November 7, 2005 4:00 AM PST

Open source, open wallet

Open-source business models are booming in the software industry, a rapid rise that has some experts wondering if it's a bubble that will burst.

Venture capital firms are pouring more money into start-ups that adhere to open-source practices, such as giving away technology for free. That rush could result in an investment bubble, similar to that seen in the early days of the Web, several industry executives cautioned at the Open Source Business Conference last week.

For an open-source business to work well, a start-up needs a number of attributes that a closed-source software company doesn't, executives said.

In particular, they have to combine their pursuit of profit with active involvement in a vibrant "community" of open-source users, some of whom are not paying customers. Not all open-source companies are hitting the right balance between commerce and community, analysts and executives said.

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What's new:
Boom in start-ups with an open-source business plan is being matched by a rise in venture funding.

Bottom line:
Some experts wonder if the investment is a bubble that will burst, noting that open-source companies need the right ingredients, such as a vibrant community.

More stories on open-source business

"Too many of these companies (now forming) are being funded without a community," said David Skok, a venture capitalist at Matrix Partners. "If a community doesn't form and form fast, then they're going to burn through their venture capital, and they're going to be disasters."

Open-source companies typically give away their software with source code to potential customers and either charge for a more functional version or charge for ongoing support services.

Over the past two years, a number of companies have chosen variations on that business model to try to unseat incumbent software providers. The pace of investment in those start-ups has also picked up.

Until the end of September this year, the amount of venture money that went to companies with "open source" in their business description was $144 million. That's more than double the total for the whole of last year, according to research from the National Venture Capital Association, PriceWaterhouseCoopers and Thomson Venture Economics.

Open source chart

In addition, a conservative estimate is that there have been at least 18 open-source companies funded in the first three quarters of 2005, compared with 12 last year, a NVCA representative said. Among this year's top investment recipients were XenSource, which landed $23 million, and SugarCRM, which got third-round funding of $18.7 million last month.

Demand for open source
That pull toward open source is fueled in large part by corporate customers, said Kim Polese, CEO of SpikeSource, an open-source services provider that landed investment this year. For that reason, she sees the growing interest as a healthy development, rather than a speculative bubble.

"I see serious, well-grounded interest and a realization that if companies aren't using open source, then they probably aren't managing their business wisely. If that's the case, that means there's a huge demand for open-source software and business models," Polese said.

Open-source practices are firmly entrenched in the software industry. Alongside tiny start-ups, established providers from IBM to Microsoft are seeking to capitalize on open-source products or replicate the collaborative approach used in their development.

But the business model has its limits, said Skok of Matrix Partners.

Skok, who led investment in open-source Java software provider JBoss, said he recently passed on funding a business-intelligence start-up. One problem was that it didn't have a sizable open-source community behind it.

A strong community of users can contribute bug fixes if the product is developer-oriented or provide feedback on desired features, executives said.

CONTINUED: Drawbacks of open-source model…
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Open Source - the Darwinian approach to software
Open Source projects must pass the Darwinian test (only the fittest (most interesting) survive) to attract developers and contributors to the project. Maybe 1% of all Open Source projects attract more than 30 developer/contributors. We hear a lot about this 1%...enough to make us think it is a sweeping movement.

The user community applies its own Darwinian test to that 1% of projects, as only the most useful and supported projects attracts a significant user community. The Open Source projects you read about are the ones that passed the Darwinian tests.

There are VERY few VC investment opportunities in Open Source. There will only be one or two winners in each space, and the larger spaces are already covered. Linux has already been covered by Red Hat, IBM, HP, Novell, and others. Apache is also supported by many companies including Covalent and Microsoft. The database space is already covered by MySQL, Postgres, Ingres, SleepyCat, BerkleyDB, and 4dbObjects. JBoss is the best pure play in the App Server space, but there are several others.

I wrote a blog on this subject today with my take on how this will play out. Read the whole story at <a class="jive-link-external" href="http://dondodge.typepad.com/the_next_big_thing/2005/11/open_source_the.html" target="_newWindow">http://dondodge.typepad.com/the_next_big_thing/2005/11/open_source_the.html</a>
Posted by Don_Dodge (64 comments )
Reply Link Flag
donation ware..
this is one dam big bubble... now, if they can just keep the returns circulating... we might all be able to afford a trip into space!
Posted by (187 comments )
Link Flag
Yup
Agree on just about every point, Don, except the motivation behind VC interest. That is, and always has been, a statistically-based ROI-over-time formula. Any underlying "goodness" to VC choicess is purely incidental. Open Source today is an attractive investment because:

1. The general stock-buying public and institutions don't understands what it means, and related business models are still in the experimental stage.
2. Investment costs per company will tend to be lower.
3. Time to market will tend to be less.
4. It has, or is achieving, a critical mass of buzz value. (forgive the mixed whatever)

Sound familiar? These factors translate into a proverbial bubble (bubble size TBD) for any investment area of interest. Eventually, hoards of Open-Source-labeled VC portfolio companies and attendant hype will hit the stock market, spike, decline into oblivion - and around we go again.
Posted by parich1776 (13 comments )
Link Flag
This has to be a good thing
These investments will undoubtedly be helpful to the open source software movement in the long run and that's definitely a good thing. As for the financial welfare of the venture captitalists-who cares?
Posted by Michael Grogan (308 comments )
Reply Link Flag
Maybe Not
Venture Capitalists will be laughing all the way to the bank, Michael. Meanwhile, public shareholders who bought in at $30.00 a share are left holding pieces of paper worth $0.14, or maybe $0.00.

Take a step back and ask yourself this: Is it in the best long-term interests of the country, the economy in general and the tech sector in particular for large amounts of investment capital to be consciously squandered on the movement du jour to the detriment of eventual business owners and employees? What, among other losses, are the economic opportunity costs?

The VC investment model continues to exist because, like any enduring business model, it benefits VCs and their investors. Period. So you might want to consider the larger picture more carefully before you so casually say "who cares" the next time.
Posted by parich1776 (13 comments )
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VCs are Always Wrong? Sort Of
Maybe its because of the herd mentality, or maybe its because most VCs today come from accounting or legal but not from tech backgrounds, or maybe its just because the VC business is about fashion, but whenever these guys dump money into 100 startups, they are always wrong.

Amybody else remember the 170 floppy-disk drive companies? How about the 250 PC-clone companies, each of whom only needed 5% market share in order to make a ton of money?

Or the 99 router companies? Or dogfood.com?

During the search engine boom, didn't something called askjeeves get funded? Wow.

Here is comes again, folks. We're going to see 100 open-source word processor companies, another 100 open-source web browser companies, and another 200 voice-over-IP companies.

Why do the VCs keep doing this? Because they are making money on the deal. You see, Venture Capital firms are in the business of selling stock. So, what you do looks like this:

1. Start a company in some interesting sub-field.
2. Hype the sub-field to your local media hos.
3. Sell the company before the bubble bursts.
4. Repeat.

It's a good business model. As long as they're competing against publicly traded dinosaurs, they are probably able to move quickly enough to execute.

The problem is that whatever sub-field gets targeted for a tsunami of VC money is doomed: Overshoot and collapse is inevitable.
Posted by (139 comments )
Reply Link Flag
OpenSource is more capatalistic I think
Isn't that what Darwinism is? The strongest
survive?
So from the outset if an OpenSource project works
then it will grow. If it doesn't then no time and
investments has been substantially wasted.
Using money to buy off people to produce a
successfull project isn't based on merit but
money incentives.
I think Google takes the approach of see if it
grows, then invest.
Posted by Blito (436 comments )
Reply Link Flag
Google invests in people and not money from the outset
Google is investing in people from the outset
money can come in later if needed but the kicker
is that it costs less.
Posted by Blito (436 comments )
Link Flag
If they want to invest in IT it's their only option
Currently the only place where new innovations can happen is in open source. There is no other option left. All is concentrated in some few big, well established corporations (MS actions being the main culprit of it)
The things these VC's are conting on is that they can fund a cool start-up, make sure it gets popular to the point it gets swallowed by one of the bug ones. That is when they make their profit
Posted by Steven N (487 comments )
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