Open source, open wallet

Venture money going to companies with an "open-source" plan is rising rapidly. Is that a good thing?

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.

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