How to get VC investment for your open source business

So, you’ve got the greatest open source idea since Firefox. It’s guaranteed to be bigger than TCP/IP. All you need now is some scratch to get your project off the ground. Given the genius of your idea, you’re sure you’ll have to beat off potential investors with a stick. If you think that’s reality, I’ve got some subprime mortgages to sell you. Getting venture capital (VC) to fund your business is hard work, even if you have a commercial product to sell. The degree of difficulty ratchets up many times if you’re an open source developer. It can be done, but it takes such single-minded focus that getting turned down multiple — maybe even dozens — of times won’t faze you.

Shoe leather and door-knocking

That’s what worked for Untangle co-founder and CTO Dirk Morris. He knocked on doors full-time for months, and lost track of the number of times he was turned down. But he stayed with it, and it has paid off; San Mateo, Calif.-based Untangle, which makes network gateway products like firewalls and spam and virus blockers, has secured about $18.5 million in venture capital.

Morris says the key in his case was presenting a solid open source business plan. “When you say the words ‘open source’ to a VC, they don’t care what license the code is going out under. It’s about the business model. It’s about a premium business model with a large community.”

That view was echoed by Jim Watson, managing director of San Francisco-based VC firm CMEA Ventures. He believes that open source developers who start riding the funding circuit without a clear, well-thought-out plan are setting themselves up for disappointment. And that plan starts with a simple question for open source entrepreneurs: Who’s gonna pay?

“In open source, you have to figure out how you’re going to make a return on the investment,” Watson says. “At the end of the day, somebody has to pay something for what you’re doing or it has no value.”

A multi-year process

Watson says he receives about 20 funding pitches for commercial development companies for every one pitch for open source. Companies that do get money normally go through a multi-step process:

• Angel funding — Also called “seed funding,” this initial round relies on private investors, called “angels,” to provide working capital. At this point, engineers are writing code and trying to build a product that can be taken to the VCs. Usually, says Watson, two or three angels provide less than $1 million total.
• Series A — The first round of VC funding. The money garnered here is typically used to develop and finish a product.
• Series B — The next round, Series B funding, is usually about building the business, including getting the marketing and sales team in place. It’s here, says Watson, that you’re “starting to create a business,” instead of just building a product.
• Series C — The final round is for growth capital. At this stage, a company has a product that is out and selling. Now it’s time to grow and expand, including enlarging the sales and marketing teams, and possibly spreading out geographically. “You’re looking for money to make it a big company,” Watson says.

Along the way, the company has been adding employees, and often will have 50 workers by the time Series C funding is secured. The entire process normally takes about five years, although there are exceptions to that. Series C funding typically happens three to four years after Series A, Watson says.

It’s a process that Marketcetera, based in San Francisco, is currently going through. It has finished the seed round and Series A funding, which it obtained through Shasta Ventures, an early-stage VC firm. Shasta has contributed $4 million to Marketcetera, which makes an open source online trading program.

Marketcetera CEO Graham Miller says his situation is different from many OS developers in that it didn’t take long to get funding. “The initial time took about four months from initial pitch to money in the bank. That’s on the quicker side of Series A. The seed round raised a few hundred thousand, just enough to go out and get some hardware and software resources, and build out the product.”

A perfect match

Miller says he met with about 15 firms before finding the right one. It’s not just about getting money, he says, but also finding a good match. “Initial meetings in that process are kind of a mutual feeling out. We give them a high-level overview of what we’re working on and see if that meets their investment objectives. It’s a process of meeting with a fair number of people before finding a fund that sees the world the same way you do. Moving forward they’re likely to be a better partner.”

Finding an investor that believes in your company and product is especially important in the open source arena, says Bob Walters, Untangle’s CEO. Open source can present more risk, making it that much harder. “Funding for open source has become very discriminating of late.”

Untangle’s Morris agrees that the fit must be right. “We probably had meetings with 20-some VCs. Some said, ‘This isn’t our area — we’re not interested.’ You’re looking for somebody who agrees with your view of the world and what you’re doing.”

Watson echoes that sentiment, and says a company will cut down on rejections if it approaches the proper VCs to start with. He says entrepreneurs need to be asking themselves questions: “Is it a brand-new startup? If so, are we the right size firm to fund it? A company has to do its homework and match up with the right size funding firm. If they’re looking for a half-million for development, we’re probably not the right company.”

The vision thing

In Untangle’s case, it had an additional hurdle. “We had our vision; the biggest showstopper for us was the small business” focus, says Morris. “VCs cringed, saying, ‘That’s a hard market — why not go after enterprises with this technology?'” Morris says Untangle stayed true to that vision, but did adapt its pitch after some early rejections. Still, he emphasized the importance of “looking for a VC [firm] that will agree with your vision and want to help you with it.”

Vision isn’t enough, however; that’s why it’s so important to have a base of users, Untangle’s Walters adds. “Unless you have a real open source community going, you have a real strike against you if you want to get funding. Community is really the value of an open source play. You get a lot of cold shoulders unless you have a community established.”

If you don’t yet have a large community, it’s even more crucial to have a strong business model and business case. The idea comes first, but a close second is the need for a strong, experienced leadership team to guide the fledgling company and convince VCs to write the checks.

In a company’s nascent phase, Watson says, he might be looking for founders who are technical, to gain confidence in product development. From there, the founders “will need to build a business team around them. [Those executives] need to be exceptionally experienced,” Watson says.

A team effort

Having a rookie leadership team makes it “really hard to succeed in this business; you need an experienced team, a partner that’s done this several times. It reduces a lot of the risk for VCs,” Watson says.

That team is critical when it comes to pitching the company. They have to understand the need to talk profits — not bits and bytes — to interest a VC. It’s the number one turnoff for Watson when companies do their presentations. “They come in with 50 slides, and 48 of them are technical. They’ll be 15 minutes into the pitch, and I have no idea what their product is. They think everyone is as deep into technology as they are.”

At that point, it becomes very difficult to sell. “I’ve had to stop people and tell them, ‘I have no idea what you’re talking about, and need money for,'” Watson says, and offers some advice on how to do it right. “Pretend you’re standing in front of a sixth-grade class and you need to explain your business.”

Who’s buying?

Beyond keeping it simple, a company must know its audience. A huge negative for Watson is “groups that haven’t thought about the market. Who’s the customer who will be paying for this? It’s amazing how many of those we see.”

One of those was a pitch from three engineers who had a technology that increased efficiency for Oracle databases. “They had an idea that they considered a major breakthrough for mankind, but I had no idea what it was about or who would buy it,” Watson says.

On the other hand, if someone comes to him with a pitch for an iPhone application they’ll sell for 99 cents, and “sell 10 zillion of them,” Watson immediately warms up. “I get it,” he says.

Marketcetera’s Miller has more advice for potential open source entrepreneurs. “One thing really helpful for us was getting input from variety of sources on our pitch, positioning, and product direction. Putting your ego aside and finding the kind of smart, intelligent individuals and getting their feedback on their approach” was invaluable, he says.

Broaden your horizons

Getting multiple points of view is a recurring theme for successfully raising VC capital. And it can start right at the beginning, according to Miller, who says to consider “having more than one founder. At the end of the day, if your idea isn’t good enough to convince two people, it’s probably not good enough to build a business” around.

Morris says that’s good advice. “Talk to a lot of people. Bounce ideas off of VCs before you start meeting [them formally]. You will learn so much about what you need to do, and what you can expect before you get a deal done.”

Most of all, keep at it if you believe in your idea. Says Morris, “You can’t get discouraged. You’re going to get a lot of people who will say, ‘No, we’re not interested.’ That’s all part of the game.”