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Venture Dollars Flow to Open Source

Wall Street is learning to love a new business model -- 'free' software companies.
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Open-source software, once seen as the province of propeller heads and anticapitalist visionaries, is winning the respect of the most clear-eyed capitalists of all: the venture capital community.

In the last few years, venture funding for open-source companies has jumped from $72 million in 2002 to $262 million in 2005, according to Venture One. Meanwhile, the number of open-software start-ups funded in those years climbed from 11 in 2002 to 30 in 2005.

Open-source companies have received just a small fraction of the total VC money going into technology. Indeed, "conventional" software start-ups garnered $5.5 billion in venture funding last year, 20 times more than their unconventional siblings. But investors with long experience in the tech wars of Silicon Valley say the momentum behind open-source software is stronger than it appears.

"Waves start long before you see them on the surface," says Ann Winblad, co-founder of Hummer Winblad, a San Francisco-based venture fund. "We've long since learned that open source is not about free software."

Red Hat


, which supports a popular version of the Linux operating system, is perhaps the best known open-source provider, with revenue that has grown from about $80 million in 2002 to $278 million in its fiscal year 2006.

Profit has grown as well, from a loss of 83 cents a share to a gain of 41 cents a share this year. But unlike Red Hat, the new wave of open-source start-ups are applications companies.

Azure Capital, for example, has invested more than $18 million in open-source start-ups since 2002. Its portfolio illustrates the breadth of open-source applications companies, including Zend, which makes development tools and languages; Medsphere, a developer of medical information software; and Fonality, which sells open-source-based PBX systems.

Although Azure is now an enthusiastic backer of the segment, it was a struggle to overcome the built-in distrust of open-source evidenced by many industry veterans. Mike Kwatinetz, a general partner in the firm, says, "We didn't want to invest in a company that thought of itself as communist."

Kwatinetz, who was speaking tongue-in-cheek, was making a serious point. The open-source business model is radically different from that of conventional software companies, and the cultural differences can be profound.

Red Hat's business model has a number of subtleties, but in general it works like this: Potential customers can download Red Hat's version of Linux and try it for free. If they like it, they may then buy a subscription from Red Hat that provides support, upgrades and access to newer versions of the software.

Unlike conventional software, open-source software functions under a general license that gives customers access to the source code, and they are free to modify it as they see fit.

Meanwhile, tens of thousands of open-source programmers hammer out patches and additions to open-source software and make their work freely available to users.

Siebel, No; Open Source, Yes

The growing popularity of open source in the business world is based, in part, on dissatisfaction with expensive -- and often unsuccessful -- installations of mainstream software.

Siebel Systems, for example, developed a terrible reputation (deserved or not) for installing problem-fraught customer relationship management software. Eventually, the former highflier was

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forced to sell itself to




In contrast, IT managers can download open-source software and test it to their hearts' content

for free

. If they don't like it, all they've lost is the labor time. If they do like it, they can buy a subscription instead of a license that commits them to large payments for a number of years.

Moreover, the same IT managers can modify the code themselves, or troll the Web for improvements hammered out by members of the open-source development community.

The difficult part of all this is the "for free" phrase. No investor is willing to fork up money for a company that has no intention of ever being profitable. "There's always a portion of the open-source audience that is anticapitalist," says Stephen O'Grady, principal analyst with a research firm ironically named Red Monk. "But there is a substantial and growing number who are more pragmatic," he says.

Andi Gutmans, Zend's Swiss-born founder, has no compunctions about the profit motive. His company, which grew revenue this year by 100%, should be in the black by late 2007. How much revenue that represents, though, is still a secret. Gutmans will only say that it's in the "double digits."

Even so, Zend illustrates an important point. If all goes well, it will reach profitability after having raised $37 million over seven years. One reason the burn rate isn't higher: It doesn't cost much to distribute software over the Web, and sales and marketing expenses are low as well.

Interestingly, though, at least half of Zend's revenue is derived from proprietary software, which adds a layer of complexity to the business model but also gives management that much more flexibility.

Medsphere, on the other hand, bases its products on open-source software developed originally by the Department of Veterans Affairs and is therefore required to remain strictly open source, says founder Ken Kizer, who not coincidentally is a former head of the VA.

The open-source business model raises other issues as well. Conventional software companies are paid when the software is delivered.

Open-source companies generally don't get money until the software is actually used and the customer likes it enough to sign up for support, says Bernard Golden, CEO of Navica, a systems integrator and publisher of an open-source-oriented newsletter. "Venture money needs to have more patience," he says.

Godzilla Meets Bambi?

And now open-source companies face competition on their own turf from conventional software giants that include



and Oracle. The database giant

began selling support for Red Hat Linux in late October.

There's some question about Oracle's claim that its support costs are much lower than Red Hat's, but having a giant stomping on one's turf is never good news. Indeed, shares of Red Hat are off 16% since Oracle entered the open-source business. They're now trading at $16.34, a loss of 40% since the beginning of 2006.

Making matters all the worse for Red Hat is the

alliance between



and Microsoft, announced in November.

Microsoft will use its massive marketing muscle to help market Novell's Suse Linux, and it agreed to a partial truce in the legal wars that slowed the adoption of Linux.

Even so, it would be surprising if at least some of the new crop of open-source start-ups don't grow to profitable maturity.

Investors, however, will have to be patient. The new class of start-ups is probably three to five years away from the kind of growth and stability needed to go public.

Will it be worth the wait? Ask Marc Fleury, the decidedly procapitalist founder of JBoss, the North Carolina-based developer of a popular open-source application server.

His company says Microsoft will use its massive marketing muscle to help mark Novell's Suse Linux

snapped up by Red Hat for a cool $350 million earlier this year. Not a bad day's work for a communist.