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.

Perhaps more significantly, an active community of users helps sell revenue-generating products and services. By giving away entry-level products, potential customers can try out the software without a long, complex sales process. That dynamic can dramatically lower the cost of sales and marketing for a provider.

SugarCRM, for example, does not employ direct sales people, who are typically highly paid. Instead, the users of its open-source product are the primary source of sales leads, CEO John Roberts said. A smaller sales and marketing budget allows it to divert its resources toward engineering, he added.

There is a drawback. By the same token, open-source companies can be slowed if an active group of customers switches to another product, said Winston Damarillo, the CEO of software developer Mergere.

Other questions
There are questions about other aspects of the open-source business model. For example, if a company relies entirely on services revenue, it will likely need to have a high-volume of customers, analysts said. By contrast, small closed-source providers can get off the ground serving a small number of customers with expensive products.

"There are many open-source business models, and every one of them is an experiment," said Andy Astor, CEO of EnterpriseDB, a database software maker that recently received funding. "A support-only (revenue model) like JBoss has is a risky model."

Instead of charging an annual support service fee on a free product as many companies do, EnterpriseDB uses a "plain old software license," Astor said. The only difference with closed-source providers is that the EnterpriseDB database is based on PostgreSQL, an open-source product.

And exposing source code introduces an "inherently risk in the business model," said Bill Schnoor, partner at law firm Goodwin Procter, which represents technology companies.

Despite these risks, open-source products, notably the Linux operating system, are already mainstays in corporate data centers. Now customers are using other products, including databases, middleware and packaged applications.

Information services company Informa, for example, decided to use an open-source content management system from Alfresco Software, a company founded by document management industry veterans. The software itself uses a number of open-source components, such as the MySQL database and development products Hibernate and Spring.

The Alfresco system serves most of the company's needs, providing the "identical stack" as existing products at a cost that is three orders of magnitude lower, said Bob Hecht, vice president of content strategies at Informa. "It got so that (the choice) was a no-brainer," he said.

Echoing those sentiments, Ron Rose, the chief information officer of Priceline.com, said that the company has become "predisposed" to buying open-source products because they of the "economic benefits." A vibrant community behind a product also ensures a long-term road map, he added.

Goodwin Procter's Schnoor puts the spike in interest in open-source software in the context of big technology shifts that have already occurred, such as the Web. The attractiveness of the open-source model will likely create a surplus of open-source suppliers, Schnoor said, and he expects many more companies to be launched. But that's typical of all major changes in the software industry, he said.

"Are there a lot of spears that will get broken along the way? Absolutely. It happens every time," Schnoor said.

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