“What is Linux? And what is GPL?” were some questions that most VCs asked in the mid 90s when entrepreneurs in the open source space approached them for an investment—who were turned down most of the time anyway,” recalls Vivek Mehra who was himself turned down by a couple of VCs when he was raising money for his company—Cobalt Networks—that built server appliances on open source technologies.
Mehra still bet on the open source momentum and emerged successful. He finally did manage to convince a few folks in the VC community, raised $45 million, took the company public and eventually sold it to Sun Microsystems for $2 billion.Today, Mehra wears the VC mantle himself. A partner at August Capital, Mehra observes, “VC folks today ask: Why are you not using linux?”

The chances that a venture partner will turn down an open source idea are quite bleak for now. “I am pleasantly surprised at the way the landscape has changed in the last five years,” notes Mehra. The VC community has become much more mature and is in fact betting on the open source wave. The success stories of companies delivering cost effective applications by adopting the open source model has dissolved all the skepticism that existed. The VCs now believe that profitable companies can be built to deliver enterprise quality applications using the open source model.

The dramatic increase in the adoption rate of open source within the enterprise attracts the VCs to watch this space is much closely now. The venture capital firms are now taking a close look at opportunities where companies focused on open source software as the foundation promise for high-growth businesses. In the late 1990s, more than $200 million flooded into the coffers of just a handful of Linux companies. At its peak, Red Hat boasted a market capitalization of more than $20 billion and VA Linux still holds the opening-day record for an IPO share price increase—more than 700 percent.

The past year has seen a return of venture investment around companies in open source at valuations not seen since the bubble days. Indeed, Forbes magazine in February asked “Is Open Source the best investment opportunity in 2004?”

Already, many start-ups targeting open source markets are benefiting from the new investment climate. Recent examples include JBoss, makers of web server software, who attracted $10 million from Accel Partners and Matrix. Scalix, built around original HP technology for mail and messaging software that runs on Linux, raised $13 million from Mayfield and NEA. MySQL, an open source database company, received $19.5 million in a round led by Benchmark Capital.

The days of deals where $100k were charged as upfront license fee for software are over. Open source has really changed the business models of software companies. Today, service oriented business and hosted application companies built around open source concept are emerging. This is a tremendous opportunity for new companies that can leverage open source—by not having to develop everything from scratch, but build applications on top of the existing ones.

Growth Areas
What are the growth areas in open source investment where start-up CEOs can pitch their firms to venture investors? “There is a great scope for product-oriented companies that leverage open source as building blocks,” says Mehra. “Whether it is a firewall, intusion detection, anti-virus, spam- filtering, or storage switching, most of the appliances can be built using Linux as the underlying platform. Startups are increasingly building their software applications on open source or low-cost software infrastructure. And this model is profitable.” In fact, one of Mehra’s portfolio companies—Neopath Networks—builds storage switches using Linux as its operating platform.

Even Rob Soni, a venture capitalist with Matrix Partners is looking for companies that develop open source applications and databases. Soni says, “Open source will become mainstream, not just the domain of “the four pony-tailed guys in the corner.”

“VCs find open source provides a low cost, accessible entry point upon which their companies can build business value. The entrepreneurs can focus on their unique intellectual property, rather than the underpinnings. This is attractive for young, thinly capitalized companies in a growth phase,” says Deborah Magid, Director, Strategic Alliances, IBM Software, Venture Capital Group.

Mehra believes that open source-based start-ups can be tremendously successful if they adopt the horizontal approach. And this philosophy applies across the startup companies’ intentions to build infrastructure, middleware or develop applications. “It will be hard for the open source model to be successful in vertical niche applications. It is hard to build a vibrant community of developers or users around a niche application,” says Mehra.

Many younger portfolio companies are increasingly adopting a LAMP stack as their Open Source infrastructure. LAMP refers to Linux (for the operating system), Apache (for the web server), MySQL (for the database), and PHP, Python, or PERL for a web scripting language. “We are finding that LAMP is particularly attractive to these startups, not just for cost savings, but because of the combination of a broadly accessible web server and database with a scripting language designed specifically for the Internet. Companies which are “born on the web” find this attractive,” says Magid.

Business Models
Kevin Harvey, a partner with Benchmark Capital is credited with having a knack of spotting profitable business models in the open source space. Harvey watches out for new business models and new businesses being built in the open source arena. “I am looking for are companies that have figured out how to make money. When there is great deal of customer demand, like in the open source space, the business model has to be different to be a profitable company.”

Many open source projects have novel ideas and technologies, however without seed funding for rapid prototyping and venture capital for taking innovations to market, they will not easily succeed. Also many companies in this area lack the real scalability that makes the nascent technology so interesting.

“More than what specific categories in which open source startups are built, I am interested in knowing what development model, licensing model, subscription service model and sales and distribution model that the company adopts,” says Harvey.

As VCs invest in models that open up new business opportunities, the notion of creating a commercial venture based on an underlying, ubiquitous open source platform or application is attractive because the open source component encourages broad adoption and therefore drags a natural and extensive customer base, without the need for a tradition direct sales force. It creates a community around which developers, partners and customers alike can build relationships. While open source investments are of great interest to VCs, the number of such opportunities has been small relative to the demand.

Recent open source deals have tended to be over-subscribed. This is partly because the success of the model has yet to be fully proven, from the point of view of revenue and return on investment. This may change, as entrepreneurs watch for the success of earlier ventures.

Challenging the Big Boys
“One of the biggest dangers I see is that open source companies pricing their products too high. Sometimes open source products are priced higher than similar proprietary software. Such a trend is beginning in the operating systems segment and will not be welcome by the market,” Mehra reckons.

In fact, it will be interesting to see how much money the big companies have lost because customers are buying from startup companies in the open source space. “Impact on existing businesses has been more profound than the revenue of the smaller new companies,” notes Mehra.

Mitchell Kertzman of Hummer Winblad concurs with Mehra’s viewpoint and adds, “In history, the battle is always between the new entrants coming up from beneath against established, highly priced competitors, and the guy coming up always wins.”

“Small companies can grow with high volume, low price offerings. Big companies have a hard time responding to small companies. They can’t afford to match the business models of the smaller ones,” says Harvey. It is these new companies that excite the VCs.