Command line millionaires

• Article 7 of 16
• LinuxUser & Developer, November 2005

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The second criterion for VCs is a viable business model for the company. Even if the companies don’t yet have one (something that can be a turn-off if the product isn’t exceptional), the VCs can help companies develop their business models through their own experience of what works for their other investments. Danny Rimer of London’s Index Ventures, which has invested in MySQL and Zend as well as Skype, says that provided there’s a community and demand for a product, VCs can find a model that will work. “We spend a lot of time thinking creatively about what the right business model is. Certainly, paying for support, upgrades and patches is the most natural business model. But if you look at MySQL, which has a dual licence model, that provides a big part of its revenue stream.”

Adds Fenton, “There’s a filter you have to apply to open source. Not all open source companies lend themselves to a financial model. If there’s no runtime component to your product, for instance – if it’s just a developer tool, say – we don’t think you’ll benefit from a venture-backed model. You might look for a something that has the ability to add value in a way that doesn’t undermine its open source success, such as support or an extension that makes it safe for use in production systems. What we try to do is study companies and then bring that experience back to the company and see if it fits. We don’t always get it right and we often have to fine tune the business model.”

Other VCs, however, believe that a pure-play open source model is never going to be profitable. A hybrid model, in which some components are open and others are closed, is the only way of making money, they claim. Frank Böhnke, partner at German VC Wellington Partners, has invested in several open source firms, including Scali and Collax, both of which have hybrid models.

“Pure open source is not going to make enough money at this point. It’s a contradiction in terms. You can’t keep something open and at the same time charge for it.” Böhnke says that his company wants to invest only in firms that have a proprietary component to their products “where you create intellectual property. Collax… is almost all open source-based, yet the packaging and the whole suite contains components that are absolutely unique. That’s the intellectual know-how you cannot acquire in an open source environment: 3-5 years of R&D.”

No VC will admit to trying to change the way a company does business, beyond guiding and providing business experience – and maybe a qualified CEO. But some confess that certain open source licences are off-putting, and having the wrong kind will prevent their investing in you. Most have no problems with the LGPL, for example, but the GPL does make some VCs nervous. Says Fenton, “I would have real questions about a new company starting with the GPL versus LGPL or Mozilla. But for us, it’s highly situational.”

Ben Hayman, one of the founders of the VC network Venture4th, which introduces VCs to potential investment companies, says he has experienced the GPL “being a set back and concern to investors because it introduces a certain amount of inflexibility. You don’t have the option down the line to commercialise the offering in quite the way you would if it weren’t the GPL. VCs generally are very interested in putting money into risky, high-return businesses. However, they are very risk averse. They will always look to licensing models that allow maximum flexibility and allow companies to test the water, so if they need to change the model they can.”

Alexander Brühl of Atlas Venture, another investor in both Collax and Scali as well as Jaluna, agrees that proprietary software may always be necessary for profit. However, that needn’t be the software that companies provide to customers, which can remain purely open. “All those companies that say they’re purely open source do have proprietary software, but it’s no longer software that’s sold to customers. What they have is in-house, self-developed software that enables them to provide services or maintenance to customers. The more cleverly you can structure the software to manage clients, the higher the margins are.”

With strong community support, the right management team, a clear business model and decent revenue streams, an open source company is almost certain to get the backing of a VC if it wants it. However, the chances of getting rich via open source are considerably smaller than via proprietary software. “Can you build a $100 million business out of an open source company? I would say that is a very challenging situation,” says Index’s Danny Rimer. “Red Hat demonstrated that you can, but I would say it’s not that difficult to build small, profitable businesses as an open source vendor, because of the efficiencies of leveraging the community and the ability to deploy and distribute your software everywhere. But to build a business that scales to the type of gross that we invest in is not trivial. Being unable to sell a proprietary licence is a big impediment.”

With VCs now ready to get behind open source start-ups and open source now a part of almost every company, the beginnings of an open source business eco-system are already well under way. In the last of this series, we’ll look at how the investment and governmental infrastructure in Europe is changing to support – or hinder – open source.