Venture Money in Open Source

prostoalex writes "Interesting statistics from VentureOne and New York Times on open source venture capital investments: "In 1999 and 2000, according to VentureOne, venture capitalists invested $714 million in 71 open-source companies." Even more interesting stats: "Most of those projects collapsed." The article talks about both successes and failures: Red Hat, TurboLinux, JBoss."

Re:Differentiate the variables

[Senjutsu]

Yeah, this smells of lying through statistics.

Most ventures fail. Most IT ventures fail, especially when the IT bubble burst.

The only relevant question is whether open-source ventures fail any more often than the average IT venture.

Re:Which is it?

[Anonymous Coward]

In terms of venture capital? A success. Very high share price at the IPO. Venture capitalists cashed out very well on this one.

Re: 80% to 90%

[icoloma]

Not correct, I think.
IIRC, they expect 20% to fail miserabily, 30% to not give any benefit at all, 30% to give very little benefits, and 20% to compense for the full stack.

according to wikipedia, "anywhere from 20 to 90% of the enterprises funded fail to return the invested capital"
http://en.wikipedia.org/wiki/Venture_capital [wikipedia.org]

Re:The Stock Market Works Differently

[Moraelin]

No. I believe the words you're looking for is "that doesn't make sense" (in which case we can argue very quickly) rather than "that simply ain't true". Because in the Real World, it simply _is_ true.

It doesn't matter if it makes sense or not, it's the way it works. The profitable core 3Com divisions being valued a _negative_ number of dollars at one point was a reality.

A _stupid_ reality, that's for sure. But a reality nevertheless.

The stock market doesn't work in the way that you own, say, a mom-and-pop bakery at the street corner. The best explanation I've ever read of it belonged to a psychiatrist-turned-stock-broker. He said it's acting like a manic-depressive.

But let's return to the point: If the company turns a profit and the money coffers grow, it still means exactly nothing, if the shares are already worth more than that.

Let's say 1 share is worth 10$ on the stock market, but only 5$ in assets (including that money coffer). That those assets grew last year by, say, 5%, making it a whole 5.25$ real worth of your share, is by far not enough guarantee to stabilize its 10$ shares. Those shares still have _plenty_ of room to fall, in spite of the company's turning a very healthy profit.

Now let's talk about the opposite situation, where the value of the assets (including that money-coffer) is _higher_ than the shares' value. It should stabilize the shares and make everyone buy them, right? Wrong. Chances are good it will just make the shareholders want to dismantle or sell the company and divide the loot. Because that loot is worth more than the shares.

Again, we're talking about a company which turns a profit.

That is, admittedly a very simplified view of the problem. The prospect of any kind of growth (e.g., that money-coffer growth) is one of the hype factors that can make investors buy. But the thing to understand is that _hype_ is the real factor, and the profits or assets are at most used to generate that hype. They are not the real things that dictate a share's value.

It's simply too much money

[Christian Engstrom]

We had a good idea, and only needed a couple million to design the software right so that it could scale as the idea got more popular.

Apparently, the limitied capital requirements you describe would be typical for new companies in the software industry. Compared to other businesses, such as manufacturing or hardware development or whatever, you simply don't need as much money.

So while getting 10M$ on a silver plate would of course be a cause for celebration for the recipient, it would normally be very difficult for a software company in its early stages to find ways of spending it productively, so that you can actually get any return on the investment.

In the article Software patents and financial investing [vrijschrift.org] venture capitlist Laura Creighton explains how it typically works. (The article is is mostly about software patents, but covers the topic of investing in software companies as well.)

An extract from the article:

Hardware companies need capital, indeed, to build factories, but the demands of Software companies are much more modest. The following is the normal development pattern of small software companies, who intend to produce a product for retail.

A few -- at most 5 -- people get together to form a company and develop a piece of software. They look for funding. Unless some of the founders have rich parents, they receive none -- because they cannot convince the lenders to lend. This is because all they have to offer is their very bright idea. Ideas about the software I intend to develop are akin to ideas about the hit-CD my band intends to produce, or the great novel I will write some day. They sound great, but only rarely live up to their dreams. In the Software industry, we have a word for such unrealised dreams. We call them 'vapourware'. And financial lenders have learned to not invest in 'vapourware', for obvious reasons.

Undiscouraged, our hero-founders decide to develop their software anyway. In order to fund their venture, they take on a consulting contract, typically in an unrelated, but lucrative field. This means that their product gets developed more slowly than would otherwise be the case. If all goes well, they reach the point where they would dearly love to jettison the consulting business, and make all of their income on business related to their new product. Or, if their consulting business is related to their product, they need to expand.

In short, they need a round of financing. This is where I come in. This is where I do my investing, and most small innovative software companies need cash to the tune of 50,000 to 250,000 Euros. This is an incredibly small sum. There is a tremendous need for this sort of funding, but it is very hard to find. And Software Patents will not help you acquire this. The amount of money you need to 'go around the corner' is one or two orders of magnitude smaller than the amount of money that you need to open a factory. It is the same problem that faces small businesses in every industry.

She goes on to explain how software patents were percieved by some to provide a solution to this problem, but how that perception turned out to be an expensive mirage calle "the Internet Bubble".

It's a long article, but an interesting read if you have the time.

It's the timing that counts with VCs

[blackhedd]

One poster said correctly that, out of 10 deals, a VC looks for 1-2 home runs, maybe 3-4 breakevens and the rest are total losses. What smart VCs do is take a perspective on the market as a whole and bet on what are the coming hot segments. Then they carefully place a few bets in those spaces. To be chosen, a company has to have a top management team, be focused (or re-focusable) on the laser-narrow segment of the market that corresponds to the VC's view, have a "correct" business model, and can check off a whole list of other variables. Everything about the company has to right, down to what color ties the CEO wears (if any).
Basically, a VC manages his risk by only choosing companies that meet a whole range of very narrow constraints, with the only degree of freedom being the specific market segment, and that is chosen by the VC.
This year, the VCs' tea leaves are showing open source as the hot space.
One very interesting comment in TFA was the initial reaction to Fleury's attempts to get funded four years ago: "you must be nuts." Since he didn't fit the VCs' pre-established business-model checkbox at that time, he couldn't get funded. The VC view of the world has changed, and now the "open source" aspect is the hot one.
Another thing good VCs always do is fund to milestones. If you don't hit substantially all of your targets, they will ruthlessly shoot you in the head and not fund your next round.
This will either win big for the early VCs or it will fail. We'll know in about a year (that's a typical length for a funding round).