Investing in Open Source Startups: Why Now?

The TechCrunch Exchange: A Weekly Dive into Startups and Markets

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Let’s begin by discussing funding, startups, and current IPO speculation.

I hope everyone had a productive week and is enjoying some well-deserved rest. However, there’s much to discuss regarding recent developments.

The Rise of Open-Source Startups

An increasing number of venture capital rounds are being directed toward startups built upon an open-source foundation. These companies often originate from existing open-source projects, frequently with the original creators of the technology actively involved.

A prime illustration of this trend is Confluent, a company that recently went public with considerable success. Its initial public offering price exceeded expectations, and the stock value subsequently increased. Confluent’s core technology is based on Kafka, a widely recognized open-source platform.

Following Confluent’s IPO, The Exchange spoke with Mike Volpi of Index Ventures, an early investor in the company. During our conversation, we explored the evolving landscape of open-source startups (OSS), which Volpi noted has undergone significant changes in recent years.

He explained that in 2015, venture capitalists were generally hesitant about investing in open-source startups, believing Red Hat represented the limit of the market’s potential.

Calculations suggest Index Ventures secured a stake valued at over $1 billion in Confluent at its IPO price, effectively disproving earlier skepticism regarding OSS.

A More Competitive Landscape

Despite his continued optimism regarding open-source-focused startups, Volpi pointed out that the market has become more competitive as more investors recognize its potential. The increased investment activity in this area is readily apparent in recent startup funding reports.

BuildBuddy, covered last December, serves as a relevant example. Furthermore, Tecton and Airbyte were recently highlighted by other TechCrunch reporters.

Interest in OSS from venture capital firms has been growing for some time. In fact, TechCrunch reported on a surge in open-source startups back in 2017. However, the Confluent IPO and the recent influx of funding rounds suggest that market demand for these types of companies has reached a new peak. (If you are developing an OSS startup and have recently secured funding, please reach out.)

A Deeper Look at Confluent's Initial Public Offering

Following Confluent’s IPO, a conversation with CEO Jay Kreps provided valuable insights. Several points from that discussion warrant attention. Below are the primary conclusions drawn:

Shifting Investment Landscapes

The traditional methods of investment are unlikely to fully return to pre-pandemic norms. While the ability of venture capitalists to conduct business remotely via platforms like Zoom was anticipated, given their technological proficiency, Kreps highlighted the success of a fully digital IPO roadshow.

This approach facilitated communication with a greater number of potential investors, and at a faster pace, than conventional in-person meetings would have allowed. The acceptance of Zoom by public market investors signals a permanent shift towards digital pitches.

Tolerance for Financial Losses

Confluent, a rapidly expanding software firm, is currently operating at a loss. The positive reception to its IPO demonstrates that sustained losses are still permissible within the current market conditions.

Kreps explained that possessing a substantial total addressable market – estimated at $50 billion for Confluent – coupled with demonstrable capital investment, justifies these losses. This is crucial information for companies planning IPOs in the third quarter, many of which prioritize growth over immediate profitability.

The Acceptance of Open-Source Models

The Exchange inquired about the implications of Confluent’s open-source foundation as it entered the public market. Was this perceived as an advantage or a disadvantage?

According to Kreps, it was definitively a positive factor. He noted the historical prevalence of open standards in technology development, positioning open-source software (OSS) as a natural progression. Furthermore, the inherent momentum of open-source projects can provide investors with confidence in the company’s future growth potential.

• Key Takeaway: Investing practices have been fundamentally altered by recent events.
• Key Takeaway: Public markets currently exhibit a willingness to support companies with substantial growth potential, even if they are not yet profitable.
• Key Takeaway: Open-source business models are increasingly accepted and valued by public investors.

Further Developments in the Open Source Realm

For those interested in updates regarding open-source software, additional news is available. Earlier in the month, Prefect secured $32 million in Series B funding. While the initial funding round wasn't covered at the time, a discussion with the company was arranged this week.

At the heart of Prefect’s operations is PrefectCore, an open-source initiative. This project assists organizations in properly configuring their data pipelines, with an emphasis on areas such as scheduling, oversight, and record-keeping. The company characterizes this type of work as 'negative engineering,' identifying it as a frequently overlooked area.

Interestingly, Prefect diverges from the common practice of providing a hosted version of its open-source project. Instead, they market a monitoring service. The company believes that offering hosted open-source solutions is a less innovative monetization strategy. Consequently, their commercial offering is an API designed to track the operations managed by PrefectCore.

Successful outcomes are indicated by consistently positive reports, signifying a well-functioning system. Conversely, any issues detected are flagged for immediate attention.

The success of Confluent demonstrates the potential for open-source startups to achieve significant growth and ultimately become publicly traded companies. Prefect further suggests that there are diverse approaches to generating revenue from open-source software.

Therefore, an increase in venture capital investments within the open-source sector is anticipated throughout the year.

Alex