It is important to remember that proprietary software companies don't actually sell software.  They sell licenses.  It is through this mechanism that they attempt to create a scarcity that gives their product value.

Proprietary software only has value once it is written.  You will sometimes see product announcements appear for non-existent yet-to-be-developed products.  Such products are derisively known as "vaporware" in the industry because proprietary software does not have value until it is written and actually availabile in short supply.

The Free Software Model

To members of the proprietary software community, the notion of free software appears insane.  This is because they think that free software means that they have to go through all of the steps and expense of the process above and then not collect any revenue on the back-end.  There are a number of problems with this assumption.

The development process for free software is fundamentally different.  First off, it is not speculative.  Developers of free software typically have an interest in actually using the program they want to write.  It also means that free software developers are usually subject matter experts for their chosen program.

Free software is much less expensive to produce than proprietary software.  The development process is much less formal than closed proprietary processes owing to the fact that development is done in the open.  This allows a more natural and organic method of solving problems and fixing bugs and, unlike proprietary development, the development tools and shared software components are free.  Free software also does not incur the engineering overhead of implementing "copy protection," user registration systems, and tiered product versions that are used to establish upgrade paths for proprietary products.

Finally, free software products don't have the marketing and sales expenses of proprietary software.

Making Money

While the proprietary software appears to make a lot of money now, is it sustainable?  Will the Internet and its ability to perform infinite duplication and distribution drain the value from software?  Only time will tell, but I'm betting that the Internet will emerge victorious.  We can already see the signs of this victory with the rise of "cloud computing" which is eliminating the need for software all together.  But cloud computing raises a number of issues including privacy and security, as well as freedom.

There has been a lot of discussion of how to make money with free software.  Most of the ideas put forth involve charging for services.  After all, Red Hat, a very successful software company, makes its money that way, but I want to suggest another possibility.

As we saw, proprietary software only has value after it is written and is available for license sales.  The free software model assumes from the start that once a program is written it no longer has value because it is not scarce.  In contrast to proprietary software, free software only has value before it is written.  The absence of a desired software program is the ultimate scarcity.  There exists an opportunity to exploit this fact.  It's not really a new idea by any means.  This is how the custom software business works.  Clients want something and pay big money to get something written.  What I envision is a business that somehow aligns many clients with developers so that the cost of development can be spread out among many clients.

What will such a business look like?  That's an exercise I will leave to my more entrepreneurial readers.

Further Reading