VCs regain interest in open source

Venture capitalists (VC) first discovered open source during the dot-com bubble at the turn of the millennium. When the bubble burst, open source was connected closely enough with its general failure that all but a handful of VCs lost interest. In the last few years, however, investor interest has started to return, due to growing acceptance of open source software and the success of existing open source companies. What now attracts investors to open source companies, VCs say, is the higher probability of innovative ideas and quicker time to market, as well as the ability to develop niche markets that were previously too small to develop profitably. If they see that the fundamentals for any successful business are in place, investors are finding firms founded on open source well worth considering.

For Lisa Lambert, managing director for software solutions investment at Intel Capital, the renewed interest is obvious as an increasing number of VCs compete for each investment opportunity. In the last few years, she says, “We’ve found that on every deal.” It’s one reason why Intel Capital started its Open Source Incubator Program, whose goal is to find projects to fund before their work is monetized. Kevin Harvey, a partner at venture firm Benchmark Capital says that, “There was resistance earlier, but now I think there’s tremendous exuberance” at the thought of investing in open source companies.

Lambert can effortlessly reel off the names of VC firms interested in open source investment, including Charles River Ventures, Matrix Partners, Sequoia Capital, and Kleiner, Perkins, Caufield, and Byers.

Interest in open source companies is still far from universal, though. Steve Larsen, co-founder of Krugle and a veteran of numerous technology startups, says that “There are a certain number of VCs who come out of the old model who are looking for patents as being a strong barrier of entry, and who view the use of open source code as having competitive issues.” But Larsen describes these pockets as an advantage for open source entrepreneurs who are looking for investment, since they make deciding who to deal with easier. Because the number of VCs willing to invest in open source is still relatively small, entrepreneurs can find potential investment partners simply by studying existing open source investment announcements, and do not need to approach VC companies blindly.

The reason for the increasing openness toward open source are not hard to find. “VCs don’t like everything new — it’s harder and increases risk,” says open source VC Larry Augustin. “Before, there weren’t many examples of how to make it work. What has happened in the last couple of years is that venture capital firms have gotten very comfortable with the idea that they can build businesses around open source, and there are examples of it having been done,” such as JBoss, MySQL, Red Hat, Xensource, and Zimbra.

However, there are limits to these examples. “The majority of the mature [open source] products are server-based,” Lambert points out. “And the majority of the mature companies and the emerging companies were deployed on the server.” She sees some potential for investment in handheld devices and cross-platform applications, but says open source on the desktop “has yet to mature.”

Why open source appeals to investors

According to Lambert, one of the main reasons why VCs are rediscovering open source is because it seems fertile ground for innovation — or “disruptive” technologies, as she calls it. “The disruptive aspect of open source is what’s really intriguing,” she says. “One of the things I do when I’m investing is look for a disruptive feature, whether that’s a technology feature or a business model disruption — say, software as a service, for example — or a distribution disruption.” She notes that disruptive technologies are riskier, but adds that risk is exactly what early investors are looking for, because a successful innovation means a greater return on investment.

Augustin agrees. “If you’re in the venture capital space, that’s what you want. For a long time, open source had the reputation for not being innovative, which always drove me crazy. To me, that’s just completely missing all the excitement that goes on around a lot of this stuff.” He suggests that even a company like MySQL, whose databases seem mainstream, qualifies as innovative because it “changed the way that we thought about databases,” with its easy availability encouraging people to write software on top of databases, especially for Web purposes.

Another reason for the renewed interest by investors is that by using open source software, companies can build products more cheaply and market them in less time — and therefore produce a quicker return on investment. Lambert observes that not only is development cheaper because it builds on existing code and can benefit from community contributions, but so is sales and marketing. That’s assuming, of course, that a startup can obtain and keep the goodwill of the community. “Speed to market, speed to revenue,” Lambert says simply.

In other words, by using open source software, startups can do more with less. As Harvey says, using open source allows “small companies to build a great product much more quickly, so they can see a much more early adoption of their product.”

For example, referring to the growth of Krugle and its development of a source code search engine, Larsen says that, had the company used traditional business models and kept its code proprietary, “we could never have done it with $10 million in three years. Impossible. Yet now, Krugle has an enterprise-class product that’s been used by some of the top Fortune 100 companies. We could not have built without having good chunks of open source code available to us. And here we are in our third year, moving from spending money to starting to make money.” Considering that, according to Augustin, the time span for a return on the average VC investment is five to seven years, this is a significant saving of time.

Still another advantage of open source companies for investors is that they allow the development of niche markets that would otherwise be unprofitable. For example, under proprietary rules, specialized search engines such as Krugle would have too small a market compared to the cost of development to interest VCs. To justify development costs, companies would have to compete with generalized search engines such Google and Yahoo! — a quixotic effort whose slim chances of success would discourage any VC from investment. However, because of the lower costs of doing business with open source, companies no longer have to compete with the giants in their field, and a decent return on investment from specialization is now at least a possibility.

“There have always been big parts of the market that companies have found difficult to reach in the past,” Augustin says. Suddenly, with open source, those parts become accessible. In this way, open source is comparable to new equipment that suddenly makes low-yield veins of minerals worth mining.

It all comes down to basics

All these advantages are significant but, like any investment, the desirability of an open source company comes down to the fundamentals of sound business practice.

Typically, VC firms considering investment in open source show a marked preference for proven business models, such as dual-licensing and software as a service. Experienced open source investors like Lambert are also looking for startups with a large and active community behind their key pieces of software, as well as what she calls a “sense of stewardship” — that is, those who maintain good relations with the community.

Augustin says he is looking for a strong sense of branding — a company that has its own identity and innovations, rather than one that simply repurposes existing open source software. Moreover, if a company dual-licenses free and proprietary products, he warns against making the free version crippleware, observing that such a move will only evoke hostility from the community.

For the most part, investors are looking for the same criteria in an open source company as they are in any company. According to Augustin, the criteria include a technology for which a demand exists, as well as a team “with passion and the right mindset,” whose members understand the relationship they are entering when they sign with a VC.

Compared to these basics, the business model is secondary. “A good VC firm will help you figure out your business model,” says Augustin. This observation is also reflected by Larsen’s comments that Krugle’s model developed with each round of financing as its investors suggested the direction that the company should be heading.

Like any investment, financing an open source company is ultimately a gamble. However, If Lambert’s experience is any indication, perhaps the biggest reason for the renewed interest in such investments is that they seem to have a high success rate.

Lambert says she has not formally compared the successes of Intel Capital’s open source and proprietary investments. However, her “intuitive” answer to questions about open source rates was telling. “We’ve invested over our history in probably about 15 companies in the open source area since the ’90s, and I will say that you would know the names of most of the companies we’ve invested in. Not all of them have had exits yet, but all of them are doing exceptionally well and will make a nice exit in their time. So I think, on the whole, the hit rate has been pretty good.”