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Breaking the rules with open source

Start-ups, investors turn to open-source software to jump-start new companies.

In the space of five months, John Roberts started a software company and delivered its first product to thousands of potential customers--a process that could easily have taken years. His secret? Open-source development.

On Monday, Roberts' new company, SugarCRM, will officially launch and announce that it has landed $2 million in outside investment, becoming one of the first open-source business application companies to be funded.


What's new:
SugarCRM announced Monday that it has landed $2 million in outside funding, making it one of the first open-source business application companies to be funded.

Bottom line:
Increasingly, investors are eyeing open source as a better way to build software companies. Not only does this model give companies access to freely available components, but using the community-based development process often means that such firms' products have a built-in user base. In other words, "this is a way to break the rules," says one investor.

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The announcement is timed to coincide with the LinuxWorld conference taking place in San Francisco this week.

"Open source is just a more efficient, effective software business model," Roberts says. "It's more than just cheaper software. It's a shift, a movement reshaping the dynamics of a modern software company."

Increasingly, entrepreneurs like Roberts, along with investors, are eyeing open source as a better way to build software companies. Rather than incur huge start-up costs and recruit high-priced software sales executives, smaller companies are building their businesses around an open-source business model, where software source code can be viewed and enhanced by others.

By tapping into the open-source world, fledgling software outfits can assemble their software products from freely available components. Volunteer programmers not only help develop the product, they also create a pool of potential customers for starting companies. In return, programmers develop new skills and get free software.

Roberts' company faces an uphill battle against established giants like Oracle, SAP and Siebel Systems. But with a lower up-front investment, entrepreneurs and venture capital firms are willing to take a risk.

"Entrepreneurs are figuring out that this is a way to break the rules," said David Skok, a partner at venture capital firm Matrix Partners, who led investment in open-source company JBoss. "Open-source is a way to get broad acceptance with lots and lots of users quickly."

Growing customer interest is helping create more favorable market conditions for companies that tap into open-source development. In a March report titled "Open Source Goes into the Mainstream," Forrester Research said that over 60 percent of 140 companies surveyed plan to use, or are using, open-source products. Companies surveyed use Linux on servers as well as open-source Web servers, databases, development tools and, to a lesser degree, desktop software.

The traditional model for starting a high-tech company is to assemble a strong engineering and management team, garner some funding and try to land customers seeking cutting-edge technology that their existing providers can't give them.

Open-source development makes that process shorter, accelerating the time to market and reducing the overhead required to run the company, proponents say. And open-source projects can yield high-quality products, comparable to "closed source" software, because a large group of contributors can view the source code and spot bugs.

SugarCRM, for example, built its sales application entirely around the popular "stack" of open-source infrastructure software that includes the Linux server operating system, Apache Web server, MySQL database and the PHP Web development language. The Cupertino, Calif.-based company didn't even have to purchase a hardware server to build its software; a hosting company in Connecticut provides that service more cheaply.

"I really don't think we're going to see companies like SAP and Oracle being created anymore, because the price points that sustain those companies will be shrunk by open source."
-- Josh Stein,
Draper Fisher Jurvetson

Going the traditional route of acquiring commercial software licenses and buying new hardware can easily add up to hundreds of thousands of dollars. Commercial open-source companies can also have dramatically lower operating costs than traditional software companies, experts say. Rather than plow half of a company's budget into sales and marketing, commercial open-source outfits can rely on the word of mouth generated from open-source projects. Lower operating costs, combined with low-cost or free products, allows open-source companies to compete aggressively on price, adherents say.

Many enterprise software companies are already struggling to stimulate new license sales, despite a general upturn in technology spending.

"Software today is ridiculously overpriced," said Josh Stein, an associate at Draper Fisher Jurvetson, which invested in SugarCRM. "I really don't think we're going to see companies like SAP and Oracle being created anymore, because the price points that sustain those companies will be shrunk by open source."

There are various business models for capitalizing on free software. One model, used by Red Hat, is to charge customers subscription fees for services and support around free software. Open-source database company MySQL has a commercial license for customers who want a support contract and a separate open-source license. Other companies, such as toolmaker Zend Technologies, charge for commercial products that are more functional than the open-source versions of their software. SugarCRM plans to charge for services around its software and will also offer its product on a hosted basis.

Still some rough edges
But despite its advantages, the open-source development business model still has significant challenges.

Software providers with a predominantly "closed source" model--Microsoft, Oracle and the like--can closely guard their intellectual property. But with different contributors to a single project, open-source development has the potential to introduce legal snags, something both software companies and their customers need to address.

"You need to get the proper licensing and identify all the open source code with proper documentation, including copyrights and other attributions," said Doug Levin, the CEO of Black Duck Software, which sells software to automate the process of separating open-source from proprietary source code. In an indication of the importance of legal protection, Black Duck last week open-source foundation, for example, was founded with a $40 million investment by IBM and is staffed largely by commercial software companies, not volunteers.

Indeed, established software companies, such as BEA Systems, Computer Associates International, IBM and Novell, have spearheaded open-source projects as a way of vetting new code and getting their products into the hands of potential customers.

"Investors, VCs and (customer) companies will start to recognize that open source is a great way to complement existing commercial efforts," said Dave Cotter, director of developer marketing at BEA Systems. "Good code is good code."

Until now, open source has had its biggest impact in the market for infrastructure software components, because software programmers who contribute to open-source projects are also potential customers. Developers, for example, have helped popularize open-source databases, Java application servers and development tools.

Matrix's Skok said that open source is best suited for breaking into mature markets, where cheaper open-source alternatives have the potential to steal customers from incumbents. New companies are already looking to expand the breadth of products offered in an open-source model.

Gluecode Software, for instance, is offering typically high-ticket infrastructure software for Web portals and business process management on an open-source basis. The model allows it to heavily undercut market heavyweights BEA, IBM and Oracle on price, said Gluecode CEO Winston Damarillo.

SugarCRM's is one of the few commercial open-source companies to take on open-source business applications, which is still a largely unproven market. But CEO Roberts, who has been bowled over by rapid adoption of his company's product, vows to stay committed to the open-source community his company helped form.

"The power of the commercial open-source business model is that you're tapping into the collective intelligence of your community," Roberts said.