We ran a seminar on Open Source Software, trying to find out if some of the recent Open source software deals really did "Change the Game" for traditional software models, particularly:
1) Investment appetite for open source companies. (My research shows that the VC community has invested over $1.25bn into Open Source software companies since 1999. Furthermore this interest is accelerating. In 2004 there were 10 first round investments into new open source companies, which represents a level of activity in a sector of the early stage market not seen since the tech boom of 1999 – 2000. )
2) Does the trend fire a warning shot across the bows of more traditional software models, which form a significant part of many VC portfolios. (see details of the seminar transcript below to answer this one for yourself).
On the panel were
- Jason Purcell, CEO of FirstCapital
- Danny Rimer, Venture Partner at Index Ventures
- Deborah Magid, Director of Strategic Alliances at IBM
- Damian Reeves, CTO and founder of Zeus Technology
Open source is no longer just Linux operating systems. Venture capital investment is growing rapidly into a new breed of open source software companies, with a diverse range of offerings up and down the application stack. This has potentially profound implications for a wide range of companies which rely on selling expensive licenses for their proprietary software.
Jason Purcell opened the seminar by stating ‘In 1999 and 2000 much of the activity was in Linux based-businesses like Red Hat, SUSE Linux and Ximian. Now we are seeing a new diverse and exciting range of companies up and down the application stack: from CRM provider Sugar CRM through to server virtualization company XenSource.’
It was within this context that the panel members were asked to give their views on the opportunities created by open source software, particularly considering the following issues:
- Market: how big, when and how?
- Is there an investment strategy unique to open source?
- Customers: why do they like it; why do they buy it?
- Issues for existing software portfolio companies?
- IP, licensing & open source: compatibility problems?
- And to Exits…
Index Ventures has invested in a number of open source companies such as Zend and MySQL, and Danny Rimer commented that many have criticised these companies, suggesting they are more able to generate mindshare than revenues. Rimer however, said ‘The rate of growth of customer deployments of open source projects is astounding’. Rimer went on to argue that the LAMP stack (Linux, Apache, MySQL and PHP) are enjoying incredible growth within the enterprise, not only with online businesses like Google and Yahoo, but also ‘traditional’ businesses, for example Lufthansa runs its ticketing operation on PHP and Rentokil’s entire IT infrastructure is based on open source.
There are many good reasons lying behind the strong uptake of open source software: it is robust, reliable, good value and it avoids vendor lock-in. In fact some vendors are finding that the customer demand is so strong that they are struggling to fulfil it, for example MySQL which operates a rigorous filter on its customer leads to work out which of €200k leads can turn into €500k deals.
Part of the reason for immense growth is explained by Open Source’s ‘stealth entrance’ into the enterprise. Developers like open source, and are excited by it, often introducing it into an organisation without the knowledge of the senior management. Rimer told how when Index made due diligence calls on a potential investment to NASA, the management didn’t realise that they were running several mission critical open source projects. In these circumstances, IT managers welcome the entry of commercial organisations to make the software robust and guarantee ongoing support.
Index Ventures’ investment criteria for open source companies include the following 3 necessary pre-conditions:
- Community (has to be large, loyal and evangelistic)
- Price elasticity (even if the software is cheap, it has to be able to defend this price over time)
- Commodity (has to solve a discreet and common problem)
VCs also need to be alert to the potential impact of Open Source on their portfolio companies, with the proviso that while some software companies may be negatively impacted, open source does not necessarily sound the death knoll for traditional software. Deborah Magid of IBM argued ‘There is still a bright future for traditional software companies addressing difficult problems in vertical industries. Some applications will never be appropriate for the open source model.’ She pointed out that you wouldn’t get an online trading application, or a Dassault Systemes from the open source community.
Damien Reeves of Zeus Technology, which has competed in the past against Open Source companies, highlighted the benefits of open source development tools for creating proprietary products. He said ‘Using open source code lowers the barriers to entry for new companies, reducing R&D spend. It allows emergent businesses to focus on building value for their customers in a shorter time frame.’ He also commented that companies with open source solutions can sustain lower-cost sales channels. The distribution model and lower price-points means the software can be sold over the internet, avoiding the need for an expensive direct salesman turning up at customer premises brandishing a CD.
Reeves went on to warn how investors should not be fooled by companies jumping on the open source bandwagon. He warned that it is a classic way to generate cheap mindshare in the early stages of development, and some of the newly emerging businesses seem to have little else than an open source ‘spin’.
Nick Kingsbury at 3i, asked the panel how venture backed businesses could use licence models to protect IPR. Magid noted that it could be done, but more than ever developers have to be careful about choosing an appropriate license, especially as modern software will have been developed with, or will integrate to open source architectures. Damien Reeves agreed, pointing out that there are two simple models to understand open source software. One is where all the individual contributors own the IP. Here it is much harder for a single company to exploit the software, though competitive support and maintenance businesses can be can created (as with Linux). The second model (followed by MySQL) is where one company controls and, in effect, owns all the mass produced copyright. In this model the development path, IPR and licensing patterns are much easier model to control.
The panel then turned to the exits for venture capitalists. Apart from IPO opportunities, who are the buyers of open source software companies? The entire panel agreed that trade sales are likely to be the incumbent software vendors who want to have a dual approach of proprietary and open source systems, and there are a growing number of these companies, emanating not only from software product companies but also from services and solutions organisations.
The panel also commented that Europe has a good opportunity to gain a leading position in open source, in contrast to many software sectors which are dominated by the US Rimer pointed out that it is the large developer base in Europe which is ‘fairly socialist’ in attitude, which is contributing time and expertise to open source projects.
Jason Purcell concluded with optimism on the opportunity for European businesses: ‘The open source phenomenon presents an incredible opportunity for European VCs to seize the initiative and take the lead in open source.’
The VC interest in last.fm continues unabated. I have been asked by a few VCs whether this is just a feeding frenzy created by Yahoo and Google’s current shopping spree OR if it’s a sustainable business on its own.
