Command line millionaires
- Article 7 of 16
- LinuxUser & Developer, November 2005
Open source or proprietary, start-ups need cash to develop their business, and the first stop for cash is the venture capitalist
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I have this great scheme. It’s going to make as both rich. Millionaires, in fact: multi-millionaires to the tune of $100 million, maybe more. Interested? Okay, it’s going to take time, maybe three years and it’s going to need a lot of preparation. So if you’re going to be in on this, I’m going to need a deposit. Say $3 million? Are you in?
It sounds like a scam. Variations on it separate fools from their money in Vegas every day. To buy into it, you’d need some pretty big assurances that the scheme was legitimate and was actually going to work.
Welcome to the world of venture capitalism. Venture capitalists (VCs) are the usual first stop for technologists in need of large amounts of money. Increasingly, companies that use open source software as the basis for their products and services are turning to VCs as well in the hope of being the next Red Hat or JBoss.
But do VCs “get” open source? Can an open source company do business with the men in suits without losing their souls? To find out, for this, the third in a series of articles on open source business, we spoke to a number of VCs around Europe and the US that had chosen to invest in open source companies about their motivations, their attitude to open source in general and whether they attempted to change the companies in which they invested.
Open source has been on the radar of most technology VCs since 1997, particularly in the US. Impressed by Linux’s ability to undermine the standard operating system sales model, it was the advance up the stack of open source from infrastructure to middleware and now to applications that is convincing VCs that open source is an area they need to be investing in.
The motivation for investing in open source companies is profit, although some have higher aspirations. “We are primarily interested in making money, although we do have limits and we try not to be bad guys and force people to do things,” says David Skok of the US-based Matrix Partners, one of the firms that invested in JBoss during its first round of funding in 2004.
Skok, like other VCs, is convinced that open source is going to take over many areas of the software business, making it a more than worthwhile investment. Deborah Magid is director, strategic alliances, at IBM’s venture capital group says the evidence for that is clear. “Open source is hot. It’s just about impossible to buy a company that does not have open source inside its products. It’s become so mainstream, we assume if a start-up comes to us, it’s using open source somewhere. VCs tell us that all the new business plans coming to them say they’re using open source and it’s now so compelling, they [proactively] ask start-ups how they’ll use it.” Some VCs are going even further. “Literally, they will go through Sourceforge and look for projects that might make decent commercial ventures. They either find the key contributor or some other entrepreneur who can build a company around that.”
According to Peter Fenton of Accel Partners, which has invested in open source companies such as Xensource, JBoss and Zimbra, the hope is to find the company that will be a brand name in five or ten years, rather than the company that gets acquired and you never hear from again. Making money is just a by-product of having found the best entrepreneur in a market with critical mass. We don’t go into this with an avaricious sense.”
VCs do have quality thresholds, however: they aren’t looking to invest in just any open source company. They’re mostly looking for two things. The first requirement is a product with a community of developers and users around it. Unlike proprietary software, which will usually need VC funding to get it to the point where it can be released, open source software’s main virtue for VCs is the word-of-mouth and momentum that a community will have already provided.
Says Shoke, “The big thing about open source is that it allows you to lower the cost of sales and marketing so you can operate far more cheaply than in a traditional software business. Open source has to have a very large community otherwise that dynamic doesn’t work. A lot of open source companies are coming in and saying, ‘Please fund us’. I look at them and say ‘Come back, when you’ve proven you’ve got a community. Otherwise, you’re going to have to go through the same long sales cycle as proprietary software, but you’re never going to make as much money as the proprietary company.’”
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.
The golden ladder: how venture capitalism works
If you’re just going to set up a florists or a corner shop, a small business loan from Barclays is probably more than enough to get you by. But for technology companies, it’s usually a different story. It can be several years before there’s even a product for the company to sell so begging money off the family or the bank manager is never an option. With R&D, sales, marketing, salaries and other costs to cover, tech companies tend to need millions, rather than thousands of pounds to get up and running.
If you’re lucky and your needs aren’t that great, you might be able to interest an “angel investor”. This is effectively a wealthy benefactor who thinks you’re onto something. In return for a stake in the company, he or she will provide you with a significant sum of money. It might be enough to get you ready to release a money-making, market-changing product. More often than not though, it will get you to the point where you have something with which to attract venture capitalists.
VCs rarely have any more money than angel investors – in fact, a significant number of them are angel investors themselves – but what they do have is access ‘funds’. Very rich people give the VCs large quantities of money, which they then combine into a fund. The VCs will then look for companies they think could be worth far more than they’re currently worth. In exchange for perhaps 30%-40% of the companies’ shares, the VC will give the companies significant amounts of money from the fund, usually a few million dollars. Typically, the VC will also get a place on the board and the opportunity to advise management on the best way to develop the company.
Sometimes, during this first “funding round”, more than one VC will want to invest and the 30% stake will be shared between the VCs. There may also be subsequent funding rounds, typically a year or two after the first round, where the management sells more of its share in the company (at its new, hopefully higher value) in exchange for further funds. This is usually to expand the company’s operations now R&D is complete.
The main aim of all this for VCs is that within three years, the company will be able to float on the stock exchange in an initial public offering (IPO) or be bought by another, bigger company in a “trade sale”. In both cases, the company should have moved from being worth just a few million dollars, where a 30% stake cost $3 million or so, to being a $100 million company or more, where a 30% stake is worth $30 million – a big pay-off for the VC, which can sell its stake to the purchaser or on the stock market.
In case you’re thinking that’s effectively money for old rope, the vast majority of companies fail to reach that kind of value and indeed fail to get off the ground at all. The high return on the investments that do succeed has to compensate for all the companies that flop, taking all that funding capital with them. And if the VCs don’t make a high enough return for the investors, the next time they launch a fund, they’ll find the investors will have taken their money to a fund that does provide high returns – putting them out of a job.
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