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Open Source: Now It's an Ecosystem

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Eighteen months ago John Roberts, Clint Oram, and Jacob Taylor decided to quit their jobs at Epiphany, a maker of customer-relationship software. The trio wanted to target the same market, but write a new application developed using open-source code. It took them only three months to create the program and just another month to close their first round of funding. Little more than a year later, their company, SugarCRM, has given away more than 325,000 copies of its software, and raised a second round of capital, for a total of $7.75 million.

Giving away software isn't your typical path for a venture-capital-backed startup. But Roberts & Co., are smack in the middle of the next frontier of the open-source movement: business applications. "No one had funded an open-source application company at that point -- it was all infrastructure," says CEO Roberts. "We broke a glass ceiling."

Consider it shattered. The open-source movement is making another big thrust forward. Entrepreneurs, investors, and many analysts say they're confident that all of a company's business software -- representing hundreds of millions in sales -- will soon be available as open source. "I don't think there are any limits," says Ray Lane, a Kleiner Perkins Caufield & Byers partner and software industry veteran.

ONE STEP AT A TIME. Many of Lane's colleagues agree. Venture capitalists have pumped nearly $400 million into 50 open-source companies in the last 18 months -- and more are on the way. That may not seem like a lot of money, but bear in mind these companies are incredibly capital-efficient. They don't need to hire armies of salespeople or engineers because the open-source community does a good deal of the heavy lifting.

Investors have funded new ventures offering everything from broad business applications like business intelligence programs that monitor company operations to very specialized applications, like running a hospital's computer systems.

Every open-source program companies download, investors say, marks one step closer to changing forever the applications business long dominated by the likes of SAP (SAP), Oracle (ORCL), and Microsoft (MSFT). Software that companies once paid millions for is now available for free via the Internet. Harried tech managers can simply download an operating system or application and play with it -- no need to free sizable chunks of the budget or get the board to sign off, as is the case with big, multimillion-dollar purchases. And since this is open source, they can customize the programs on the fly to better fit their needs.

WHOLE ENCHILADA. A new open-source ecosystem is emerging. While a big push is on to develop more applications, the movement is much broader: Tech-services companies are popping up to jump-start adoption of all of this open-source software.

Consider SpikeSource, headed by software veteran Kim Polese, who founded Marimba and is one of the original developers of Sun Microsystems' (SUNW) Java software. SpikeSource was incubated at Kleiner Perkins under Lane's watch. "We were looking at these open-source component companies like MySQL and JBoss, and every one of these things is just a little piece of a big puzzle," says Lane. "We said, 'Why don't we play the whole puzzle?'"

SpikeSource, and competitor SourceLabs, both act as a go-between for big corporations and open-source projects, finding, testing, and evaluating ideas by the hundreds. Then they consult with companies on how to implement them, and provide support if something goes wrong. For legal safeguards, there are even startups like BlackDuck, a Waltham (Mass.)-based company that digs into whatever open-source code a company has downloaded to make sure the licenses are all in order to avoid liability issues.

TRAILBLAZERS. "It was really a Wild West when we started with open source," says Charlie Brenner, senior vice-president of Fidelity's Center for Applied Technology, which manages its open-source projects. The financial services giant is an investor in SpikeSource -- and also a customer. "SpikeSource is a perfect example of a company doing for the external world what we've done internally. It's well worth the price for us."

The Linux operating system, which burst on the scene in 1991, led the first big wave of open-source software. The program, developed and maintained by thousands of volunteers, already represents a $4.2 billion slice of the $49 billion server market, and is set to grow at least 15% a year for the next five years.

In the Web-browser market, open-source champion Firefox has captured an 8% share of the business. That's not much when you compare it to the 87% share held by Microsoft's Internet Explorer. But Firefox has been steadily growing -- knocking IE's share of the market to under 90% for the first time in years. Not many software companies have been able to chip away at the giant of Redmond.

BOTTOM-LINE IMPACT. Then came infrastructure companies such as MySQL, a challenger to Oracle's database business, and JBoss, which markets open-source application-server software to compete against proprietary programs sold by BEA Systems (BEAS) and IBM (IBM) (see BW Online, 7/8/05, "The Myth of Open-Source"). So far, these companies are mostly small and private, but they're doubling and tripling in revenue every year.

More impressive, many already are profitable, thanks to the low cost of operating an open-source business. Analysts expect MySQL to make $40 million in revenue this year. "We're probably one of their biggest customers," says Greg Gianforte, chief executive of RightNow Technologies (RNOW), which hosts software that manages call centers for companies.

Gianforte says his company has slashed expenses by running entirely on open-source software. "[Open source] has a tremendous impact on the profitability of the business," he says. His tech costs, which include personnel, communications, and equipment, now run approximately 6% of revenues -- down from around 20% if he used all proprietary software or as high as 40% for top-of-the-line proprietary software, he adds.

BUZZ WORD. A gold-rush mentality is developing in open source. Many venture capitalists are so eager to find the next hot vehicle, they're going so far as to scour Web sites that coordinate ongoing open-source projects, looking for anything that promises to blossom into a business.

Entrepreneurs are every bit as eager. The words "open source" are finding their way into pitches and PowerPoint presentations around the world. After Nick Sturiale, partner at Sevin Rosen Funds, invested in open-source startup XenSource, which makes software to manage efficient use of computing power, more than 30 entrepreneurs came to pitch him open-source ideas.

Sturiale didn't fund any of them, and more than half weren't worth a second meeting, he says. "There's a flash crowd developing, and it's unfortunate," he says, skeptical that many of the deals being funded will make it. "There are too many VCs and not enough growth markets."

FREELOADING. Of course, it's too early to tell if these companies will sprout into thriving ventures and produce venture-style returns. Most business models rely on giving the software away over the Web, then either charging for a souped-up version of the program or for training, maintenance, and support.

But revenue continues to be a problem. While open-source companies trumpet hundreds of thousands of downloads, on average just about 2% of those customers are actually paying any money. After all, just because every piece of software companies rely on to run their businesses can be replicated with open-source alternatives, that doesn't mean there's a market for it, caution analysts.

The upside is that many more companies will try open-source software because it's free. The viral nature of the Web and the open-source community means companies don't need a costly sales organization. Instead of hiring expensive, experienced salespeople and investing a lot of money and time in closing deals with skeptical CIOs, open-source companies just put their code online. Developers within companies often download the software for a test drive. Word of mouth spreads the news. Before long, young companies such as SugarCRM and JasperSoft are getting tens of thousands downloads a day, without spending a dime on sales calls.

NICHE DWELLERS. Because of this low cost of entry, some companies are skirting the venture-capital route altogether. Two of the oldest and most successful application companies, Digium and Compiere, have never taken a dime of funding, nor have they needed it. They may never develop into $1 billion businesses, but they've carved a nice niche in the open-source landscape. Jorg Janke, founder of Compiere, says he has turned down numerous offers of venture-capital funding.

Compiere makes open-source enterprise resource-planning software. It's a tough category, because the program runs everything from a company's accounting to manufacturing to human resources. The software usually takes a lot of customization and can cost companies millions of dollars to install and maintain.

Even so, companies have downloaded nearly 900,000 copies of Compiere's software since the outfit was launched in 1999. Janke doesn't delude himself that big companies will pick Compiere over SAP or Oracle, but he has found interesting niches in the midsize business world -- prisons, for example. Most have several small businesses running within them, such as license-plate manufacture, and need some low-cost software to manage those operations. "We didn't even target them," he says. "They found us."

THREE REQUIREMENTS. But Compiere makes money on only a small percentage of its customer base. It relies on a network of some 60 independent resellers to do a lot of the customization its software requires. Some implementations reach the $50,000 range, but Compiere takes just a small cut of that. But with very low overhead, the company has been profitable since 2003 and is doubling revenue every year, Janke says. "Our business model isn't to conquer the world or to be super-profitable," he says. "We just want to have a sustainable business."

Companies with venture backing will have to do better than that. And because only a small percentage of downloaders are paying customers, they'll have to do far more volume than the average startup. That worries some investors.

Danny Rimer of Index Ventures has been one of the more aggressive investors in open source. Having funded MySQL and voice over Internet protocol company Skype, Rimer isn't turned off by a business model that relies on free downloads to gain steam. But making such businesses successful requires three things, he says.

First, it has to be a commodity product, like database software in the case of MySQL. It also has to be a type of software that's so common companies know what it is and why they need it before they consider replacing their existing software with a no-frills alternative. And it needs a huge market of users so frustrated by the expense or hassle of existing software that they're motivated to try open source. Rimer thinks there's opportunity for some of the service companies and infrastructure companies. But when it comes to open-source applications, he's not so sure the commodity market is large enough.

BIG GUNS. Rimer may have a point -- at least in the near term. Even the biggest proponents of open source aren't moving their entire businesses to it any time soon. "We're great enthusiasts of open source, but we're still very much committed to the systems we get from large vendors," Fidelity's Brenner says. "We rely on large-scale commercial vendors' applications, and we're not likely to move away from them."

Over time, if the software works as advertised, you can bet companies like Fidelity will move more and more of their business to open source. But it will be a gradual process -- and that could spell trouble for VCs betting too heavily on it now. "A small business that's highly profitable making $15 million year in and year out isn't going to move the dial for us," Rimer says. "We're looking to invest in major software vendors."

The new generation of open-source companies will soon get the chance to prove just how mainstream their software can become.

By Sarah Lacy in Silicon Valley

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