Most startups sell niche ideas that compete in relatively small markets. But a few startups develop big ideas that shake up huge markets. To survive their beginning years and hit a growth inflection point, big ideas require the right timing, the right people, and the right product. And contemplating the source of game-changing, breakthrough ideas makes us ask whether success is based on luck. Or on skill. On both. Or on something else.
Despite the fact that Red Hat Software was built more than 20 years ago, its lessons apply squarely to today’s startup environment. In this growth study, we’ll cover how Red Hat’s founders discovered a new business model by:
- Taking advantage of market changes (in this example, open-source software) to build a new, disruptive product
- Leveraging creative, outside-of-the-box thinking
- Listening carefully to clues offered through face-to-face, detailed conversations with industry experts and users
- Trusting their gut instincts about the validity of their new business model despite initial negative feedback from venture capitalists
- Having the grit and foresight to stick with their core plan for a period of years until buyers were ready to fully adopt their product offering
After Red Hat started growing, we’ll see how its founders grew it faster by:
- Establishing themselves as thought-leaders and problem-solvers for a bigger mission than just their product
- Building favorable partnership deals
- Taking Red Hat public to build the credibility to gain larger customers
- Stepping aside as CEO so Red Hat could become all it could be
Software company Red Hat supports a particular kind of high-demand open-source software, Linux, that runs servers and other applications. In 2015, Red Hat returned nearly $1.8 billion dollars of revenue, through its unique business model stipulates giving its product away for free. How does that work? Red Hat earns revenue by providing service, support, and official documentation for its software—not by selling the software itself.
Linux is also unique because a customer can easily fine-tune it to a particular need. For example, Cornell University’s Institute for Biotechnology and Life Science Technologies installed Red Hat’s Linux to help it manage data-intensive research projects like DNA sequencing. Financial firm CME Group installed Red Hat to help its trade platform sort and otherwise manage its billions of financial transactions per year.
Here is Red Hat’s revenue growth for its first seven years which we will analyze year-to-year in this study.
Red Hat’s is a David vs. Goliath story. In 1995 when Bob Young and Marc Ewing merged to form Red Hat in a tiny office in Durham, North Carolina, they were taking on Microsoft right in its wheelhouse—software that runs computers: operating systems. In doing so, Red Hat surfed a monster wave and never fell off. How were such energy, strength, and balance possible?
Was Red Hat’s success the product of luck? Or did something else contribute, too? Something repeatable—that translates to our own ventures?
In 1981 Bob started his own computer-leasing business, Vernon Sales and Leasing. In 1990 Bob sold it to Greyvest Capital when the Canadian economy weakened. The stock-swap transaction made Bob a millionaire—at least on paper. But soon after the merger, Greyvest ran into financial trouble of its own and its share price tumbled from four dollars to ten cents—reducing Bob’s millions to pennies.
At least he still had a job.
In 1991 the Youngs moved to Connecticut to open a Greyvest office in New York City. With personal computer (PC) prices falling, Bob started leasing servers—central computers that run multiple desktop terminals, print drivers, and other applications. To find customers, Bob crashed meetings where programmers talked about the latest trends in the software program UNIX that runs on servers.
Bob’s attending these UNIX meetings was instrumental to the later creation of Red Hat. There he picked up the first puzzle pieces that one day he’d fit together to start Red Hat. But for now, Bob was an awkward outsider.
“They had no interest in having sales guys hang out at their meetings,” he remembers. “I could pick up from their body language and from a lack of enthusiasm towards me that they had very little interest in my stories. But when they told jokes with punch lines like ‘/dev/null,’ that would bring down the house. We were from two different worlds.”
But soon Bob finagled acceptance by offering something the brainy group lacked—marketing and organizational skills. He started a newsletter for them, New York Unix that announced meetings and organized user-group sessions.
In 1992 Grayvest laid Bob off, leaving him nearly broke. New York Unix was Bob’s only business idea at the time, so he incorporated it as ACC Corporation and tried to turn it into a revenue-producing business by selling advertising. He developed a close relationship with his scientist-niche readership, and sought their advice. “I’d ask the user groups, ‘What do you want me to write about in this newsletter that you can’t get from other publications?’”
Readers kept telling Bob about “free software” and how mainstream computer publications rarely wrote about it. And readers also referenced an obscure free software program called Linux that seemed to be growing in popularity. At the time, Bob had no idea what “free software” or “Linux” were.
The Rise of Linux Software
This software is “free,” but not because it doesn’t cost money. Instead, the software’s source code can be viewed freely and manipulated to do specific work for programmers. Source code is software’s building blocks – like the letters of the alphabet or the standard parts that make up a machine. Most software companies, like Microsoft, deem its source code proprietary intellectual property. But free software’s code is freely owned by the general public.
Free Software was a movement begun by computer hackers frustrated when companies started claiming rights on code created collaboratively. They were especially angry when, in 1979, AT&T claimed copyrights on UNIX. Programmers weren’t happy about that because they had helped create it. They claimed that source code should be “free,” meaning available like the alphabet—especially since they helped build it.
Throughout the 1980s programmers embarked upon a movement centered on one question, “Can we build collaboratively a version of UNIX ourselves?” But the collaborative efforts to build a better operating system lacked a key element, a “unifying kernel.” The kernel is part of the core software that enables computers to link and multi-task. But in 1991 while working on a personal project, twenty-one-year-old Finnish student, Linus Torvalds, invented a unifying kernel. The unifying kernel led to Linus’s invention of the UNIX operating system. Months later he released it under a GPL (General Public License) and called it “Linux.”
Programmers combined Torvald’s Linux kernel with existing GPL code and the entire operating system became known as Linux.
After that, most Linux development was done under the radar. The only people who took it seriously were geeks and computer wizzes. They collaborated to solve each other’s problems, just as university professors collaborate on their sciences research.
Proprietary software companies like Microsoft and IBM also attempted to build operating systems to compete with UNIX. But their operating systems didn’t offer user-control, nor did these systems have features attractive to programmers who appreciated free software. At that point, a door was left wide open for a new idea.
The Guy with the Red Hat
In 1992, when Bob was first discovering Linux through his New York Unix readership, he assumed the programmers working on Linux were setting up a big corporation to take advantage of their work. He didn’t believe that collaborative, altruistic models work effectively to deploy sophisticated technology. “Corporations need a wringable neck,” Bob reasons. “They need to know there’s a 1-800 number standing behind their bright kids who are deploying this stuff.
“So I just knew in ’92 when I first saw this stuff that IBM, Microsoft, UNIX or one of the commercial vendors was going to take over this opportunity. I thought that it was a fun little experiment. Let these guys have their fun! But I knew they were just setting up the market for Microsoft to be successful.”
To Bob’s surprise, though, in 1993 Linux’s popularity grew while large technology companies continued to ignore it. In response to this growing popularity, Bob published The Linux Journal. But his newsletters weren’t paying the bills for his family. “My publishing empire was not going well,” Bob said. The family was living “on the knife’s edge,” using credit cards to pay bills. To earn more money, ACC evolved into an online catalog reseller of software applications for UNIX and Linux, books, and other computer-related products. Bob noticed that Linux applications were some of ACC’s bestselling products.
So he started asking customers for leads to find more Linux resellers. One referral was Marc Ewing, a twenty-three-year-old Carnegie Mellon computer-science graduate with a “scraggly beard and a dirty t-shirt,” Bob remembers. Marc had recently started Red Hat, a tiny Linux shop in Durham, North Carolina.
“I had a couple of customers who said, ‘Hey, you should talk to this kid who’s doing Red Hat, because I got a beta of his CD and it’s actually pretty clever. He’s going in the right direction.’”
Red Hat got its name from Marc’s infatuation with his grandfather’s red lacrosse hat. While at Carnegie Mellon, Marc was known for his computer mastery and for being “the guy with the red hat” he wore between classes.
Marc created Red Hat Software in 1994 by accident while working on another software project. His program needed to run on a UNIX workstation, but he didn’t have the $10,000 to buy one. Then he stumbled upon Torvalds’ Linux as a free alternative to UNIX. Gradually he dropped his first project and started spending his time making Linux easier to use.
“I discovered that I wasn't spending any time working on my project, I was spending all my time fixing Linux and getting it updated and making it easier for me to use,” Marc explained in a 1999 interview with Salon.com. “I dropped my other project and started [fixing Linux] as a business.”
Marc created a Linux distribution that was more organized and easier to use than the GPL version. On July 29, 1994, he sent a select group his “Red Hat Linux” software loaded onto a red CD-ROM with accompanying documentation and instructions. His version of Linux was well received, getting good feedback.
ACC’s online catalog became Red Hat’s exclusive distributor. But as separate companies, they struggled in jointly managing channels to market, customer support, and pricing. Within two months of becoming partners, Bob and Marc realized they should be one company.
The Light Bulb Flickers
Since Bob’s personal finances were on life support, before getting into even deeper debt with Red Hat, he wanted to learn more about Linux. “I needed to double-down,” Bob said. “Before I gambled my kids’ college education on this, I needed a little more confidence that free software had a future. So that’s when I did this tour.”
Bob’s “tour” took him to several Linux experts for answers: Why didn’t Linux programmers patent and sell their code? Why hadn’t technology firms capitalized on Linux?
One stop was the Goddard Space Flight Laboratory in Greenbelt, Maryland, a NASA research facility that was installing Linux. This tour stop was both enlightening for Bob and also instrumental in his creating Red Hat’s unique business model.
Goddard was making a big commitment to Linux—replacing a $5 million supercomputer they had bought three years earlier with $40,000 worth of PC hardware running Linux. Bob visited there with a programmer who was writing new Linux code for Ethernet drivers. His plan was to use the new code at Goddard, but also upload it for free, public consumption. Bob wanted to understand why. “You’re spending real money on building these sophisticated Ethernet drivers. Why don’t you sell them?” Bob asked Tom Sterling, the programmer’s manager.
“Because in return for giving away our Ethernet driver code, we get a complete operating system with source code under a license that allows me to put it on as many machines as I can get my hands on—all for free,” Tom explained.
“Why are you building supercomputers that run on Linux? I know Sun Microsystems would be happy to give you source code if you would do this on Sun units.”
“Yeah, but if I do it on Sun, I have to get my lawyers involved to find out what I’m allowed to do and what I’m not allowed to do with their source code. If I use Linux, I get it with a license that allows me to do whatever I want!’”
Tom had just given Bob a valuable piece of the puzzle—control was users’ hot button, not features.
“So, what he was articulating was that he was not using Linux because it was better, faster, or cheaper technology,” Bob said. “He was using Linux because it gave him control over the technology. And he had no alternative—not from IBM, not from Microsoft, not from Sun, not from Apple—no commercial vendor would give him that benefit. I’m a sales guy. I don’t sell features. I sell benefits. And he had just articulated a benefit that no one was willing to deliver—control. So by then, the light bulb was flickering, if you like.”
In 1994 Linux was still an under-the-radar, barely-talked-about solution for managing a computer’s operating system. Proprietary software firms were ignoring Linux as still being in R&D, so big software firms saw either few possibilities in or threats from Linux. But Linux was quietly gaining momentum, with shipments increasing to 1.5 million units in 1995 from only 100,000 in 1993.
And yet almost no money was exchanged for these shipments, just sharing among computer programmers—like a technology-centered socialism. “When I asked them where this free software was coming from, they would use lines like, ‘You know, it’s from engineers according to their skill, to engineers according to their need.’ Right out of Karl Marx,” Bob recalls.
Merging ACC Corp with Red Hat (January, 1995)
Bob’s tour inspired him to take the leap and merge ACC Corp with Red Hat. They needed each other’s skills—Marc’s programming and Bob’s marketing. Negotiating merger terms was painless because neither Bob nor Marc thought their businesses were particularly valuable. They split ownership in the new company fifty-fifty, retaining the name Red Hat.
Red Hat started as a small lifestyle business, merging personal and business funds. “The beauty of really early-stage companies is you know where every dollar is going,” Bob says. “So whether I used this money to pay my mortgage one month, or to buy Marc a new server, or to pay for Marc’s and Lisa’s spring holiday—it was all one pot of money.”
To finance the growing expenses associated with marketing and improving Red Hat Software, they raised seed money from eight friends and family who bought between ten and fifteen percent of Red Hat’s stock. Bob calls their investment “love money”: investing without expectations.
“A love-money round is precisely what it says—people are investing in your business not because they know anything about your business, or because they think you’re clever. They’re investing because they love you.”
Suffice it to say, Red Hat’s “love-money” investment turned out to be a good one. In 2000, when Bob’s aunt, Joyce Young, donated $40 million to the Hamilton Community Foundation, that was the second-largest community foundation donation in Canadian history. Regarding her investment in Red Hat, she told The Hamilton Spectator, “It was exactly like buying a lottery ticket. You don't expect to win….”
Red Hat’s Unconventional Business Model
Red Hat’s business model took shape between 1995 and 1999. “The business morphed. It evolved,” Bob said. Its model was predicated upon an unconventional idea – giving away its product and source code for free. Bob did that to keep the Linux community satisfied—after all, they were building his product and he didn’t have to pay them.
“It was a small community in the early days, so we knew everyone,” Bob says. “Though free software was frequently painted as an ideology or a cultural thing, we approached it as a customer-service thing. Our best customers were saying, ‘I really want to see you guys succeed. But guys, if you layer proprietary software on it, I can’t use your stuff; I’ll build my own. So if you just share your code with me as quickly as you can, I’ll use Red Hat rather than making my own.’”
Red Hat gave customers what they wanted by effectively horse-trading with them. Customers took advantage of Red Hat’s pre-assembled version without paying – source code and all. And Red Hat also benefitted from analyzing the enhancements and contributions customers made to Linux without paying for the privilege.
Red Hat’s business model was different from other Linux start-ups. Competitors’ management came mostly from the software industry, so they did what they knew, and built proprietary software applications that ran on Linux. For example, Caldera Corporation created a Linux Network system with proprietary features that they sold.
Red Hat’s idea, on the other hand, was unique in giving away its product for free. But how would it make any money? The answer became the genius of Red Hat’s business model, the energy-point that allowed it to stay balanced on the crest of a huge wave going forward.
To figure out Red Hat’s business model, Bob also spent a great deal of energy learning from those who didn’t adopt Linux, another kind of tour for him. He discovered Linux was often too complex for non-adopters. For example, more than 600 separate programs make up Linux. Who on the customer’s staff would maintain them all, and who would keep track of each one’s updates and changes?
And Linux non-adopters perceived that programs were maintained by long-haired programmers in far-away places—not ideal for running mission-critical company functions. Companies were used to having support, security, confidence, and backup plans direct from their software providers. They wanted “official” documentation to show their bosses and auditors that they had a legal right to use the programs. Linux didn’t offer any of that. It appeared to lack support and reliability. Therefore, Linux wasn’t widely adopted. Only computer scientists in back-office cubicles in organizations like NASA installed Linux in 1995.
What if Red Hat somehow responded to the non-adopters’ objections? Would they then adopt Linux? But how could Red Hat sell a product that addressed the needs of Linux non-adopters without alienating the Linux community?
Red Hat began distributing the same product two different ways:
- a free, downloadable version that included the software and source code
- a CD-Rom “official” version that customers could purchase.
Both versions were the exact same software program – source code and all. The key difference was that Red Hat’s “official” version included a product serial number, installation guides, how-to manuals, customer service, and support. To its buyers, the Red Hat Linux paid version stood solidly between hackers and the establishment. Buyers regarded serial numbers and support as insurance against loss.
And because Red Hat hadn’t had to invest the man-hours to build Linux, it could compete aggressively on price. Red Hat Linux, therefore, retailed for $49.95, compared to Microsoft’s Windows NT’s retail price of between $150 and $314 or more.
So control over software was the key benefit of Linux that proprietary software makers Microsoft or Sun Microsystems or UNIX couldn’t provide.
Bob credits that strategy as Red Hat’s greatest decision. “Our biggest single thing was [that] by abstracting away from all the noise, we understood that the core benefit the users were getting from Linux was not better, faster, or cheaper software. It was control over the software. And by being committed to delivering that value to our customer, control, we avoided a lot of the mistakes of our competitors.”
Bob succeeded by working with the industry’s flow, not setting his energy against it in a defensive posture.
The Wave Begins to Form: Learning to Attract Paying Customers (1995 – 1996)
In 1995, Red Hat’s first year in business, it recorded $930,000 in revenue and lost $155,000. Most of its revenue that year didn’t even come from selling Red Hat Linux, but from ACC’s catalog sales of software, books, and applications. Red Hat Linux was barely getting started—it was then still based upon Marc and Bob’s grand vision.
But Red Hat Linux’s popularity was growing among computer engineers, most of whom downloaded its free version. Red Hat released upgraded versions of its Linux software with memorable names like Picasso (May, 1996) and Colgate (October, 1996). Newer versions installed useful applications like advanced editors, email routers, file transfer protocols, network controls, databases, and Web servers.
Red Hat’s paid-version sales slow-cooked. In 1996 most people didn’t know how to use Linux. “From ’95 through 2000, everyone conceived the value of it, but very few people actually understood how to make it work,” Bob recalls.
In the beginning, most of Red Hat Linux’s limited sales came directly from computer programmers calling the 800-number or ordering on its website. With such a low price point, $49.95, Red Hat needed greater sales volume, so Bob looked for other places to sell Red Hat Linux. “We’re talking two years; it slowly got into more and more distribution channels,” Bob says.
To grow, Red Hat needed to be in retail stores like CompUSA. But to do that, they’d need a distributor. Ingram Micro, one of the world’s largest software distributors, at first declined to carry Red Hat Linux—fearing a small start-up might leave them with stale, unsold inventory. Since Bob was persistent with Ingram for more than a year, they finally agreed to carry Red Hat. His diligent follow-up paid off because by 1998 Ingram and another distributor accounted for 54% of Red Hat’s sales.
Red Hat’s eventual revenue growth would derive from getting large sales, installing Linux on thousands of servers for corporations. But from 1995 to 1999, executives at large corporations resisted Red Hat Linux because they still thought it was unreliable. “All of their engineers who liked Linux said, ‘Oh, my boss is such a pointy-haired idiot!’” Bob says.
The “pointy-haired idiots,” a Dilbert cartoon metaphor, were the technology directors, high-level executives responsible for technology at big companies. Bob’s conversations with them usually followed the same script, with their declining even to advance conversations.
For example, at the 1996 UNIX Expo, Bob explained the benefits of Red Hat Linux to a giant financial firm’s technology director and then asked, “Can I interest you in buying a hundred copies of Linux from me?”
The technology director declined, telling him Red Hat would never fly at his company. “What you’re telling me about Linux is you guys down at Red Hat – and you admit there’s only fifty of you working away in the tobacco fields of North Carolina – by your own admission are writing maybe five percent of the code that I would buy on your disk. And the other ninety-five percent of that code you have only a good guess where it’s from, but you really don’t know. Just how long do you think my career would last in front of either that bank inspector or my board of directors?”
Bob replied, nodding, “As a sales objection, that’s as good as I’ve ever heard. I don’t have a comeback to that one. You have a great day.”
But Bob had inside information that the tech directors didn’t. Several servers at the director’s financial firm were already running Red Hat Linux. For example, a server administrator from the same company, many levels below the technology director on the org chart, would approach Red Hat’s trade-show booth and buy a copy.
That server administrator was buying Red Hat Linux to satisfy a specific yet unbudgeted need. For example, an HR manager at his firm needed to send internal announcements, so would ask for help in doing so. If she didn’t have $10,000 in her budget to buy the necessary software, the server administrator would suggest an inexpensive workaround—paying $49.95 to install Red Hat Linux that accomplished what she needed. Soon this growing demand for server applications became the norm, and Red Hat Linux’s use in large corporations grew under the radar.
This story illustrates the grass-roots demand that Red Hat Linux both satisfied and created more of. Linux was an inexpensive, flexible, workable solution to major problems of corporate communications growth. Bob says situations like these later led to valuable corporate subscriptions because corporations like the one described above would later need to account for hundreds of Red Hat Linux applications running on their servers. They’d need to prove they had a license to use it, so ultimately they’d need support to keep Red Hat Linux up-to-date.
“And so many of Red Hat’s very best customers are not the result of Red Hat’s great salesmanship,” Bob said. “They are the result of some new technology director discovering that he has a problem [accounting for] a thousand Red Hat servers, and his board is about to fire him because he has no control over these things.” The upshot of this common situation was that many companies came to Red Hat, asking to buy the product—very nice work if you can get it.
So Red Hat positioned itself down the road to be needed by technology directors. Bob allowed the selling process to play out naturally, and didn’t follow the conventional wisdom of forcing “top-down” sales on technology directors. It never would have worked in that type of corporate culture. He let the wave’s energy do the work for him.
Red Hat Begins to Ride the Swelling Wave (1997)
Bob and Marc’s hard work making Red Hat Linux easy to use was paying off. On February 1, 1997, when Red Hat had only twenty employees, it shared with Microsoft the honor of being InfoWorld Magazine’s product of the year for operating systems. In November that same year, InfoWorld published “Tired of NT? Put on Your Red Hat.” It defined Red Hat as a “complete Internet server in a box for a price you can hardly turn down.”
Red Hat’s marketing strategy was the linchpin of its early success. Through Vernon Leasing & Sales and New York Linux Bob had learned a great deal about marketing commodity products. He had been forced to figure out how to stand out in a crowd. He understood the importance of having a brand that stands for quality and service. Bob summarized Red Hat’s marketing approach in a 2000 letter:
We looked at the commodity industries and began to recognize some ideas. All leading companies selling commodity products, including bottled water (Perrier or Evian), the soap business (Tide), or the tomato paste business (Heinz), base their marketing strategies on the building of strong brands. These brands must stand for quality, consistency, and reliability. We saw something in the brand management of these commodity products that we thought we could emulate....
Heinz does not own 60% of the market because Heinz tastes better…. Heinz dominates the ketchup market because they have been able to define the taste of ketchup in the mind of ketchup consumers. Now the Heinz Ketchup brand is so effective that as consumers we think that ketchup that will not come out of the bottle is somehow better than ketchup that pours easily!
Like Heinz, Red Hat also excelled at marketing and Bob was open-source software’s primary ambassador. The consummate salesman, Bob stumped free software to the media. He wasn’t pushy as much as he was evangelical. His charm and witty metaphoric comparisons also helped Red Hat gain attention. For example, in speeches and interviews Bob compared proprietary software companies like Microsoft to “feudal lords.”
And Red Hat spent considerable energy building a Web presence. They made REDHAT.com more than just a place to download Linux—it also became an online community for Linux users and developers. In addition, it offered other products related to open-source software, including a growing menu of downloads.
Now that Red Hat was getting more attention, it needed financing to keep up with demand. Venture capitalists started taking notice because Red Hat was a clear leader in the world of Linux. However, when Bob told them Red Hat’s business strategy of giving away its software for free, they vanished.
“The VC’s didn’t understand because they weren’t talking to the customers. Our business model hinged on giving away our software for free. And the VC’s said, ‘Well, you can’t make money in the software business if you give your software away.’ And I’d go, ‘Well, that’s too bad.’” Venture capitalists rarely called a second time, so Red Hat just went about its business of focusing on customers.
In 1996 Bob was referred to businessman Frank Batten, Jr., whose father, Frank Batten, Sr., was an early investor in the Weather Channel in 1981. From the fall of 1996 until August of 1997, Batten, Jr. observed Red Hat’s unconventional business model make headway. Revenue ending February 28, 1997, had nearly tripled to $2.6 million from $930,000 the year before.
On August 15, 1997, Frank Batten, Jr. made a “Series A” $2 million investment in Red Hat by purchasing 6,801,400 shares for about 29 cents each. After the transaction, Bob and Marc each had approximately 4 million shares, making Batten, Jr. now its largest shareholder.
The Big Kahuna: Accepting the Wave’s Energy (1998 and 1999)
Red Hat’s biggest competitor was Microsoft, the same company that to get its own start had outfoxed IBM. The same company that was conniving to crush Netscape (and did). And by 1998, Microsoft was quite aware of Red Hat’s taking market share.
Microsoft NT had the biggest market share for server operating systems, but its share wasn’t growing: steady at 36% from 1997 to 1998. In contrast, Linux-based operating systems were gaining popularity as its market share improved to 17% in 1998, from 7% in 1997. And of the Linux servers shipped, 56% of those had Red Hat Linux, or approximately 9% of total new server license shipments. Of those 9% loaded with Red Hat Linux, a small percentage was actually paying Red Hat.
“The reality is most of our users don’t pay us squat,” Bob says. “So our business model [showed] that if we had millions of users, we only needed one-tenth of our users to actually find something of value to pay Red Hat for.” But that small percentage was a growing part of a huge market.
Microsoft, on the other hand, was on the defensive. They didn’t like Red Hat Linux invading their operating systems market. Did Microsoft feel threatened? “If Microsoft’s earning $40 billion worth of operating system sales, and if we [reduce that to] a $4 billion-a-year market, because nine out of ten of the people that use our operating system aren’t going to pay us, we’re quite happy with a share of a $4 billion-a-year market,” Bob recalls. “However, Microsoft cannot afford to change their business model, because they have $40 billion worth of sales to protect.”
What could Microsoft do? How does a company beat free software—or free anything, for that matter? “The beauty of it is we knew they couldn’t respond to us. There were barriers to entry from the big guys coming in,” Bob explains.
Yet Microsoft tried to combat Linux in a surge of public relations. A Mindcraft, Inc. report showed that Linux was 2.5x slower than Windows NT. But thousands of Linux users refuted the report as bogus. When it was later shown that Microsoft paid Mindcraft for the report, the giant came away with egg on its face.
To take advantage of Linux’s growing popularity, in 1998 and 1999 Red Hat negotiated a whirlwind of product-integration, co-marketing, and distribution partnership deals with global software and technology companies such as IBM, Dell, Intel, Compaq, Oracle, SAP, Netscape, Hewlett-Packard, and Novell. Their customers were asking for a Linux solution. The big firms wanted to figure out a way to capitalize on Linux— or at least not miss out on its value to both their customers and employees at every level.
Red Hat was a $10 million company when doing these deals, but Bob was negotiating with these multi-billion-dollar companies practically as an equal because of Red Hat’s unique business model and value proposition. Bob Young’s co-authored book, Under the Radar, tells stories of intense negotiations. IBM Vice President Bob Dies once told Red Hat, “You need to understand we can just come in and take the market from you,” then he backtracked, adding, “But we don’t want to….” Red Hat walked away from IBM due to a contract disagreement over an indemnity clause, but IBM came back and resolved the issue.
While negotiating with some of the world’s most powerful companies, Red Hat never wavered from giving away its code for free. And the website was becoming a hub for Linux discussion groups, downloads, and applications. In March 1999, RedHat.com had 265,000 unique visitors and 2.5 million page views. With diligence and great patience, Red Hat had remained balanced on the wave, and those institutionalized habits of balance were paying off. Red Hat was hitting its growth inflection point.
During 1998 and 1999 Intel, Netscape, Benchmark Capital, and Greylock Management invested more than $13 million in Red Hat to support increased demand. In 1999 Red Hat’s board wanted to explore taking the company public. The motivation wasn’t just to raise capital, but also to gain credibility for Red Hat and Linux. The reasoning was that after going public, big companies that in the past had rejected Red Hat would reconsider Red Hat as a viable vendor. “Not until Red Hat went public did Linux become safe for corporate managers to invest in,” Bob said.
Red Hat indeed went public, on August 11, 1999, and in the midst of the dot.com boom. It sold approximately ten percent of Red Hat’s shares, raising $84 million – or 6 million shares for $14 per share. The offering valued Red Hat at approximately $840 million—an enormous valuation, considering that revenue ending February 28, 1999, was only $10.8 million.
After Red Hat went public, operations grew more complex. Revenues ending February 28, 2000, increased to $52.8 million. And the upstart now had hundreds of employees spread out all over the world. Managing the many interrelated operational functions was challenging for Bob since he had never juggled competing interests to that degree.
“Red Hat had moved from this period where innovation was the #1 priority and process management was a secondary priority, to the opposite,” Bob recalls. “It was blindingly obvious to all concerned that I was way past my pay grade. Which means I’d had no experience running a business as big as Red Hat had become.”
Late in 1998, Greylock helped recruit to Red Hat forty-one-year-old Matthew Szulik. He was a seasoned technology executive with experience managing growth-oriented technology firms. Matthew had recently helped MapInfo go public. After arriving at Red Hat, Szulik was soon promoted to president and worked in that role for Bob.
In November, 1999, Bob turned over the CEO position to Matthew because he saw that managing Red Hat was beyond his experience level and that running a larger business was not work he liked doing. To this day Bob insists that helping recruit Matthew to Red Hat was his single biggest contribution to the success of the company. Szulik was able to keep the company, though now under all the pressures of public-company scrutiny, still surfing successfully.
Where is Red Hat now?
Today, Red Hat is a leading provider of Linux and has more than 7,900 employees worldwide and a market capitalization of more than $14 billion. The company has evolved from selling $49.95 CDs to selling multi-year enterprise subscriptions and services. Red Hat is far beyond viability and exhibits plenty of strength for the future.
Red Hat’s stock price has excelled, too. According to Morningstar, it has returned an average of 20.8% annually for the fifteen years ending June 15, 2016. For that same period of time, the S&P 500 has returned an average of 5.7% annually and the software application stock category has returned an average of 7.8% annually. Microsoft’s return during that same period has averaged 3.9%.
According to an August, 2001, New York Times article, even Bill Gates has invested in Red Hat stock. Bob remained on the Board of Directors at Red Hat until he retired in 2005 to pursue his new venture, Lulu.com. “In a funny way, my resignation is perhaps the finest compliment I can pay to everyone associated with Red Hat today; I have complete confidence in the future of the company,” Bob told eWeek.com that year.
The Lessons from Red Hat’s Incredible Ride
What role did luck play with Red Hat’s ability to ride the wave of open-source software? Was Bob lucky or brilliant? He was clearly both, yet the lessons from this story are timeless and should be applied.
1. Keeping lines in the water” helps discover great ideas.
“Entrepreneurs create their own luck,” Bob says. For comparison, he cites his brother, Michael, who has learning disabilities but still manages invariably to win the family’s annual fishing tournament because he keeps “lines in the water” by fishing longer hours than anyone else. The more you fish, the “luckier” you’re going to appear to be at catching fish. But it’s not pure luck. The top winners on Bass Masters prepare better, search better, and thus they attract the odds to their side better than the other guys.
For example, if, back in 1991, Bob hadn’t attended UNIX-user meetings while working for Greyvest in New York, he wouldn’t have learned so early about Linux. First of all, just showing up as an outsider to those “computer-wizard” meetings shows a will to learn and listen–an early stage of winning. When Bob first started attending those Unix meetings, the members made him feel uncomfortable–different from them. But Bob made himself relevant by publishing a newsletter for them, giving them something useful, paying attention, and earning their trust. And when Greyvest laid Bob off, he didn’t go out and find a job just anywhere. He worked to make a business out of New York Unix. To earn a living, Bob kept throwing lines in the water and listening—and learning.
Then, while running New York Unix, he didn’t just go through the motions. Instead, he asked readers for niche content. That’s how he discovered Linux in its infancy. And when Bob discovered Linux, he didn’t simply stumble into Marc Ewing; he discovered Marc by asking customers who was making the best Linux programs. After he was directed to Marc, he went on a “tour” to figure out how to build a company that could compete with multi-billion-dollar companies like Microsoft.
That tour was how Bob came up with Red Hat’s unconventional, yet effective, business model of giving away its product for free to some customers—then charging money for service and support for those who needed it.
2. What might be the next Linux?
In business, innovation often seems to emerge like a sudden big wave. The Gutenberg press, the dynamo, the automobile, and the Internet are all examples of important innovations that inspired thousands of other ideas – sub-innovations. And sub-innovations of sub-innovations appear, too, in certain conditions. For example, consider how many new applications have been built for Apple’s iPhone, yet the iPhone itself is a sub-innovation of wireless technology. Sub-innovations develop out from, then latch themselves back onto, the bigger innovation. In a way, sub-innovations surf the wave of the bigger innovation.
Bob and Marc were able to spot that big wave–open-source software–when hardly anyone knew it was coming. So what is today’s next “open-source” software? Is it 3-D printing? Virtual reality? The sharing economy? Or is it a problem you know a lot about that’s experiencing rapid change? Maybe a change that big companies don’t have the time, resources, or relationships to truly understand or address?
If you see these opportunities, this story shows that interviewing and listening to experts and going with their flow are timeless activities. Too many founders try to force their ideas onto the market as they first envisioned them instead of patiently understanding exactly what the market needs. Bob was open to learning what business model made the most sense for Red Hat’s early adopters—the programmers. Unlike his competitors, Bob didn’t rush to treat customers as profit-sources who did things the same old way–by the numbers. He came to realize that satisfying their needs would be the key to Red Hat’s eventual success.
“I saw the benefit of open-source articulated by guys like Thomas Sterling at Goddard,” Bob says. “But all the business guys working for Oracle and Sun Microsystems and Microsoft and all the rest didn’t have the opportunity to see it because they weren’t asking the questions.”
Thousands of programmers all over the world built Linux, but Bob figured out the best way to turn their work into a business that benefited everyone except Microsoft. And then later on, he uncovered paying customers by understanding the requirements of conservative corporations. He learned that software cost wasn’t their critical concern—they needed support, service, and official legal documents to construct a history of legal actions…a paper trail.
3. Building a clever business model is just as important as building clever technology.
Superior technology is only one of the requirements for building a disruptive, multi-billion-dollar company. Figuring out a unique business model is just as important, if not more important. Bob created a scalable business model by being one of the first to offer a “freemium” option. While Red Hat’s freemium edition was only slightly different from its paid subscription version, it was just different enough that people who wanted it would pay. He proved there were two different types of “personas” who appreciated Red Hat: the programmers who wanted it free and contributed to it, and the conservative corporations that wanted support and documentation.
Red Hat’s business model creation was an integrative process. There were many moving parts –changes to Linux, big companies making threats, and Microsoft breathing down their necks. But Bob juggled the variables and put the pieces together successfully. Most important, he listened to what customers wanted. That completed his pattern of coiled, balanced energy potential, identifying with and learning the wave so well that he nearly became one with it. Who can deny the power of personal receptivity?
“In hindsight, everyone puts these value judgments on [my decision to start Red Hat]: ‘It took guts. It took courage. It took brilliance.’ It didn’t take any of those things. All it took is practical. It’s common sense. It’s what you already know: listen to your customer. If your customer says, ‘If you do this for me, I will continue to buy your product. If you stop doing this for me, I’ll stop buying your product,’ it doesn’t take any guts not to stop doing that.”
4. Sell a vision rather than just a product.
Bob trumpeted to the masses the advantages of open-source software just as much as he did Red Hat Software. He became an advocate for a mission bigger than a product. That’s what successful founders do all the time: they attach themselves to a mission that people care about; one that makes their lives better.
You should be doing the same with whatever problem you are solving. How is your offering making the world a better place, and are you marketing that message instead of pushing a product? This strategy is akin to the great books Crossing the Chasm by Geoffrey Moore, Different by Youngme Moon, and Purple Cow by Seth Godin.
5. You don’t have to be CEO forever.
Many great companies, such as Red Hat, will forever be linked to their founders even though the founders are no longer their CEO. Reid Hoffman of LinkedIn, SophiaAmoruso of Nasty Gal, and so many others are good examples. When Red Hat grew to a few hundred employees, Bob was humble enough to recruit someone to replace himself; someone who enjoyed organizing business processes. This turned out to be a great move and enabled Red Hat to grow as a publicly traded company.
If you’re building a great company, then perhaps the answer to “what’s next?” could be something different than being CEO.
Bob Young didn’t successfully compete against established leaders Microsoft and Siebel Systems, respectively, only because they were lucky or “in the right place at the right time.”
Call Red Hat lucky, skilled, or whatever. It doesn’t matter. Just like waves coming to shore, the Linux revolution was going to happen with or without Bob. But the fact is, he got on the wave and accepted its energy – working with it, not against it, he didn’t fall off. He used his perception of the energy to find his own balance on the board. He stayed alert and worked with the flow.
Entrepreneurs embrace the wave’s force by taking human nature into account: spending patterns, technology trends, and psychological dynamics. But whether surfing real waves or business waves, the winning strategy is to go with the flow, listen, be alert, and remain balanced. It’s common sense to do so. It’s practical.