A rollercoaster - as trite as that image may be - is the right analogy for venture capital investing in open source companies. And what a long, strange trip it's been.

Starting in the mid '90s, a few brave pioneers like Benchmark invested in an open alternative to proprietary software and made a fortune. By the end of the decade, everyone wanted a piece of the action. A second wave of VCs rushed in at ridiculous valuations and got their clocks cleaned. In 1999 and 2000, over-capitalized, over-valued open source companies burnt through hundreds of millions of dollars. Shame on the dumb money that gives efficient markets a bad name. Then, the bubble burst, and we entered nuclear winter followed by the trauma of 9/11. Valuations plummeted to the ground. Investors panicked and ran for the exits. Things hit bottom when the vulture capitalists waited until the CEO of SuSE Linux was in a cab on the way to file bankruptcy before agreeing to invest at a valuation set at 1% of SuSE's peak value in 2000.

In retrospect, the SuSE recap was the turning point.

In 2002 and 2003, more smart money like Benchmark, Accel, and AdAstra fueled the open source industry with much needed capital. With the sale of SuSE Linux to Novell in November 2003, the industry reached a new inflection point. Valued at 50% of its peak, the SuSE exit excited a new rush to invest in open source in 2004 (no one wanted to miss the boat). After a small dip in relative value in 2005, when Novell dropped the open source ball, venture capital investment is on the rise and valuations are healthy.

Figure 1 shows a comparison of Red Hat's and Novell's stock prices over the past nine years. Typical of "useful" statistics, this chart proves our a priori view of the history of relative valuations in the open source industry (even though Novell didn't enter the open source industry until 2003).

How Much Did They Invest?
Interestingly, it appears that the relative values in the open source industry also correlate to the intensity of money flow.

We found an article in the New York Times called "Open Wallets for Open-Source Software" (April 27, 2005) that stated that approximately $149 million was invested in 20 open source companies in 2004. A Google search turned up a VentureOne study (www.ventureone.com/) that venture capitalists invested $714 million in 71 open source companies in 1999 and 2000, most of which failed. We also found an estimate that $1.3 billion in venture capital has been invested in open source companies in the last five years, compiled by Robin Vasan from the Mayfield Fund and Matt Asay (http://asay.blogspot.com/).

From these numbers, combined with two hours of painstaking research of more than two dozens open source deals, we were able to construct the graph shown in Figure 2 that proved what we know already (it's in the air like WMDs). It proves what Adam Smith figured out two hundred years ago - supply and demand really do determine price.

So far we've examined the relative valuations and money flows in the open source VC community. Now, let's take a look at who the major players are. The graph in Figure 3 depicts venture capital firms in the blue ovals and open source companies in the green boxes, with arrows between them. Obviously not every VC nor every venture-backed open source company are listed here, but it's a good overview of the open source VC universe.

Some Opinions from the VCs
To help us understand if this is a good or bad time to invest in open source technology, we spoke with various major players in the VC community (i.e., those who called us back). Cameron Lester from Azure Capital was generous enough to discuss his views on this matter with us. Azure Capital has been quite active, with investments that include Zend Technologies, Medsphere (an open source enterprise application software company for the health care services industry), and Fonality (an open source IP-PBX systems for small businesses).

Cameron Lester's main reasons for investing in open source companies:

1. If you want to identify emerging trends, follow what the developers are doing, and many developers are to be found in the open source community. Follow them and they will teach you what will happen in mainstream markets in the future.
2. Azure's research has shown that open source adoption is a reinforcing trend. Once a certain industry segment (such as telecommunications or the government sector) starts to understand the benefits of open source, barriers to adopting open source technology will break down, and organizations will start to become more comfortable with open source.

Conclusion
As parting note, it's hard to guess what will happen in the open source software industry, specifically how relative valuations will change over time and how VCs and markets will react. Let's take a look at a basic three-month chart from Yahoo! Finance of the stock prices of VA Software and Google (see Figure 4). Notice anything interesting? Oh, you could have lost $100 a share if you owned Google between January 18 and February 18. Or, in the same month, you could have doubled your money with VA Software. This is not for the faint of heart, my friends.

Interview...

Another VC who called us back was Vladimir Jacimovic, a partner at NEA (New Enterprise Associates). He specializes in investments in information technology including software, communications, and technology-enabled services. He serves as an advisor to our friends at SugarCRM. Vladimir was kind enough to respond to a few questions about views on investing in open source companies.

Q: What about open source software (OSS) business models is really compelling to you?
VJ: What I find most compelling in the OSS business models is the recent shift from the support- and services-based revenue models to the commercial open source. In the commercial open source model, about 80 percent of the product functionality is released as OSS, which guarantees a great product for most customers. The remaining 20 percent of functionality, which is useful to only large customers, is released as a low cost commercial product. This approach ensures that the interests of the different types of OSS users are aligned with the interests of the companies developing OSS products.

Q: What are the best reasons to invest in OSS companies?
VJ: There are two great reasons to invest in the new generation of OSS companies. The first is that they have global reach from day one, and, in many cases, serve emerging markets that were difficult to reach before, such as Brazil, Russia, China, and India. The second reason is that OSS is enabling the creation of thousands of entrepreneurs who open up previously untapped portions of the market. They serve real customers by either developing extensions to the existing OSS products or implementing business solutions that include a lot of OSS."