Tuesday, May 20, 2008

Venture Capital Funding for Open Source Shows Significant Increase in First Quarter

The Venture Capital Journal noted in its April issue that investments in open source software increased dramatically in the first quarter of 2008 to $112 million from $200 to 250 million each year. The VCJ attributes this increase to the demise of the traditional multi year enterprise software licensing model as well as the recent very successful exits by open source companies such as MySQL and Xensource. One of the most significant advantages of the open source business model is the reduction of the cost of sales and marketing. For example, Amit Pandey, CEO of Terracotta, which provides infrastructure software for enterprise Java, notes that his download rate has risen 1000% since they shifted to an open source model; he estimates that a traditional software company would have had to spend $4-5 million dollars to achieve the same effect. Yet the article concludes in controversy: several VCs believe that early stage open source investments are no longer of interest because all of the good deals have been done yet other venture capitalists, such as Larry Augustin, believe that many new early stage open source companies are attractive and will get funded this year.

My experience is consistent with Larry’s view. I am seeing an increase in companies which have started with an open source business model as well as many companies which are shifting either in whole or in part to an open source business model. However, entrepreneurs need to be careful not to believe that “open source” is funding “pixie dust”.

This reality was emphasized in a recent SD Forum presentation on Successful Open Source Venture Investing. The venture capitalists, Kevin Efrusy from Accel and Prashant Shah of Hummer Winblad, are very experienced in open source investments. They emphasized that “open source” was not magic: companies must fit the same financial criteria as other software investments. Both venture capitalists noted that the open source business model does provide significant advantages in swift and inexpensive adoption by end users. Yet the company needs to take advantage of these “free downloads’ by finding a way to monetize them. The most popular model for venture backed companies is “dual” licensing in which proprietary additions are made available in a commercial offering which also includes the “free” open source software. However, the typical open source company uses a variety business models: dual licensing, advertising, maintenance services and professional services (including customization and installation). In fact, many of the older open source companies started with a service only model, providing only maintenance and professional services. David Lilly, the founder and CEO of Groundwork Open Source, described how the company shifted their business model by reducing service based revenues from 80% to 30%. The open source business model continues to have significant advantages over traditional software business models, but open source companies must still meet the traditional economic criteria for venture backed software companies.