How Do VC’s Think About Open Source?

Question: How does the VC community deal with open source? I am working on an embedded device that can be built either way, open or closed. This decision is complicated since our group (due to past successes) is capable of funding the first few rounds internally. We won’t need external VC until the last round in order to enable full production. Which product would the VC rather see, SlimDevices (completely open) or the Zune (completely closed)?  Actual product is neither of those devices. Is the creation of a user/hacker community worth the exposure of having the source code open? What does a VC perceive as the downsides of open source?

Before I take a crack at this, I want to point you to an excellent post that Will Price at Hummer Winblad posted yesterday – The Three Most Important Letters in Open Source: CYA.

Like most things in software – some VCs get it and some VCs don’t.  Now that open source has become mainstream – initially through the commercialization of Linux but also the success of VC-backed companies like RedHat, JBoss, and MySQL – there is real history and precedent around how to create a successful open source company.  In addition, there are a set of VCs (think “individual partners, not firms”) that have a positive track record helping fund and build open source companies.

There are several different layers to the issue.  The first is the most basic – many companies use open source components as part of their proprietary products.  Several years ago VCs and entrepreneurs got tuned into the risks associated with this due to several absurd lawsuits – such as the SCO / IBM one – that created an uncertain potential future liability for these companies, their customers, and any larger company that acquired them.  As a result, there was an immediate irrational buyer backlash against open source – we sold several companies to large public company acquirers that had very tortured negotiations around their open source IP – usually resulting in unnecessarily complex IP representations in the purchase agreement, actually code modification as a condition to closing, or fundamental challenges in getting a deal done.  As people began to understand the liability dynamics better and products for evaluating source code for open source emerged (including several that are VC backed), this started to settle down and today is in a much more rational zone.

Next is the actual creation of commercial company around an open source product.  Many successful open source products have a small number of key architects (and often one “king of the project.”)  A relatively small set of people have figured out how to effectively commercialize the companies and – as a result – you’ve seen some impressive businesses built around open source projects.  The key phrase here is “a relatively small set of people” – the vast majority of software VCs don’t really understand open source in any great depth – especially when you get into the intersection of community, legal, and commercialization issues.  As an entrepreneur – this is yet another case where you should make sure you are filtering your potential universe of funders carefully and trying to evaluate early whether or not someone will get it.

The question asks very directly “what’s the downside” and “is the creation of a user / hacker community worth the exposure of having the source code open.”  These are tough questions to answer because they are circumstantial in nature – most commercialized open source projects either emerge from (a) an existing open source project that becomes popular and reaches some critical mass or (b) a specific product that has a software component that can be enhanced by active user involvement in the build / development of it.  Companies in category (b) are particularly interesting, as they have open source software as a strategy component of their business, usually driving commercialization theme that is attached to the software (e.g. a hardware device that is user configurable / programmable.)

Open source is undeniably here to stay and a critical part of the software ecosystem.  However, as the question forshadows, even though open source (and its father – “free software”) has been around for a while, the mainstream software industry is still wrestling with many issues surrounding it and we expect they will continue to for a while.  Herein lies great opportunities for entrepreneurs and investors.