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This article appeared in the January 2000 Issue of Linux Magazine. The only changes from their version and this one is the change from Verticality Investment Group to Opticality Ventures. Hadar Pedhazur made the investment when he was still part of Verticality, and when he left Verticality, the management of this investment was transferred to Opticality Ventures.

Linux Magazine (http://www.linux-mag.com) January 2000

Copyright Linux Magazine ©2000

Linux Magazine | January 2000 | TAKE THE MONEY AND RUN (RELIABLY) | Venture Capital Prospecting in Open Source's Wild Frontier

Venture Capital Prospecting in Open Source's Wild Frontier
by Wendy Goldman Rohm
Venture Capital

Angel investors and venture capitalists are swarming around the open source community these days. Red Hat's IPO created an initial buzz, but since Linux hardware vendor Cobalt Networks followed up with the fourth-most-successful IPO in history, the floodgates have been opened. Investors are now courting both upstarts and established players in hopes of staking a claim in the burgeoning open source market.

The level of interest is "remarkable," according to Eric Sink, the CEO of SourceGear, a company that is repositioning itself as a provider of Linux tools. Sink's company, best known as the creator of the open source word processor AbiWord, is in the midst of a round of venture funding, and he's felt the change since his company first announced AbiWord in August of 1998. "We've had situations," said Sink, "where a money manager will call us and say, 'Hey, I manage the money for so-and-so, they're ultra-wealthy and retired, and they called and said I want my money in a Linux play because I saw what happened to Red Hat.'" SourceGear has been courted by individual investors offering several million dollars and is in talks with traditional venture-capital firms as well. "It's amazing how Red Hat's IPO increased the visibility of Linux," Sink said. "Even retired people in Florida want to put their money in it."

Fishing for the Big One

VC Vixie
The VCs all want to hear a big story. They want to hear about paradigm shifts, and about how you're going to be the next Netscape -- all without ever understanding a single word you've told them. .....Paul Vixie, Vixie Enterprises

This gold-rush activity is proving to be a boon for some CEOs seeking funding for their open source efforts and a bust for others. For sure, taking on a VC can be a double-edged sword. After all, in exchange for their money, companies often have to offer board seats and give up control of their management team.

Paul Vixie, CEO of Vixie Enterprises, says his company has had better experiences with individual investors than with venture capitalists. "The VCs all want to hear a big story," he said. "They want to hear about paradigm shifts and about how you're going to be the next Netscape or Microsoft. Then they want to replace your management team and want an exclusive on subsequent funding rounds. And they want to bring in their cronies as managers and co-investors -- all without ever understanding a single word you've told them except 'we're going to be bigger than Netscape.'"

Vixie says venture capitalists have their place only after a company is large enough to manage the relationship with them. "Every single VC I've ever talked to wants to be more than just money, but only one so far actually has anything to offer except money."

Thus far, Vixie has relied on private investors and handouts from big vendors like DEC and Sun to support the development of BIND (Berkeley Internet Name Domain), the software used by almost every server on the Internet to translate URLs into IP addresses.

SourceGear, however, is ready to take the VC plunge. The company is currently seeking to raise a modest sum -- less than $5 million -- and in the process has learned about a "pecking order" that exists in the VC community.

"We're starting to get a real sense for the VC pecking order," said Sink. "The truly enormous opportunities go to the top pick of the VC firms, like Benchmark and Greylock. What's interesting is the next tier down, the VC firms that have to live off the crumbs that Kleiner Perkins and others leave behind. They don't always get to look at deals like us and are excited to have a potential Linux play in their portfolios."

Hadar Pedhazur, a partner with Opticality Ventures, is eyeing an investment in SourceGear. He says that one of the problems with VC firms is their reluctance to take a chance on unproven models.

"They'd much rather copy an existing success and hope that they can either refine the strategy a bit or simply throw more money at it," said Pedhazur.

Linux Magazine | January 2000 | TAKE THE MONEY AND RUN (RELIABLY) | Venture Capital Prospecting in Open Source's Wild Frontier

Source Gear Searches for Funds

SourceGear's AbiWord word processor, which is available for both Linux and Windows, has been successful, with 20,000 downloads a month, according to Sink. SourceGear also has been selling a line of development tools.

Several months ago, Sink's company acquired Cyclic Software, which had managed and supported CVS (Concurrent Versions System), version-control software that lets programmers do collaborative development over the Internet. The acquisition put SourceGear in the position of leading support provider for CVS and increased the company's prominence as a development tools vendor.

Storming the Gates

Being in the Midwest has been an uphill challenge for us in looking for venture investments, but the process is going well. The Red Hat IPO made things a lot easier," Sink said, noting that smaller VC firms are most appropriate for the modest amount of funding his company seeks. Opticality's Pedhazur is not new to such ventures and was a visionary in his early investment in Digital Creations, which has tripled in size since it open-sourced its technology. He is now chairman of the board of the company.

In fact, with Digital Creations it was the venture capitalist who promoted the cause of opening up the company's software. "We would never have gotten funded if we hadn't given stuff away," says Paul Everitt, CEO of Digital Creations. "Pedhazur led us through the business decision." Everitt added, "Before going open source we were marginal. After going open source we are hot. We are a safer bet."

Everitt thinks that the investment community has a "herd" mentality. The Red Hat IPO convinced investors that a new market seemed to be emerging. Getting funding up to that point was not as easy. "Until there is a validator, you have to fight like hell to find the one in 20 that might give you a shot," Everitt said. "As soon as there's a validator, they all come storming the gates."

That's not true just of investors, according to Everitt; it applies to customers as well -- especially those in the vaunted Fortune 500. "The people we're talking to now see us as an open source company," says Everitt. The increased recognition of the value of open source in the enterprise is beginning to open doors for customers like Zope. "Before, we were educating them about why open source was important to them. But that's no longer the case," he said.

How Zope Became Open

VC Hadar
VCs would much rather copy an existing success and hope that they can either refine the strategy a bit or throw more money at it. .....Hadar Pedhazur, Opticality Ventures

Digital Creations was formed in 1995 as a joint venture between Paul Everitt, and his business partner (and Digital Creations COO) Rob Page, and a company known as Infinet -- a joint venture between newspaper chains Gannett, Knight Ridder, and Landmark Communications. Infinet's goal was to bring newspapers online, with a full-service operation. It provided a point of presence for every newspaper and then allowed that newspaper to resell the service under its own brand. Infinet administered the service, managed the help desk and signups, and so on.

Infinet also began to develop software for newspapers. They commissioned Digital creations to create a classified advertisement engine for newspapers looking to transfer their lucrative classified advertisement services to the Web.

"Our job for Infinet was to create applications for the newspaper business, and out of that came an architecture," said Everitt. "Once we did it enough, we began to see a pattern." One of the big patterns was that its customers had customers, and those customers had customers. Infinet's newspaper customers had customers that were businesses in local communities, for example. Eventually Digital Creations realized that the best way to make its software scale was to develop an object-oriented Web application-development platform. That platform ultimately became Zope.

In 1997, the Infinet board decided to get out of the software business. The plan was to focus on being a hosting provider rather than continuing with its original line of work. When that business was sold, Digital Creations -- as part of the dissolution agreement -- got the intellectual property rights for the architecture. Infinet didn't see this as valuable, according to Everitt. Zope had been open-sourced for about a year-and-a-half, and Digital Creations decided to create a closed-source commercial application server as a "big brother to the free stuff," Everitt said. About two months after Digital Creations got control of the Zope platform from Infinet, in July 1997, Everitt received an e-mail message from Hadar Pedhazur.

Linux Magazine | January 2000 | TAKE THE MONEY AND RUN (RELIABLY) | Venture Capital Prospecting in Open Source's Wild Frontier

"I suppose you guys are looking for money," Pedhazur said. "My reaction was, hell yeah we're looking for money," said Everitt. VC Pedhazur at the time had been an information-technology director for Union Bank of Switzerland. He knew of Digital Creations' work because he had been using open source technology from the company at his bank. Pedhazur was in an extremely profitable area in banking -- global equity derivatives -- and had created an information system based on NextStep that had been a hit for his company. He added technology to it for rapid application prototype and design, and discovered Digital Creations' platform. The original technology that would eventually become Zope was at first named Bobo.

"We wanted to release it as open source," remembered Everitt, "so I had to come up with a name, and I said I'm going to come up with a name that is so bad we'll be forced to come back later and rename it!" And everyone fell in love with Bobo, he said.

Because Bobo was open source, Pedhazur could look inside and appreciate what the Digital Creations people had done. He used it to create a realtime financial data feed for his bank, astonishing customers who couldn't believe he'd done the work in just three days. Based on the work he had done with Bobo, Pedhazur wanted to put his money behind his belief. Digital Creations was focusing on a commercial version of the technology known as Principia at the time.

"He correctly realized that we were up against multi-billion-dollar companies in the application-server business," said Everitt. "It would take tons of money to go out and fail. He didn't want to put up tons of money to go out and fail."

The discussions broke off for a number of weeks, and finally the company returned to Pedhazur with the realization that it should be in the services business rather than the product business. By October 1998, Pedhazur had invested $750,000.

By November, the venture capitalist was urging the company to open-source Principia and the rest of its technology and give it away for free. "We were initially very worried that open source was not going to go mainstream and would not have coattails, and that we were going to be on the bleeding edge of something that went off a cliff," Everitt said. But the company realized that when companies make a $100,000 consulting decision, a $4,000 application server is a moot item.

There appears to be no end in sight for investment in these technology companies. Everything is in perfect alignment. .....Kirk Walden, PricewaterhouseCoopers

Digital Creations then unified its three previous products, Bobo, Principia, and another commercial product for integrating relational databases. It all became Zope, an application server for building dynamic Web sites -- particularly portal sites, content-management systems, and community sites.

"The biggest ideas in Zope are you have a rich environment for managed content. It's all managed through the Web," Everitt said.

Digital Creations' primary business is consulting, and Zope is the platform on which this business is based. "The synergy between the decision to go open source and the increase in revenue is direct. It's astounding," Everitt said.

One of the biggest surprises during the fall of 1998 was that the company found itself competing with Vignette, the Cadillac of content-management systems. Vignette's customers were the giants: Time Warner, AT&T, CNET.

Everitt recognized that, for all those sites where downtime is unacceptable, open source was a huge opportunity. They were depending on a technology that was out of their control because it was not open. "If you look at what happened to MCI when it had its outage because of Lucent, or when eBay had their recent outage, they're all based on proprietary software," Everitt said. "There's nothing they can do but watch their stock price go down. They have no control over their own business."

In terms of business model, the value proposition of Digital Creations is to create Zope as a strong platform and a powerful brand in the market. It then makes money writing applications for customers to use on top of Zope, where time to market is critical.

Linux Magazine | January 2000 | TAKE THE MONEY AND RUN (RELIABLY) | Venture Capital Prospecting in Open Source's Wild Frontier

Flush with Cash

Kevin Harvey, a partner with Benchmark Capital, the Menlo Park, CA VC powerhouse that took an early stake in Red Hat, said his firm is eager to invest in additional open source companies. On top of its Red Hat investment, last summer Benchmark made a $3 million investment in Collab.net, the Internet-based development marketplace for open source.

Kirk Walden, head of venture-capital research for PricewaterhouseCoopers, expects to see more VC activity in the open source arena reported in the fourth quarter.

"I can tell you that VC funds are flush with cash at the moment and have been for at least a year. Deal flow is critical to them. It would not surprise me that Linux companies are getting calls. It's a bit of reverse intuition. You hear of companies going begging for money. Instead, now they get calls from VCs."

Indeed, Benchmark's Kevin Harvey says that the first cold call he'd ever made in his career was to Red Hat. "There appears to be no end in sight for investment in these technology companies," PricewaterhouseCoopers' Walden said. "Everything is in perfect alignment."

Venture-capital firms themselves, however, realize there are risks in throwing money blindly at open source companies, and they are scrutinizing the business plans of their would-be partners meticulously. "We want to make this market happen," said Harvey, noting that Benchmark is not just interested in "me too" open source companies that are trying to imitate the business plans of others. "We want to see new business models and new businesses being built in the open source arena," he said.

Too Many Offers

VC Fernand Sarrat
We have talked to a lot of people, and only one very conservative firm questioned whether or not Linux was really going to make a space for itself. .....Fernand Sarrat, Linuxcare

San Francisco's Linuxcare has been courted by VCs and investors for some time, and on May 1 received an infusion of cash from Kleiner Perkins. Last year, even before the Red Hat IPO, the company had "a couple of companies offer to acquire us," said CEO Fernand Sarrat. "The activity picked up some more after the Red Hat IPO," he added. Despite the current gold-rush environment surrounding open source companies, Sarrat says the specific business plan of each company makes an enormous difference. "There are business plans out there that support strongly the interest to put money into Linux, and there are some business plans that don't. Taking free code and adding stuff to it and publishing and charging for it is a business model that can be easily blown up," he asserts.

"Our goal is to create the infrastructure of support for Linux that would have been there if a company had written Linux. There was no company, so it's our job to put the infrastructure in place," Sarrat said.

At this early stage, investors find it hard to differentiate between lasting models and models that have a higher degree of risk. "Frankly, we have talked to a lot of people, and only one very conservative firm questioned whether Linux was really going to make a space for itself or not. The rest did not question that. The focus was more in our case: What are the business models by which you will make money, are they scalable, and so forth. There is no question that customers are going to buy it," Sarrat said.

"When Linux arrives at a level where it is 31 percent of the Web operating systems, and the Web is pretty large, it clearly bypasses Solaris and NT as the Internet operating system. It's pretty hard to argue there won't be an opportunity there. If you can show you have a decent model, you're going to be in good shape."

Currently, Linuxcare is in the midst of its second round of funding. Though secretive about who the investors are, Sarrat said the company's goal was to raise $25 million, but investors are virtually throwing money at the company. "We already have been offered $300 million," he said. "Our problem is to say no."

Sarrat says Linuxcare will approach a public offering sooner than anticipated because of the enthusiasm for the company's product and business plan.

Of course not all companies are eager to rush into the arms of venture capitalists, especially companies deeply rooted in the open source ethos. A number of open source companies, including Vixie's MIBH and Sendmail, Inc. have secured so-called "angel" investment instead. This kind of investment generally comes in a much more hands-off manner than that of the venture capitalists.

"We went in search of management and money separately," said Vixie. "We'd hoped to find [them both] by talking to top VCs," he said, "In both cases we found what we needed among the community of people who were already involved in our industry."

Linux Magazine | January 2000 | TAKE THE MONEY AND RUN (RELIABLY) | Venture Capital Prospecting in Open Source's Wild Frontier

Show Me the Money

VC Kevin Harvey
We want to make this market happen. We want to see new business models and new businesses being built in the open source arena. .....Kevin Harvey, Benchmark

The venture-capital firm that has been the most active in open source investments is August Capital, which has funded open source firms Cygnus, TurboLinux, and Cobalt Networks. August Capital partner Andy Rappaport says that the rush into new investment opportunities is understandable. "I think that there are a lot of people who felt left out when Red Hat went public," he said.

"Others are investing in [Linux] because it appears to be something that can cleave value off of Microsoft in very large chunks," Rappaport said. August Capital's investment in Cobalt Networks was decided in the spring of 1999, months before the Red Hat IPO. Back in 1997, it had made its first open source play, investing in Cygnus.

Rappaport says that when evaluating a company, it is the business model -- not simply whether or not the company plans to feed off anti-Microsoft shifts in the market -- that counts.

"Our feeling is there will be places where open source software as a methodology in general, and Linux in particular, will be applied. We recognized, first with Cygnus, that the software-development methodologies are changing, the tools and services required to support those are changing, and open source is becoming an important weapon in the arsenal of software developers and distributors," Rappaport said.

Cygnus' business model was clear: It would support the deployment of software in new ways on new platforms, "and have a viable mechanism to 'tax' for it," Rappaport said. "Our thought was: Let's invest in a company that can profitably support the development community, and that community will spawn other things. It was a real business."

August's investment in TurboLinux was also well before the Red Hat IPO. "There again, we've been looking for an opportunity to invest more directly in Linux software. The thing we liked about TurboLinux was the company is going after the heart of industrial-strength, server-class mission-critical applications where the calling card is not Linux per se, but the application of it to the enterprise," Rappaport said.

August Capital wasn't really sure how much money, if any, would be made trying to get Linux installed on desktop computers, "but we know a lot of money will be made supporting enterprise-class customers who want to deploy real applications based on Linux."

August Capital's view is that Linux is creating "economic dislocations," according to Rappaport. "It's making possible things that weren't possible before, and as a result it's creating new applications and shifting money from one place to another. "And when money is being shifted, you can be sure the investors will be there to cash in."

The Players

VC firms and the open source companies they have invested in:
VC Firm Investments
Accel Partners Scriptics
AXA Placement Innovation Mandrakesoft
August Capital TurboLinux; Cygnus; Cobalt Networks
Benchmark Capital Red Hat; Collab.net
Greylock Management Red Hat
Kleiner Perkins Cauffield & Byers Linuxcare
Chase Venture Capital Cobalt Networks
CMEA Partners Linuxcare
Alloy Ventures Montavista Software
Techfarm/Techfund Capital Cobalt Networks
Vanguard Venture Partners Cobalt Networks
Crystal Internet Venture Fund Cobalt Networks
Sequoia Capital VA Linux
Opticality Ventures Digital Creations

Wendy Goldman Rohm is editor-at-large for Linux Magazine. She is the author of the best-selling book The Microsoft File: The Secret Case Against Bill Gates, and Under the Radar, written with Red Hat CEO Bob Young. She can be reached at wendy@linux-mag.com.

Linux Magazine (http://www.linux-mag.com) January 2000

Copyright Linux Magazine ©2000

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