Open source: Where the action is

Proposals to invest in open source-based software companies increased by a factor of two or three in 2006 over 2005 at Index Ventures, said Bernard Dallé, general partner at the venture capital firm.

Index Ventures invested about US$10 million in open source companies in 2006. These include investments in MySQL AB, a provider of database management software, and Pentaho Corp., which delivers business intelligence software.

For a variety of reasons, software companies are increasingly looking to add value on top of base open-source platforms. The main Linux distributor, Red Hat Inc., is a case in point.

The move in October by Oracle Corp. to undercut Red Hat on price for services shows that an open source company is vulnerable if it relies primarily on platform support for revenue.

Red Hat made its own move beyond the operating system in June with its US$350 million acquisition of Java application server vendor JBoss Inc. Although JBoss is considered open source software, JBoss, now division of Red Hat, has more control over the source code for its software than Red Hat does over Linux. With control comes a greater ability to monetize the code.

"The days of making money off the open source operating system are over," said Cameron Lester, a general partner at Azure Capital Partners LP, a venture capital firm that also has invested in several open-source startups. "These companies have definitely responded to the evolution of the industry."

Over the course of the decade the open-source realm has become an incubator for innovative business models. Venture capital money will continue to fuel developments.

For example, Zend Technologies Ltd. develops Web applications based on the open source hypertext preprocessor programming language known as PHP. It has received US$36.7 million in venture capital, including funding from Azure and Index.

Zend has adopted a hybrid business model, participating in the PHP open source community and improving the underlying code, while also offering proprietary Web applications and development tools, said Andi Gutmans, the company's co-founder and vice president of technology.

"The big benefit we get from open source is, first of all, we have a huge community that helps us to develop (PHP). We have a very large R&D team, so to speak," Gutmans said.

Zend's proprietary products give the company a unique value in the marketplace. For instance, Zend Studio 5.5, launched Dec. 6, offers full lifecycle management of PHP-based Web applications.

Members of the PHP community also are a ripe market for Zend's commercial products, Gutmans said.

By basing applications on top of open-source software, companies get a built-in adoption and distribution channel, according to Pradeep Tagare, an investment manager specializing in open source at Intel Capital, which also invested in Zend.

"As the applications get more and more specialized, the community of developers who can contribute to it becomes smaller," Tagare said. "But, by using open source as a distribution channel, these application companies can really reduce their sales and marketing costs and reduce the barriers to adoption."

Intel Capital has also invested in MonoSphere Inc. which uses the open source PostgreSQL database management platform to build its Storage Horizon storage-capacity planning software product. MonoSphere has raised $26 million from various venture capital sources, including $11 million in funding Oct. 25. Building the product on open source made better economic sense than to build it on a more expensive proprietary platform such as from Microsoft Corp.

"We basically made a cost decision," said Ray Villeneuve, MonoSphere's president and chief executive officer (CEO).

Open source software also helps Fonality Inc. undercut larger competitors in telecommunications, said Chris Lyman, co-founder and CEO. In January Azure invested $5 million in Fonality, a provider of IP-PBX (Internet Protocol-private branch exchange) telephone systems for small and medium-size businesses.

Lyman got the idea for the business when he first launched Fonality. The company was originally intended to be a residential VOIP (voice over Internet Protocol) service provider. He balked at receiving a quote for $15,000 for a mere 5-phone office IP-PBX from Avaya Inc.

"I said, 'That's our new business,'" said Lyman, and changed Fonality's business model to selling IP-PBX systems.

Fonality's IP-PBX offering is based on the Asterisk open source program for telephony management. Developing proprietary call management products on top of Asterisk enables Fonality to offer IP-PBX systems for smaller companies at about a quarter of the cost for systems from companies like Cisco Systems Inc. and Avaya.

Asked whether he's worried that they will also develop open source products, Lyman responded, "They better hurry because open source is about to eat their lunch."

Red Hat sees the open source trend as not simply moving up the software stack, but growing in all directions, said Scott Crenshaw, general manager of Enterprise Linux at Red Hat.

Crenshaw sees a second wave of open source innovation in 2007 as virtualization and service-oriented architecture, which enable operation of an IT infrastructure dynamically, become open sourced.

"The goal isn't just to move up the stack," he said. "The real goal is to fundamentally change the economics of IT once again."