VCs’ Open Source Attraction

The open source market is decidely hot right now, from software to support and services. Recently, venture capital firms have upped the ante, investing millions in open source-focused companies with the hopes of cashing in like JBoss did, when Red Hat scooped it up for a tidy US$350 million in June.

“Compared to two years ago, I would say [VC interest in open source firms] is probably up 200 percent to 300 percent,” said Pradeep Tagare, investment manager of open source investments at Intel Capital, the investment arm of Intel.

Bernard Dalle, general partner with Index Ventures, agreed. He too is seeing roughly two to three times more investment in open source companies this year than he did last year, he told LinuxInsider. “The reason for that is, a lot of the startups recognize the fact that it’s difficult to get into the software business if you don’t have an open source [component] to your story,” he said, comparing that to a few years ago, when the reflex was to keep code proprietary.

Funding Boost

Open source firms are seeing an increase in funding at a time when venture capital funding of other sectors is slowing. According to the National Venture Capital Association, total private equity fundraising levels receded in the third quarter of 2006 compared to the first two quarters of this year.

Open source investments, however, appear to be going strong. Intel Capital was among several investors that put $18.5 million into MySQL’s coffers in February. That firm distributes the world’s most popular open source database. In March, Intel Capital also helped Centeris, a company that makes software that integrates Linux servers into a Windows network, raise $11.5 million.

Other firms, such as Digium, an open source VoIP software maker, received $13.2 million in first-round venture capital funding in August. Zend Technologies, a PHP (hypertext preprocessing language) company, secured $20 million, also in August.

However, Linux distribution vendors that haven’t already secured at least some funding may be out of luck. The prominence and success of Red Hat and Novell in the distribution space present high barriers to entry for any pure Linux startup. Red Hat accounts for about half of all Linux distributions, said George Weiss, an analyst at Gartner. If you look at it only as a percentage share of those users who are paying subscription costs, then Red Hat has nearly three-quarters of the market he said.

“Our view is that Linux is clearly currently in its prime time but that the opportunities to fund startups around Linux on servers and desktops is limited given the dominance of existing distributions,” Index Ventures’ Dalle told LinuxInsider. His firm has funded open source vendors MySQL, Zend Technologies, a PHP engine, Trolltech, a vendor of applications for desktop and mobile devices, and Pentaho, which distributes business intelligence and reporting applications.

An Open Source Angle

Instead Dalle sees opportunity in the embedded space where companies such as Trolltech, Montavista, A La Mobile and VirtualLogix are developing tools and solutions to leverage the capabilities of Linux in smartphones and connected devices.

In that vein, rPath, a startup maker of software appliances, tools to deploy software on Linux-based appliances, virtual machines and embedded devices, received $6.4 million in VC money in January.

In September Linux Networx, a company that builds technical computing clusters running Linux and its own software, scored a $37 million investment led by Lehman Brothers. In October, CCTV Investments was the lead investor for $21 million in funding for SiCortex, a company that’s building Linux clusters for technical applications.

Meanwhile, in March the Open Source Development Labs announced the establishment of the OSDL Fellowship Fund. The OSDL is a global consortium that advocates the adoption of Linux and open source software. The fund will provide financial support to software developers working on Linux or other open source projects if they don’t have access to other kinds of funding.

As VCs continue to demonstrate their willingness to fund young open source companies, many are finding that closed source companies are trying to change their business models to an open source-type model just to be more appealing to those with the cash. “A lot of the startups recognize the fact that it’s difficult to get into the software business if you don’t have an open source angle to your story,” Dalle said.

Jumping on the Bandwagon

So what’s the big attraction? To a degree, it’s a pack mentality. “That’s one of the risks of investing in this space today, it’s almost become a bandwagon for people to jump onto because there’s a lot of investor interest in the open source space,” Intel Capital’s Tagare said.

That can lead to risky behavior, he warned. “We see deals where it doesn’t make any sense to have an open source business model but companies are changing to an open source business model in the hopes that they will be able to get funding for it.”

There are several key reasons why the VCs are flocking to open source.

First, many open source projects develop relatively quickly. “From a VC standpoint, the attractiveness is being able to get to results quickly, that’s something they’re always looking for,” said Chander Kant, CEO of Zmanda, distributor of Amanda, open source backup software for MySQL. “They want to see within 18 months what kind of traction we can get,” he said.

Another benefit of an open source company is that right from the start, there is a community of developers and other potential customers who are already interested in the product. “With a traditional software company you’ve got to have a big sales force, you’ve got to invest a lot of money, and even then, there’s the prospect that you … don’t really know whether they want your product or not,” Tagare said.

Creative Models

An open source firm also has greatly reduced research and development costs, which means lower cost of goods sold.

Of course, an open source company may have to be more creative when it comes to deploying a successful business model, but it can be done. Those who have it figured out have a clear advantage in the competitive VC arena, and, interestingly, the relationship between the players is often reversed.

In other words, the VCs aren’t necessarily the ones being courted by the startups. In some cases it’s the other way around. “From an investment perspective we get at least two queries every week where people are asking us whether we’re interested in raising more money,” said Zmanda’s Kant.

Founded last year, Zmanda has received $5 million in funding fromCanaan Partners and BlueRun Ventures. Kant thinks the fact that Zmanda is an open source company was key for the VCs: “We would not have been funded [otherwise]. No way would we have gotten funded.”

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