The Rise of Open-Source Software & What Draws Investors to OSS
The Open-Source Investment Landscape: Exploring the Key Factors Behind the Growing Interest - [Open Source Software Evaluation - Blog Post Series #2]
In the previous blog post, we explored Origins of OSS & The Impact of Open Source Software on Modern Technology. In this blog post, we'll explore the factors that attract investors to OSS projects and the momentum that OSS is currently experiencing. So, let's get started!
In recent years, we've seen open-source software (OSS) gaining ground and even replacing some proprietary solutions. Companies are now enthusiastically trading their critical infrastructure for cutting-edge open-source alternatives. This shift appears to be only getting stronger, as major software companies struggle to keep up with new competitors who, instead of investing huge sums in sales and marketing, rely on a vibrant and diverse user community to make their mark in the market. Moreover, developers are adopting new technologies at such a rapid pace that even some of the more established open-source champions are being outpaced by younger, fast-growing open-source projects. It's a thrilling time for open-source software!
The Momentum Behind OSS
The trend of building open-source companies is accelerating, making it more attractive than ever, particularly in Europe. Here are five key reasons why:
Proven IPO and M&A market appetite — Open-source software (OSS) is an appealing space for venture capitalists (VCs), with exit multiples ranking among the top quartile of high-growth, high-margin cloud companies. This results in more capital being available for OSS companies. Successful exits, such as Red Hat's acquisition by IBM for $34 billion and Elastic's IPO, demonstrate the strong market appetite for well-established open-source companies.
Widespread OSS adoption and development within large enterprises not only for internal use but also as separate projects or spinouts. Major enterprises have recognized the benefits of adopting and contributing to open-source projects, leading to an increasing number of projects being spun out or adopted internally. This not only popularizes OSS development but also highlights its potential for innovation and collaboration among industry leaders. Examples include Linkedin (Kafka -> Confluent), Uber (Cadence Workflow -> Temporal), Spotify (Scio), Yandex (ClickHouse -> Altinity), and Stripe (Sorbet). This significantly boosts the popularity of OSS development.
Growing availability of collaboration tools — The rise of modern collaboration tools such as Zoom, Slack, and GitHub has made asynchronous and distributed work more accessible, encouraging collaboration between individual contributors worldwide. These tools have enabled the open-source community to work together more efficiently, regardless of their location, helping to fuel the OSS momentum.
Experienced, distributed, and global talent — aligns with the philosophy of open-source development, so the more companies embrace remote work, the better it is for the OSS community. As remote work becomes increasingly popular, talented individuals from around the world can contribute to OSS development without geographic limitations. This diversity of talent and ideas further strengthens the OSS ecosystem and drives innovation.
Proven monetization models — There are established strategies for turning open-source projects into commercial opportunities. Some of these models include offering premium features and support for a fee, providing managed or hosted services, or licensing proprietary add-ons that complement the open-source core. These tried-and-true monetization models encourage entrepreneurs to build businesses around OSS projects while maintaining the core values of openness and collaboration.
The momentum surrounding OSS is propelled by a combination of market appetite, increased adoption, collaboration tools, global talent, and proven monetization models. As these factors continue to converge, the open-source ecosystem is poised for sustained growth and innovation. It's essential for both entrepreneurs and investors to understand the factors that attract investors to this space, as this knowledge will assist them in making well-informed decisions while navigating the open-source landscape. In the following section, we'll delve into the factors that make OSS an attractive investment opportunity.
What Draws Investors to Open-Source Software
Reduced technical risk compared to early-stage closed-source products
For early-stage investors, the technical risks of investing in open-source projects are significantly lower because founders have already spent time building the product, often while being financially supported by their employers.
Many popular open-source projects began when their founders worked at notable tech companies. For example, Maxime Lamothe-Brassard started LimaCharlie as an open-source project while working at Google, and Jack Naglieri founded Panther while working at Airbnb (note that both startups are no longer open-source). Most employers are comfortable with developers working on open-source projects on the side, allowing technical founders to bootstrap their ideas and consider raising capital from investors only when they're ready to grow and commercialize their creations. The same is true for open-source projects originating from research, such as Apache Spark, which began as a research project at UC Berkeley in 2009 and was open-sourced in early 2010. When the founders realized its potential for machine learning workloads, they built a company around it - DataBricks - which, as of 2021, was valued at $38 billion.
When VCs invest in the seed round of an open-source project, the project typically already has thousands of free users. An investor can either fund a proprietary system that no one is using and still needs to be built, or they can invest in an open-source project used by thousands of people, some of whom may eventually be willing to pay. At the time when a VC is deciding to invest in an early-stage open-source project, there is already some customer validation: they know there's a problem, they know the founders have a solution that's being used, they know that the cost of customer support will be lower due to the community's power, and so on. All this changes the equation of risk and makes open source an attractive area for VCs.
Engineering-first product-led growth
Open-source projects enable bottom-up adoption, allowing companies to conduct a proof of concept (POC) and proof of value (POV) before engaging in the enterprise sales process. This is particularly important in industries where more and more tools are adopted by first being tried and tested by practitioners. As CISOs focus more on strategic, company-wide tasks such as building relationships with other departments, working with boards, and attracting the best talent, members of their teams are looking for new approaches, trying new tools, and discovering what can address their company's problems.
While developers and engineers are a great fit for the adoption of OSS, they don't control purchasing budgets, so founders of open-source projects should keep their monetization plans in mind.
Low customer acquisition costs
Compared to traditional proprietary tools, the customer acquisition cost of open-source projects is typically as close to zero as it can reasonably be. Since open source is available to everyone, it can effectively grow through word of mouth, referrals, and the so-called "engineering as marketing" when every time someone shares a link to the solution, it drives other people to give it a try.
Open-source projects can scale usage quickly without the need to invest in marketing and customer support. While people can play the role of marketing, the inherent transparency of the open-source model, supercharged with a passionate user base, also reduces the need for investment in customer support: instead of hiring someone who can help understand how to use the product, founders can simply design a way for users to collaborate and help one another.
Open source is an incredibly important strategy for product distribution. As Jocelyn Goldfein of Zetta Venture Partners noted at The Linux Foundation's Open Source Leadership Summit (OSLS) in 2018, "…startups are in a race with big companies to win the hearts and minds of developers, and open source is the best way to do that."
Ability to find product-market fit (PMF) quicker
With continuous feedback from the community and the benefits of building in public, open-source founders can observe how their product is being used, ask questions, and identify problems and use cases they could not have thought of on their own. Having continuous feedback from the community can enable open-source projects to rapidly validate the product-market fit for the initial free version, which can be a precursor to the PMF expansion and the introduction of revenue-generating offerings.
Innovation and collaboration
Open-source projects are often seen as a hotbed of innovation, as they allow multiple contributors from different backgrounds and organizations to come together to solve common problems. This collaboration can lead to rapid improvements, new features, and a more resilient and stable product.
Venture capital firms recognize the value of innovation in open-source projects and are keen to invest in projects that exhibit the potential for growth and continued development. Investing in open-source projects can provide VCs with an opportunity to support and benefit from cutting-edge technology that may shape the future of various industries.
Exit opportunities
Another reason why venture capitalists are interested in open-source projects is the possibility of a lucrative exit. Several well-known open-source projects have been acquired by large tech companies, such as Microsoft's acquisition of GitHub in 2018 for $7.5 billion, IBM's acquisition of Red Hat in 2019 for $34 billion, and Elastic's IPO in 2018, which reached a market cap of over $15 billion by 2021.
These exit opportunities can generate significant returns for investors, making open-source projects an attractive investment option for VCs looking to diversify their portfolio and maximize returns.
Large total addressable market
This is especially the case for open-source projects targeting tens of millions of software developers who, not accidentally, are the main consumers of open-source tooling today. The total addressable market for open-source cybersecurity tooling is smaller, especially for those targeting security professionals - engineers, analysts, architects, and the like. The security industry is maturing and becoming more technical, but the size of the TAM for projects that solve security challenges for developers is going to be much larger for the years to come, compared to those that are to be used by security practitioners.
Connectivity and the flywheel effect
A traditional company, to support interoperability, needs to hire engineers so that they can build more connectors and integrations with other tools. In the case of open source, users of the project can contribute different integrations and extensions themselves, making it possible to grow the product functionality and the number of connectors much quicker. This is especially important for cybersecurity where every organization’s needs for connectivity are different, and most customers have 30-50+ products in their environment that must talk to one another.
The flywheel effect is one of the outcomes of the connectivity: as more developers contribute connectors and extensions, more people can start using the product out of the box, which then encourages them to contribute to addressing their unique use cases, and so on.
The momentum of open-source software and the factors that attract investors to OSS make it an exciting and promising field for both entrepreneurs and investors alike. The benefits of open-source development, such as lower technical risk, engineering-first product-led growth, low customer acquisition costs, quicker product-market fit, large total addressable market, and the flywheel effect, create an attractive ecosystem for innovation and growth. As the trend of building open-source companies continues to accelerate, we can expect to see even more groundbreaking projects and successful businesses emerge in the coming years. In our next blog post, we will explore the OSS Engagement Stages and Product Journey, providing insights into how open-source projects evolve and how businesses can successfully navigate this promising landscape.