The results are in for the first quarter in venture investing and they are positive. After a tough 2009, the first quarter resulted in a significant increase in venture capital investing. The Dow Jones report for global venture capital investments increased by 13% over last year  http://bit.ly/1Q10Glbl. The US continues to take the lead with 65% of deals by numbers (and 67% by value). This growth is confirmed by my discussions with Silicon Valley Bank who have told me that they have seen a significant increase in the number of new bank accounts opened for startups. In fact, SVB told me that the number of new accounts in March was more than all of the accounts opened in both January and February.  This increase reflects the general optimism expressed in DLA Piper’s 2010  Technology Leaders Survey. http://www.dlapiper.com/US/news/detail.aspx?news=694c8f9d-faf5-40d2-8018-7c352437288f.

The growth in the US was roughly the same as the global average at 12%. http://bit.ly/1Q10Fin.  Venture capitalists invested $4.7 billion in 578 deals. And the shift in the relative amounts of investment among industries continues to shift. For a long time, IT represented more than 50% of deals, yet in the first quarter, IT was only 32% of the deals. The IT investments in the first quarter represented a 15% increase over the same period last year.  However,  the cleantech category increased by more than 69% in the same period. 

But I think that these comparisons in the IT sector may mask the new reality of starting software and web companies where the cost of developing a product has plunged due to the use of open source software and cloud services.  In the past, a software startup would need to buy its own servers and proprietary software development tools, representing significant capital expenditures.  Now, most of my software companies use open source and other pre-existing software to “assemble” their products and host them on the cloud. They require much less money to start; and they wait to seek traditional venture capital until they are much further along in product development and distribution.

Red Hat has launched “Opensource.com” as the town square for the “open source” community http://opensource.com/should-be/10/1/welcome-conversation-opensourcecom. It provides for a single location to discuss the legal, social and economic consequences of the open source model. This site comes at an inflection point for the FOSS community: FOSS is now ubiquitous and many of the earlier battles for credibility and acceptance are won. Yet, with those victories, the FOSS community finds itself facing new challenges, such as how to deal with managing the numerous modules of open source in many products in a consistent manner (the so called “Bill of Materials” problem) and the continuing problem of dealing with patents http://opensource.com/law/10/2/looking-out-bilski-software-patents-v-foss. And open source is now being viewed as a model for collaboration beyond software http://opensource.com/business/10/2/what-could-politicians-learn-open-source-way. These discussions cut across wide variety of topics and have been spread out across many sites and blogs.  

Opensource.com provides a forum to discuss these topics in one place and the opportunity to collaborate in the best tradition of the FOSS community. However, the site will only be valuable if it is used by the community. Red Hat has done the community a great favor and provided the platform, but now the community needs to step up and participate in the discussion. Let’s get to it!

The NY Times published an article about open source yesterday which was very disappointing. The article perpetuated many of the myths and misperceptions about open source.  http://www.nytimes.com/2009/11/30/technology/business-computing/30open.html?_r=2&hpw=&pagewanted=all The first misperception is found in the title: “Open Source as a Model for Business is Elusive”.  Open source is not a “business model.”  It is a development methodology which supports multiple business models as I have discussed in an earlier post. http://lawandlifesiliconvalley.com/blog/?p=147  The article starts from two false premises: (1) open source software is released free of charge to the world and is maintained by volunteers and (2) the revenue for open source companies comes solely from “support” deals.  These assumptions are very dated.  For the last five years, much of the most useful open source software has been created by commercial companies who develop most of the software using their own employees, such as SugarCRM and Zimbra.  Similarly, most open source companies use a combination of license or subscription revenue as well as revenue from support services. For example, MySQL received revenues from licensing of a commercial edition its software as well as “support” revenues.

The most disappointing quote was the following: “Whether open source firms are practical as long-term businesses, however, is murkier.”  The problem is that the long term business strategy of most software companies is “murky” due to the rise of less expensive “open source” alternatives and cloud computing.  The fact that several open source companies were sold at very substantial multiples to their revenues suggests that large software companies view them as valuable.  Moreover comparing the profitability of open source businesses with the traditional enterprise software model fails to take into account the tectonic changes which the traditional software business model is undergoing.  In fact, the traditional enterprise software model has proven  not to be a “long term business” for many proprietary companies. You need only consider the demise of Siebel Systems and PeopleSoft. Open source software is one of the major driving forces in these changes. For example, the Linux operating system is the most serious competitor to Microsoft’s operating system business. The fact that it is supported by IBM, Intel and other large companies is a further testament to its competitiveness and value. Although the Linux code may be contributed by corporate employees, the Linux operating system is continues to be distributed at no charge under the GPL: it is truly an “open source” program.  Moreover,  Linux users do not care whether the contributors are corporate employees or individual “volunteers”.  And Linux has succeeded where proprietary operating systems from major companies, such as IBM’s OS2 failed.

The final part of the article continues the unfortunate pattern: it suggests that the sale of open source companies to larger traditional software companies is a failure of the “open source business model.” It is not. This conclusion fails to consider that more than 90% of venture backed software companies in the past three years have been acquired rather than gone public, whether they used an open source or a proprietary development methodology. These acquisitions prove little about the viability of the ”open source business model” or open source software companies. In fact, they suggest that sophisticated companies are willing to pay a substantial premium for such companies.

It is not often that the Department of Defense provides an industry with a marketing hook.  However, I can’t think of a better description of the memorandum issued by on October 16 by David Wennergren, Deputy CIO of the Department of Defense. The memorandum is entitled “Clarifying Guidance Regarding Open Source Software” (“OSS”). http://www.defenselink.mil/cio-nii/sites/oss/2009OSS.pdf and provides one of the best (and most cogent) summaries of reasons to adopt open source software. This summary is all the more persuasive because it comes from one of the most conservative IT cultures on the planet.  I have included the relevant part of the memo below:

There are positive aspects of OSS that should be considered when conducting market research on software for DoD use, such as: 

                (i) The continuous and broad peer-review enabled by publicly available source code supports software reliability and security efforts through the identification and elimination of defects that might otherwise go unrecognized by a more limited core development team.

            (ii) The unrestricted ability to modify software source code enables the Department to respond more rapidly to changing situations, missions, and future threats. 

            (iii) Reliance on a particular software developer or vendor due to proprietary restrictions may be reduced by the use of OSS, which can be operated and maintained by multiple vendors, thus reducing barriers to entry and exit.

                (iv) Open source licenses do not restrict who can use the software or the fields of endeavor in which the software can be used.  Therefore, OSS provides a net-centric licensing model that enables rapid provisioning of both known and unanticipated users.

                (v) Since OSS typically does not have a per-seat licensing cost, it can provide a cost advantage in situations where many copies of the software may be required, and can mitigate risk of cost growth due to licensing in situations where the total number of users may not be known in advance.

                 (vi) By sharing the responsibility for maintenance of OSS with other users, the Department can benefit by reducing the total cost of ownership for software, particularly compared with software for which the Department has sole responsibility for maintenance (e.g., GOTS).

                  (vii) OSS is particularly suitable for rapid prototyping and experimentation, where the ability to “test drive” the software with minimal costs and administrative delays can be important.

Open source companies should quote this memorandum in all of their marketing material. It has the virtue of being both correct and persuasive.

Mindtouch recently named the Most Influential People in Open Source in their blog http://www.mindtouch.com/blog/2009/10/27/most-influential-people-in-open-source/. I think that it is a measure of the health of the industry that it is difficult to identify those people and it is always difficult to choose only five people. Mindtouch deserves the thanks of the industry for the survey and creating an excellent list (in the interest of full disclosure, I was named in the Honorable Mentions category, so how can I disagree?).

However, I think that they should consider splitting the list into a business and technical list since they serve very different roles in the industry. Congratulations to those honored!

Although we were not able to include a separate legal track in OSCON, we have put together an independent track (with the assistance and blessing of OSCON) in a connecting hotel.  We will address venture capital financing, choosing a license, basic legal issues and understaning the GPL. The speakers are very well known to the open source community including Larry Augustin, Brad Kuhn, Josh Stein and Larry Rosen.  If you are available check out the schedule at http://en.oreilly.com/oscon2009/public/schedule/detail/10440.

We have limited space, so please come early.

In a major change in the law, the Court of Appeals for the Federal Circuit (”CAFC”) held in Transcore v. ETC found that covenants not to sue have the same effect on patent exhaustion as a patent license (i.e. a sale permitted under the covenant not to sue would “exhaust” the patent) http://www.cafc.uscourts.gov/opinions/08-1430.pdf.  

Consequently, a first sale that falls within the scope of a patentee’s covenant not to sue is considered “authorized” and exhausts the patent with respect to downstream customers and users. This holding is dramatically different from the assumptions of most lawyers.  In fact, lawyers frequently use a convenant not to sue rather than a patent license to avoid patent exhaustion. 

This issue is very important for software licensors, both commercial and open source,  because they must now rethink their approach to patent licensing.  For example,  Red Hat used covenants not to sue in its Firestar settlement to cover certain parts of its ecosystem http://www.redhat.com/f/pdf/blog/patent_settlement_agreement.pdf. This decision means that lawyers need to review their existing agreements to see how this change will effect the rights of their clients. They also need to be much more careful about drafting patent agreements. 

Another troubling aspect of the Transcore decision is its finding the covenant not to sue applied to a patent not yet issued at the time of the settlement on the basis of the theory of “legal estoppel.”

I am participating in SDForum’s Global Open Source Colloquium for the third year. This Colloquium is held the day before OSBC. http://www.sdforum.org/index.cfm?fuseaction=Calendar.eventDetail&eventID=13371  The event is always fun because it is much smaller than OSBC and permits you to interact with the speakers on a personal basis.  The speakers are always drawn from major figures in the open source industry with a leavening of speakers from overseas.

This year has a particularly interesting set of presentations with Larry Augustin as the keynote. Larry is a seasoned entrepeneur and a very successful investor in open source companies.  We will also have several panels with open source CEOs which focus on the global market. And we will have a great panel of venture capitalists who invest in open source (I know because I will moderate the panel!). 

The Colloquium will begin at 11:30 am at the Palace Hotel on March 23. I hope to see you there!

Recently, Trip Chowdry, a Silicon Valley pundit, predicted (as reported in Barrons): ’”‘almost every’ VC funded open-source company is struggling and will run out of funds within the next 6 months”  http://blogs.barrons.com/techtraderdaily/2008/11/10/trippin-with-trip-one-mans-view-of-carnage-to-come/.  I share Matt Asay’s scepticism.  http://news.cnet.com/8301-13505_3-10094221-16.html. 

Based on my experience with the open source startups who are my clients, Trip is simply wrong. In fact, I have been involved in two different open source venture fundings in the last thirty days. At worst, no more than 10% of the open source startups that I represent are in difficult straits. I have been working with startups for over twenty five years (and remember about half of all startups fail over time), this percentage is hardly unusual.

Bill Snyder makes some interesting points about the differentiation between open source companies and other technology companies (particularly Web 2.0 companies) http://weblog.infoworld.com/tech-bottom-line/archives/2008/11/nuclear_winter.html. I think that the open source companies will thrive in the current market because of their lower cost (critical as IT budgets shrink). However, open source is not business magic and open source companies need to manage their resources and costs carefully.

Matt Aslett of 451 Group notes that announced venture capital investments in open source vendors in the third quarter of 2008 was down 12.2% over the third quarter 2007, from $87.2m to $76.5m.  The overall market itself is down 6% overall.

Given the fact, that the first quarter of 2008 was the largest ever for open source investments and that second quarter investments were also significant, this reduction is unsurprising. Matt noted that the open source market is small enough so that even one missed deal can effect the statistics.  His analysis also notes that the deals in this quarter are more late stage and the average deal size is larger ($9.6m); only two Series A/Seed deals were announced.  For more information, see Matt’s post. http://blogs.the451group.com/opensource/2008/10/16/vc-funding-for-open-source-down-12-in-q3/.