Why IBM Wanted Red Hat

SMITH BRAIN TRUST – It is the most expensive deal in IBM’s 108-year history, but the $34 billion acquisition of Red Hat is one that seems likely to pay off, says Maryland Smith’s Tunay Tunca.

Tunca should know. In recent research, he and two co-authors studied closely the intense competition between the tech stalwart and its younger open-source software and cloud computing rival. “Looking back, it was not surprising that a deal like this would happen,” says Tunca, professor of management science and operations management at the University of Maryland’s Robert H. Smith School of Business.

With the deal, IBM is bringing its chief rival in the open-source domain under its own roof. Red Hat will remain independent, the companies have said, in a move that Tunca describes as a plus.

“IBM is giving Red Hat a certain amount of independence, which will help stimulate innovation,” says Tunca. “That’s so that IBM can continue to reap the innovation that’s coming from both sources – both IBM and Red Hat.”

In recent years, IBM has been struggling to find its niche, as it watched Microsoft and Amazon speed ahead. Its acquisition of Red Hat will help IBM vie for market share in cloud computing and open source development, an area of relative strength for IBM. And, IBM will no longer have to compete against Red Hat for revenue. “IBM is reducing competition, essentially by purchasing its biggest competitor,” Tunca says.

Under the open source business model, the underlying infrastructure, or source code, of computer software is made available for use or modification by developers and other users, for free. Companies make money by charging for services – consulting, integration and other expertise.

In their research, Tunca and the University of California San Diego’s Terrence August and Hyoduk Shin created an economic model to study how software licensing attributes affect a software maker’s decisions, with insights into how policymakers might incentivize welfare-improving open-source outcomes. The research is published in Information Systems Research.

In the past decade, the researchers note, open-source software has become an increasingly prominent tool, paving the way for service-based revenue models that provide steady revenue streams for companies like Red Hat that invest, develop, maintain, and support the software solution approach. Red Hat and IBM have been major players in the space, competing in open source solutions for more than a decade. “They are the two best-known names for some of the most prominent open-source software products. As a combined company, they will certainly see an advantage based on the scale of their expertise,” says Tunca.

Companies that build new software must decide whether to embrace an open approach or a more proprietary one. If they choose the proprietary path, they don’t benefit from the value-adding contributions of other developers, who might use the software, expose its flaws, experiment with fixes and build upon the code. On the other hand, they keep the ability to generate revenue by selling copies of the software.

The software originator who pursues the open-source path forfeits the ability to charge for that now-free software, deciding instead to make money by offering integration and support services for the software. And those services can be of significant value to customers.

In their research, the authors find that when an open-source contributor is adept in benefiting from its own efforts to a greater extent than the originator, requiring or favoring less restrictive licenses can increase the originator’s profits and its welfare. On the other hand, if the software creator is able to take effective advantage of contributor efforts and maintain high service margins, relying on other developers’ contributions can improve profitability and overall software quality.

And that is a lot like what’s happening between IBM and Red Hat.

In tech, there is “a natural gravitational pull” toward mergers, Tunca says. “A company that is bigger, or better positioned, or that has more cash can always purchase the other one. And by purchasing the other one, it can reduce some of the price competition, which enables the newly joined entity to have higher margins and increased profitability. In the open source domain, with a deal like IBM made, this can come together with continued benefits from the innovations of the purchased company ”

Read more about the research: Generating Value through Open Source: Software Service Market Regulation and Licensing Policy is published in Information Systems Research.