The Open Road

With the market for initial public offerings in a deep freeze and a dwindling number of potential buyers, start-ups have fewer opportunities to exit and retire to Costa Rica.

This is worrisome to entrepreneurs, but if anything, it should be of even greater concern to the venture capitalists that fund them, a point made by TechFlash's John Cook. Venture capital firms simply aren't structured to invest efficiently in this market.

VCs raised billions of dollars during technology's boom, and it's unclear where they can now profitably invest those dollars. IBM, Oracle, Cisco Systems, and Microsoft can buy only so many companies. The industry consolidation that paid big returns to VCs earlier this decade has left far fewer potential buyers, with an anemic IPO market to provide an alternative outlet.

The situation has the potential to get worse. As IBM's Savio Rodrigues writes, Oracle has been hit hard in its middleware business as enterprise IT seeks to minimize the damage from Oracle and SAP price hikes in applications. This could make it harder for the company to afford acquisitions down the road.

In venture investing, small is the new big. Smaller, strategic funds like O'Reilly Alpha Tech Ventures can score big on a "base hit" $20 million exit, given its seed-stage investments of $500,000 to $1 million. Meanwhile, a large firm such as Kleiner Perkins Caufield & Byers will struggle to break even on such an exit, given that its investments need to be much bigger because its funds are so much bigger.

Venture firms have compensated by throwing money at weaker companies that arguably shouldn't get funded. This isn't sustainable. If exit options are dwindling for good companies, they're nonexistent for bad ones.

Compounding the problem for VCs, not only are exits likely to shrink in the new technology economy, but start-ups need less cash to thrive due to low-cost open-source and cloud infrastructure. This is true for most start-ups, but particularly so for companies that sell open-source software.

VCs potentially need to trim their existing funds, and almost certainly should be raising smaller funds.

For those that want to put existing capital to work, it might make sense to swing for the fences with consolidation around portfolio companies. I've described one winning open-source combination (Acquia, Magento, and OpenX), but there are plenty more. The upside to this strategy is that it fattens up a potential acquisition. The downside is that equity positions get heavily diluted in the process, and there are few potential buyers.

It's hard to make early-stage investments in a climate when entrepreneurs need less money, and when the exits promise to return far less. But that is precisely the environment in which VCs find themselves. It may be time to trade in that Porsche for a Honda.

Software mergers and acquisitions have been on overdrive this week, with Adobe, Google, and Intuit collectively spending roughly $2.5 billion to add to their respective product lines. Against this backdrop, OStatic's Sam Dean asks, is the time ripe for open-source mergers and acquisitions? The answer is a resounding, "maybe."

Virtually all M&A is motivated by a search for strategic value. That value comes from acquiring expertise in emerging markets, like cloud computing or virtualization, or by delivering developer communities, as VMware got by buying SpringSource.

This is why Dean is right to point to CloudEra and Acquia as ripe acquisition targets. It's not that either company has managed to build significant revenue streams yet. They haven't. But both sit on the crest of exciting markets or vibrant developer communities.

To be valuable, so-called open-source companies must deliver new markets or developers or both. Using open source to lower sales and marketing costs is an excellent strategy for building a business, but not for establishing strategic value to would-be buyers.

Speaking of SaaS (software as a service) businesses and their impact on enterprise IT, Christopher Lochhead, former chief marketing officer with Mercury Software, suggests, "The real innovation is when technology and a new business model meet." The same is true for open source.

The best bet for open-source M&A is to look for companies that have amassed a developer community or sit atop an exciting new market and have a growing customer list to suggest that a vein of gold runs through its community and/or market.

There aren't many of these, but they do exist.

Oracle has much to say to Sun Microsystems customers in a front-page advertisement it placed in Thursday's European edition of The Wall Street Journal.

The advertisement commits to greater investments in Sun hardware and Solaris software, but has absolutely nothing to say about MySQL. Is this a necessary omission to appease European regulators, or is it a sign of Oracle's intentions?

In the advertisement, Oracle commits to the following:

IBM, which has been cleaning up at Sun's expense, gets a warning from Oracle CEO Larry Ellison: "We're in it to win it. IBM, we're looking forward to competing with you in the hardware business."

Sun's business has tanked in the ongoing uncertainty over Oracle's takeover bid. The advertisement is clearly intended to placate customers that might otherwise flee to the apparent security of a relationship with IBM or Hewlett-Packard.

It's interesting, therefore, that Oracle gives no assurances about MySQL. This could simply be a politic action designed to sidestep the ire of the European Union, which has been investigating the effects an Oracle acquisition might have on Sun's MySQL business.

Or it could simply be a recognition that assuaging the fears of MySQL's customers is a comparatively unimportant task. MySQL was doing roughly $100 million in sales at the time Sun acquired the company. Given that Sun stands to lose billions in its hardware business the longer the Oracle bid drags on, losing a few tens of millions from MySQL is pocket change.

Besides, it's not at all clear that Oracle's decision to snag Sun has done anything to slow MySQL adoption. A vocal minority within the open-source development community has wrung its hands over the deal, but I've yet to hear MySQL's customer base, which skews toward the technology-savvy Web crowd, fretting about Oracle's impact on MySQL's business.

Oracle's advertisement is designed to shore up confidence in the CIO crowd that still buys Sun and probably has no clue that their organizations are running MySQL throughout the enterprise. At some point they'll know. But by that time, Oracle's acquisition of Sun should be complete.

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The European Union undoubtedly believes it is taking a principled stance against the specter of antitrust as Oracle attempts to buy Sun Microsystems. As I've written, however, the EU's delay threatens to gift Sun's customers to IBM and other competitors while doing little to no good for its MySQL business. Worse still, the EU may be paving the way for Oracle to drop its bid, only to return to scoop up Sun's software assets at a rock-bottom price.

Think this is far-fetched? Consider the following (increasingly likely) scenario:

Let's say the EU holds up Oracle's acquisition of Sun by four months. In the technology world, this is an eternity. The lack of clarity around the business has already contributed to two woeful quarters from Sun, with Q4 revenue down 31 percent year-over-year.

Sun's revenue drop is bad, but it will almost certainly get worse the longer the EU drags out its "in-depth investigation." How much worse? Perhaps 50 percent. Heck, perhaps as bad as 80 percent. IBM and HP, in particular, have been crowing about hundreds of Sun customers jumping ship in the wake of Oracle's beleaguered acquisition. Thirty-one percent may come to seem like the good ol' days.

The sad thing is that the EU will almost certainly bow to the inevitable and withdraw its objections. It will look silly for holding up a deal on the specious grounds of MySQL's health (it's doing just fine, thank you, and isn't in danger of being lobotomized by Oracle, which likely will prove to be a better manager of this asset than Sun was).

The EU, unfortunately, is likely not to notice just how silly its stance was, and we'll see other companies go through the same rigamarole.

Regardless, Oracle isn't a silly company, and isn't going to pay top dollar for a diminished asset. It would not be surprising to see Oracle drop its offer by as much as 50 percent, claiming it's actually a premium as revenues are down by more than that. (There is precedent for this in Oracle's various offers for PeopleSoft.) Sun, ruined by this point, would have little choice but to capitulate.

All of which would make Oracle's acquisition of Sun's software business even better than before. As Larry Augustin noted, Oracle's $7.4 billion offer for Sun effectively valued the software at $0.00. Getting a better price on the hardware business and still buying the software business for $0.00? That sounds like a sweet deal.

After all, Oracle is primarily interested in Sun's software assets. Getting Sun for $3.7 billion would make it even easier to quickly flip Sun's hardware business to Fujitsu or HP at a profit, which some speculate is waiting in the wings to buy Sun's hardware business and which I noted back in March was considering a joint-bid on Sun with Oracle.

"Angelic" may not be the word most often associated with Oracle. "Shrewd" is more apt, and low-balling Sun after the EU scuppers its value is shrewd business indeed.

EU competition commissioner Neelie Kroes probably means well by holding up Oracle's acquisition of Sun, but the only group she's helping with the investigation is Oracle, which may end up getting Sun for half what it planned to pay. I'm sure Ellison will give her a ride on his yacht for her troubles.

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IBM and Hewlett-Packard could not have planned it any better.

The European Union has launched an in-depth investigation into Oracle's acquisition of Sun, potentially delaying the merger by several more months. In doing so, the EU is actually guaranteeing the demise of Sun's hardware business and gifting it to Sun's competitors by misunderstanding the deal's impact on open source, generally, and on MySQL, specifically.

If you haven't been paying attention, the delay on the merger due to U.S. and EU scrutiny has already resulted in two shockingly bad quarters from Sun. Many enterprise customers are already moving to competitors like IBM because of the uncertainty surrounding the future of Sun products, The Wall Street Journal reports.

Further delay will only compound the problem.

Unlike the U.S., which approved the deal, the EU's Competition Commissioner Neelie Kroes is concerned that Oracle's takeover of Sun will end up diminishing competition:

Systems (like MySQL) based on open-source software are increasingly emerging as viable alternatives to proprietary solutions. The Commission has to ensure that such alternatives would continue to be available.

The Commission doesn't have to. MySQL's open-source license already does. It's open source: even Oracle can't put the open-source genie back in the bottle once it has been released, as MySQL has, under the GNU General Public License.

Consider: some of the folks cheering loudest for the EU to clamp down on the proposed merger, like representatives from Monty Program, have already demonstrated Oracle's (and Sun's) lack of control over MySQL. Monty Program has created a significant fork, or derivative, of the MySQL database, and stands to gain much by the EU's obstructionism.

In delaying the merger, the EU isn't helping MySQL. It's helping its competitors, including Drizzle, OurDelta, MariaDB (Monty Program's fork), Percona, etc.

Competition within and around MySQL is alive and well, regardless of Oracle. After all, as former MySQL CEO Marten Mickos has been saying for years, MySQL has never really competed with Oracle, anyway. MySQL serves (and has helped to create) a very different market: the Web database market.

When asked in April if Oracle's bid for Sun would end up hurting MySQL, Mickos responded: "MySQL works for Web-based applications. Oracle is for older, legacy applications." The vast majority of Oracle's revenue comes from enterprise IT. The vast majority of MySQL's revenue comes from Web companies like Facebook, Google, etc.

MySQL and Oracle don't really compete. They live in two very different markets.

So, if anything, Oracle's acquisition of Sun helps it leverage MySQL into a market--the growing Web database market--that its own technology is ill-equipped to manage. It also gets a lower-cost product with which to bludgeon its real enemy, Microsoft, coupled with a greater footprint in the rising open-source developer community.

Open source is not the enemy in this deal. Microsoft is.

The EU, however, has made itself an enemy to Oracle, Sun, and MySQL by holding up the merger, a situation that will only get worse due to its glacial pace, as CIO.co.uk's editor Martin Veitch suggests. Customers are not the beneficiaries of its intervention: Sun's server competitors like IBM are.

Though the EU purports to be in tune with open source, its meddlesome muddling reveals a surprising ignorance of open source, and shows a complete disregard for MySQL's true market opportunity.

UPDATE @ 6:59 Pacific on 9/4/09: I solicited comment from Gartner vice president and Distinguished Analyst, Donald Feinberg, who had this to say:

The EU does not understand open source. This is clear by using DBMS (MySQL) to extend the deadline. It also is clear that this is an attempt to use MySQL as a cover-up to a political agenda. It is protectionism at its worst.

The EU is entering deep water here, water that it clearly does not adequately understand.

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As open source has become big to businesses, it has also become big business, with Gartner predicting that vendors will increasingly maintain the leading open-source projects. Vendors, and predominately "proprietary vendors," dominate open source today. Given this assimilation of open source into the proprietary software fabric, has open source won? Or lost?

In 2007 Tim O'Reilly predicted that "virtually every open-source company (including Red Hat) will eventually be acquired by a big proprietary software company." Red Hat still stands independent, though there is good reason to believe it could make an attractive target, but it increasingly stands alone as a pure-play open-source company.

It's likely to get even lonelier.

The 451 Group's Matt Aslett suggested 2009 was to be the year of open-source mergers and acquisitions. While that hasn't yet materialized, it's just a matter of time before the best open-source vendors are scooped up by proprietary vendors.

Take Zenoss, for example. The company recently registered its one-millionth download, with an active community and user base. If you're a proprietary network management vendor stuck in the old model of high-cost sales, why wouldn't you buy into Zenoss' success? Sure, you will generally pay a premium, as it's not cheap to build successful open-source companies, but I've yet to hear a company complain about an open-source acquisition.

But with all this past and projected merger of the open-source world into the proprietary world, should we be concerned that "open source" will lose its meaning?

I don't think so. Gartner's Brian Prentice is absolutely correct to suggest that "we are rapidly moving to the point where all software companies will, to some extent, be an open source company." It's simply a matter of degree (Red Hat sells more open source than Microsoft) and revenue model (Open core versus open complements versus...).

Unfortunately, for the next year or two, we'll remain in transition. I've called it "commercial open source's awkward teenage years," but it's awkward for more than just traditional open-source vendors.

Take Microsoft. Microsoft used to be able to conveniently label open source as "un-American" and "an intellectual-property destroyer." Now that open source is a core part of its strategy, however, Microsoft's soundbites on open source won't be nearly as potent or pithy.

Take Microsoft's announcement about a new bridge it built between open-source PHP and .Net. No talk of "the American way" or anything cool like that. All the talk was about technology working together.

How boring is that?

If you're an enterprise CIO, this is what you've been waiting for: the war between open source and proprietary software to end and simply work together. CIOs can't afford to be dogmatic. They like open source for its flexibility, low-risk evaluation, etc. They couldn't care less about open source as a religious coda.

Customers win in the process. IBM's Savio Rodrigues writes: "It was/is inevitable that any software vendor with a budget to worry about will choose to consume open-source components versus building from scratch when the customer value point is higher up the stack." This means less money spent reinventing the wheel, and more on customer value.

Indeed, I suspect that IBM is really the best model for an "open-source company" going forward. IBM has invested heavily in open source and uses it throughout its product line, but also competes aggressively with open source (Ask a member of IBM's Unix team whether a customer should use Linux or Unix).

IBM, in other words, understands that open source is not "one-size-fits-all" when it comes to meeting customer requirements and ensuring its business is sound (so that it can scale its ability to meet more customer requirements). IBM is an open-source advocate without being an open-source polemicist.

This is the model going forward. It doesn't fit into convenient taxonomies, but it's arguably the right way to think about an "open-source company."

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What is the value of an open-source asset? Over the past several years, and most recently with SpringSource, we've seen a number of open-source companies acquired at valuations of 10x or better. Did the buyers get their money's worth?

It's a tricky question to answer--and likely depends upon far more data than I have at my disposal. It also depends on the acquiring company executing, which has not been the case with Yahoo (which bought Zimbra) or Sun Microsystems (which bought MySQL). No open-source company can offer a panacea for an acquiring company's failure to execute.

But after talking with a range of the companies involved, it would appear that the answer is "yes"--open-source acquisitions are paying good dividends.

Consider:

• JBoss, bought by Red Hat for $350 million at a valuation 15 times sales (i.e., a 15x valuation), has gone on to grow twice as fast as Red Hat's core Linux business and is the key to its ability to sell strategic value to CIOs, rather than simply commodity Linux servers.
• XenSource, inarguably the richest acquisition at 166x, was doubling its customer count every quarter at the time Citrix bought it for $500 million. This would be less significant except that the company had already pulled in 1,000 customers. Compounding that number...? That sort of growth is hard to hard and continues to feed Citrix today. XenSource's valuation was overly rich but then, it was bought on the heels of VMware's explosive IPO. Some valuation hubris was to be expected.
• Zimbra, which Yahoo paid $350 million to acquire, has largely been buried in the belly of a company that has yet to figure out what it wants to do when it grows up (and out of Google's shadow). Even so, the company, which was doing north of $20 million at the time of acquisition, continues to grow quarter after quarter. Yahoo may not know what to do with Zimbra, but Zimbra's customers apparently do: buy more.
• And then there's MySQL. Ironically, Sun's $1 billion acquisition of MySQL, which was ridiculed as dramatically rich in valuation, has the lowest multiple of the lot, given that MySQL recorded sales of over $90 million the year it was acquired. Despite Sun's myriad problems over the past year, MySQL is growing, recording some of its best quarters ever.

Open-source assets, then, are growth assets. And their growth appears to be hard to check, even in cases of significant mismanagement. Perhaps this is the nature of open source: the company behind it may falter, but ultimately, the success of the project is only a download away, provided that the development community remains vibrant (and, in each of the examples above, it has).

So long as development continues, so will downloads. If downloads continue, there really should be no reason that a company can't benefit from it. It may derive substantial or anemic benefits, but it should benefit.

Looking around, it's hard to find a company that, on balance, isn't happy with its open-source investments. If open source didn't work, we'd expect to see companies exit, but in addition to the companies mentioned above, Oracle (Sleepycat), IBM (Gluecode), Cisco (Jabber), and others have increasingly bought into open source, and none shows any signs of abating its interest in increasing its open-source activities.

One might think that buying an open-source asset, rich in adoption but relatively light in monetization, would be a poor investment. Based on the data I've seen, however, this supposition is wrong.

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No other investor has had as much success in open-source software as Peter Fenton, general partner at Benchmark Capital.

A competitive triathlete, Fenton has turned the standard marathon of open-source business-building into a sprint, churning out four big open-source sales--JBoss ($350 million), Zimbra ($350 million), XenSource ($500 million), and SpringSource ($420 million)--while most investors have yet to turn a profit on any.

Not that Fenton is a one-trick pony. He also just sold FriendFeed to Facebook and sits on the board of Twitter. It's fair to say that Fenton can now afford a second Aston Martin.

But Fenton is still busy, sitting on the boards of open-source companies Pentaho, Terracotta, and Engine Yard. He's also willing to share the secrets to his open-source success, telling The Wall Street Journal the key to building a winning open-source business.

Spoiler? Build a direct line to your customers using open source and then ensure an excellent product to pave the way to adoption, then usage, then sales. According to the Journal article:

Rather than "expensive sales efforts and negotiations with the upper management to get the most money possible," the people that will be using the software can easily download and try the product. This helps the best products proliferate and weeds out the underperformers.

"If you don't have the best product, you're not going to make it in open-source," unlike traditional enterprise software, where customers often flock to good-enough products.

Having a well-received product not only results in plenty of downloads, users and developers, it also makes the sales process that much easier. With SpringSource, "anyone the company sold to was already using the product," he said.

Sounds easy, right? Well, no, not if you've ever been involved in an open-source business. Building a great product is hard enough, but doing so in a transparent fashion while encouraging active adoption without appearing faux to your community...? That's hard.

Venture investing may be more art than science to some, but Fenton has done more than most to turn open-source investing into a science, as VentureBeat reports. For instance, many open-source companies are ecstatic to have widespread adoption, but Fenton is careful to call out the difference between adoption and actual usage, as he does in this Benchmark presentation (PDF).

In this presentation Fenton calls out two strategies for investing in either "farm-raised" or "free-range" businesses. Think of these categories as company-led (e.g., Zimbra) or community-led (e.g., SpringSource) open-source businesses. Neither is better than the other: they simply refer to whether an open-source community predates a company set up to monetize it.

The strategies Fenton takes depends. For "free range," it looks like this:

For "farm raised," Fenton's strategy looks like this:

All of which means your next open-source investment or company should be a snap, right? Maybe not. It's one thing to call the correct shots--and quite another to make them. Part of the reason Fenton has been so successful is that he has invested in exceptional operators at each company, including Marc Fleury and Rob Bearden (JBoss); Satish Dharmaraj, Scott Dietzen, Andy Pflaum, and John Robb (Zimbra); and Rod Johnson and Rob Bearden (SpringSource), among others.

Perhaps this is really the key to Fenton's success, after all is said and done: he knows how to attract top-tier entrepreneurs to top-tier open-source communities. That's not something one accomplishes with a jog or casual bike ride. That's the work of a triathlete, which makes Fenton perfect for the job.

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I've been writing a lot lately about SpringSource, largely because it has demonstrated a big vision (nothing less than the redefinition of the application server and an end-to-end application story), and so I wasn't terribly surprised today to see VMware buy SpringSource for $420 million. On roughly $20 million in sales, much of that services, it's a rich valuation, but one that is absolutely deserved given SpringSource's potential.

In fact, it's almost certain that SpringSource sold too early, at least as measured the size of potential exits it could have had given a bit more time. Like Zimbra before it, SpringSource had unbounded potential to shake up the application server and development market.

I remember talking to Peter Fenton, partner with Benchmark Capital and an investor in both SpringSource and Zimbra. He indicated that the firm had made tremendous efforts to keep Zimbra from selling to Yahoo as it still had so much potential to build toward an even bigger valuation.

Happy as Fenton is with the SpringSource acquisition, I wonder if he feels the same as he did about Zimbra. So much money left on the table.

Indeed, I found out about the SpringSource acquisition back in July, apparently even before formal discussions started between the companies (due to a leaky source at VMware). SpringSource CEO Rob Bearden denied the existence of acquisition discussions between the two companies and Rod Johnson, the company's founder and CEO, was on vacation at the time.

But in denying the rumors, Bearden, COO at SpringSource, suggested that given "one more year...(SpringSource) will be bigger than MySQL," acquired by Sun for $1 billion.

I think Bearden was right. The company's valuation has been soaring due to efficiently run operations (Bearden) and a big vision for the company's prospects (Johnson and others). It was only a matter of time before it IPO'd or was acquired.

I had hoped, however, that Red Hat would complement its JBoss business with SpringSource, but it's not to be, and this doesn't bode well for Red Hat, on two counts.

First, with every acquisition of a leading open-source company by anyone other than Red Hat, Red Hat becomes more and more isolated. Other companies are integrating open source into their business strategies. Red Hat's differentiation as "the" open source company doesn't have much of a shelf life left.

Second, SpringSource's ubiquitous Spring Framework already threatened Red Hat's booming JBoss business. But add VMware's leading virtualization technology and suddenly Red Hat is under siege by a highly credible and disruptive competitor that could well outflank it.

Johnson describes the offering:

Working together with VMware we plan on creating a single, integrated, build-run-manage solution for the data center, private clouds, and public clouds. A solution that exploits knowledge of the application structure, and collaboration with middleware and management components, to ensure optimal efficiency and resiliency of the supporting virtual environment at deployment time and during runtime. A solution that will deliver a platform as a service (Paas) built around technologies that you already know, which can slash cost and complexity. A solution built around open, portable middleware technologies that can run on traditional Java EE application servers in a conventional data center and on Amazon EC2 and other elastic compute environments as well as on the VMware platform.

Here's what it looks like:

Astute observers will notice that the operating system, Red Hat's core competence, becomes increasingly less relevant in this world. Vendors like Oracle, Microsoft, IBM, and others have less to fear from this threat, because they're already building high-value solutions above the operating system.

Red Hat doesn't. Red Hat is exposed by this VMware and SpringSource combination. It needs to become more aggressive.

Red Hat is, of course, taking a leadership role in virtualization and increasingly cloud computing. But it will need to quickly move beyond its dependence on its operating system business to sell a larger, strategic story or it faces the prospect of being an excellent, limited basic infrastructure vendor.

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