How to Successfully Invest in Open-Source Startups

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  Joseph RuscioGeneral Partner
  Heavybit

Investing in Open-Source Startups: What to Look for

Open-source software (OSS) leverages the power of community to create a vibrant software product that constantly evolves and improves over time. So maybe it’s not surprising that so many successful companies have made their way into OSS.

On the other side of the table, savvy investors understand the potential value of commercial open source (COSS) projects and spend their days finding and evaluating such companies.

Successfully investing in COSS projects requires more than finding the GitHub projects with the most stars. Successful COSS businesses require a team with technical savvy, the ability to maintain vibrant communities, and a commercial mindset.

Here’s what IVP General Partner Cack Wilhelm looks for when investing in OSS startups. Cack has led investments in successful infrastructure companies such as Cribl and CircleCI, having worked at Cloudera and Oracle prior.

Get even more insights into the world of OSS investing by joining the DevGuild: Open Source event.

Why Investors Look at Open Source

Joseph Ruscio: What’s one of the main reasons you invest in OSS startups?

Cack Wilhelm: I am sure my answer here does not represent the consensus for all investors, but for me, “open source vs. not open source” is not the main distinction I consider. I don’t view open source as a business model unto itself. Today, open source is functionally more similar to being a unique and differentiated marketing channel. With open source, you are trading off marketing (DevRel) dollars spent today (over sales dollars); by the time you reach $100M in ARR, those dollars will have been more than made up for in sales. I concede I am belittling the meaning behind the impactful gesture of being open source, but open source is still functionally akin to a path to market.

I personally invest in OSS businesses, in part, due to my background of having worked at Cloudera (and Oracle) prior to entering venture capital. Coming into venture capital I had a predisposition towards cloud and data infrastructure companies, where many companies have OSS underpinnings since that is what the community requires.

If you’re building infrastructure, especially data or cloud infrastructure, your user base expects that they can try it out in a very risk-free, full-fidelity way. To do that authentically, it has to be open source. Developers don’t always like the alternative of undergoing a proof-of-concept and speaking with sales, all before evaluating whether a certain technology is fit for the job. To say nothing of being stuck with vendor lock-in.

For a new founder who might be choosing open source vs. proprietary, founding and scaling a successful open-source startup might actually be harder. The community can be an asset, but startups may have to view them as another constituency to honor. A community ecosystem can be an asset for social proof and relevance but may be a liability when other vendors use your technology for their own benefit.

In contrast, if one were building an application layer company, one would build proprietary. The concept of open-source applications is not yet mainstream.

Specific Investing Criteria

JR: Are there specific, non-negotiable criteria you need to see from an OSS startup before you even consider writing a check?

CW: The first thing that comes to mind is to see clear examples of commercial, production adoption. I would like to see a handful, maybe three to five true examples, even at smaller ACV values of $10K-$15K. But real, scaled, production-level use cases that show demonstrable value to the user.

To answer the question slightly differently, here are some risks to avoid:

First, we’re trying to avoid investing in startups that may never break into the enterprise. For example, the platform as a service (PaaS) layer may never break out of the hobbyist app dev market. Not breaking into the enterprise is not necessarily bad, but it makes it harder for an investor, especially at the Series B or Series C stage, to make a meaningful mark on the world (and a meaningful return on their investment).

Second, one thing some startups get wrong is being too dogmatic about the community. We had a dose of this at Cloudera–conflict between our commercial pursuits and the reverence for keeping the community intact. On the flip side, we evangelized “Hadoop” for too long–helping the whole ecosystem–while we lost time evangelizing our commercial products. I would put Docker in a similar category, of an imbalance between the needs of the commercial engine versus the community.

Open source or not, for startups, having a community does not negate the need to commercialize your software product, especially when working within the venture capital ecosystem. (Which is not to say that venture-backed is the only avenue; one can build an interesting successful, innovative business without seeking investment. For example, Signal funds itself via a foundation as a 501(c)(3) nonprofit. Kudos to them for taking that route.)

Third, and I realize this may seem even more controversial to some, but: Is open source actually meaningful to your community and your potential customer base? Users and buyers in databases and foundational layers tend to pay a lot of attention to whether their tools are open source or not. However, further up the stack, the emphasis on open source relaxes. For example, take analytics, where you have proprietary incumbents (such as Tableau and Looker) and both proprietary and open-source challengers. I’m not sure the average business analyst cares as much about open-source code as they care about functionality, collaboration, etc. Founders would know best, based on feedback directly from their customers.

Maybe there’s an aspect of overthinking here. Founders may be thinking, “If my project is open source, it has to adhere to all these important principles.” However, end users are focused on the functionality–the problem they need to solve for their use case: “Does a solution exist? Is it compatible? Can I afford it?”

What Investors Look for in an OSS Business Model

JR: What would you say is the key for OSS startups to implement a successful business model?

CW: There is no “one right way.” As time goes on there are more and different paths that have worked. The early years of open source were monetized by professional services, which in the eyes of an investor is non-recurring, lower-value revenue (such as the early years of Cloudera). Followed by the open-core model (e.g. HashiCorp) where a company maintains two teams – one for pure open source, and one for the commercial wrapper and conventional enterprise features around the core. And today, deemed most contemporary, is the cloud-hosted model, where newer companies are adopting this from the start (e.g. Databricks), and others have migrated (e.g. Mongo Atlas).

Just as there is no clear and universally repeatable path to market, there is no clear and universally repeatable path to a successful OSS business. It will depend on accepted standards at the time and the expectations of communities at the time. And I’ll reiterate that I think building a highly successful commercial open-source business is harder in the long run than building a proprietary software startup.

Predictors of Success

JR: In your time investing, is there an indicator you’ve found that reliably predicts the future success of an OSS startup?

CW: As you get into Series A, Series B, and Series C investing, we are looking for breakout potential. We are looking for companies that have a superlative and a supermetric that confirms that. The obvious answer is taking into account stars, contributors, forks, mentions, social proof (in the form of partnerships, endorsements), etc. With metrics and social proof, the trouble is it’s not obvious until it’s obvious to everyone.

Each great OSS company to date has taken advantage of an inefficiency or created their own reality, such as HashiCorp finding an opportunity with multi-cloud and achieving Switzerland status, and more recently, Tailscale observing endless innovation in storage and compute but an absence of innovation in networking; Vercel building a framework, defaulting to open with adjacent frameworks, and doggedly creating a vibrant ecosystem surrounding it; Chronosphere recognizing a need–for a cheaper Datadog–and leveraging OSS to make it a reality. Each is unique and each is powerful in its uniqueness.

Conclusion

OSS projects can have great commercial potential, but they also have unique challenges. Founders seeking funding need to prove their startups are commercially viable and can carve out a defensible corner of the market for themselves.

Get more details on what investors are looking for in open-source startups by joining DevGuild: Open Source.