How to keep investors happy when you have an open source startup
👋 Hey, it’s Jaime. Welcome to my weekly newsletter where I share how thriving open source projects grow their communities.
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In this week’s newsletter, I’ll share a bit about my early financial mistakes with open source, and we’ll cover what to look after to keep your open project financially sustainable, and eventually what you need to fulfil to go after private investments.
My open source journey
When does an open source product need funding?
A/ What investors look for
1. Is this a viable project?
2. What’s the competitive advantage?
3. Who forms the team?
4. Is it the right timing?
B/ Is this an idea worth investing in by an investor?
5. Scalability
6. The exit
If this is not you because you’re a bootstrapper, a public agency or a non-profit, feel free to skip it, next week I’ll come with more content you should be interested in.
Read time: 26 minutes
Making ideas available for the benefit of everyone is a wonderful project. Open source allows people to study, improve, modify and even commercialise an idea that has the potential to change the world for the better.
And it does this without creating artificial scarcity or bottlenecks through intellectual property.
But when we try to do this in a business context, investors are usually reluctant to fund organisations that don’t lock their intellectual property behind patents, copyrights, or any other form of enforceable legal restriction.
My open source journey
But before we dive in, a disclaimer.
I’m not particularly eager to talk about myself, as I’d rather talk about the people who inspired my journey, as I usually do on this channel. But telling you about the journey that led me to write this article will help you better understand the ideas I’m presenting.
In 2012, I was trying to build a startup promoting open source principles.
It was a platform to crowdfund open source prizes—think the X-Prize, but open source and funded by communities. For example, if you wanted to invent tights that wouldn't break, you could gather a community of people who are also interested in such a product to raise funds and launch a prize.
If someone found a way to invent these unbreakable tights and open source the design so anyone could use, study, improve, produce, sell and keep sharing them, they would be awarded the prize and public recognition for making and sharing the invention.
To say I didn’t know what I was doing in my search for investors is an understatement. I knew that when investors heard an entrepreneur doing open source, the image that popped into their minds was a guy shooting himself in the foot.
But I didn’t know how to reconcile the idea that open source and profitability could go hand in hand. So I tried to talk a good game. To write down some flowery language and get excited about it. Spout my ideas as if they were new and special. But it was pretty hopeless, and at that time, I didn’t know any better.
(The irony is not lost on me that I could have crowdfunded my own platform…)
But I’ve come across many entrepreneurs who still ask themselves the same question: I want parts of my business to be open source because it can spread our impact, build a community and help many more people, but how can I make money and keep investors happy?
Each time I’ve heard this question, it used to bother me, because I could relate and had no articulated answer. But the more businesses and investors I work with, the more I see that there is a way that both can co-exist.
And the answer is now coming from the open source software movement.
The open source movement started with fringe players, with projects that seemed to be worth nothing since it was pretty easy to copy them and turn them into worthless commodities.
But over the last 30 years, 200 companies have been founded with open source as the core technology. And collectively, these companies have raised $10B, of which 80% came after 2005.
And these investments have turned into IPOs and large M&As.
In 2008, mySQL was purchased by Sun Microsystems (which Oracle later acquired) for $1B dollars. And for a long time, nobody thought an open source company would ever break this mark.
But in the last few years, companies like Cloudera, MongoDB, Mulesoft, Elastic, and GitHub have been a part of multi-billion dollar IPOs or M&A deals.
Source: Peter Levine and Jennifer Li
And of course, there is RedHat. In 1999, it went public at $3.6B, and in 2019, it was sold to IBM for $34B.
A few innovations have driven this transformation from open source as a commodity to open source as a virtuous business engine, like the development of SaaS solutions, sharing the core of the technology in open source and professional solutions as a paid service, or paying for support.
Sharing an idea is great to increase the speed of innovation, to drive adoption without the barriers of patents, and to improve reliability by letting others peek into what’s not working.
But what has also helped hugely is that the business models have matured by leaps and bounds.
Red Hat has shown that a support model, where clients can access the software for free, but pay for the support and added services can be made scalable.
Wordpress has shown how selling hosting, tooling and operations can be a great open source business that drives millions in revenue.
Arduino, an open source electronic micro-controller, has proven that a physical product, where clients can fiddle with the electronics and access the designs can scale by becoming the standard in the industry.
And companies like Confluent or Elastic are other examples of companies giving away their technology’s core in open source.
And less known actors like Adafruit, Aleph, or Laravel have grown and spread at incredible speeds thanks to their open source approaches.
So 2023 has seen many open source software projects explode in valuation. But I predict that many projects adopting open source approaches will also reach the same heights outside of software in the coming years.
And this will be hard to achieve if private and public investors don’t support this movement. Normally, we wouldn’t expect these projects to be worth much, if anything, since they are pretty easy to copy and turn into commodities.
So the most common advice is to tell the founders of these projects to bootstrap or raise funding through crowdfunding. And even if it’s a path I would also recommend, it can take too much time or hinder the potential of many ideas that are ripe for investment.
So this article is mainly for startups, so they can understand the elements they have to present to an investor so he can invest in your project.
But if you’re an investor, this article will also serve you to decrypt the potential of an open startup and look for private funding.
Keep reading, and you’ll find out.
But first:
When does an open source product need funding?
Startups, or any company, whether open or not, need funds when they grow, and their profits are not enough to fund that growth.
Here comes the paradox of growth.
The faster you grow, the more cash you need to keep your head above water. The more you sell, the more cash you’ll need to build your stock and invest in your team and infrastructure.
Let’s look at an example of a company that has doubled its growth from Brewdog’s book, Business for Punks:
So to prevent the growth of your open product from strangling your cash, you will need to have a financial strategy to fund the increased tension on your cash flow.
This applies to any company selling physical products, whether clothes, cars, electronics, or other things. The more you grow, the more people you need to hire and pay, the more tools (offices, printers, professional tooling, shelves, …) you need to plan for each new hire, and the more inventory you need to prepare.
As we saw before, the more you sell, the more you manufacture, and the more money you need to fund the growing product and material stocks. That’s what’s called a working capital requirement (WCR).
And there are five ways to fund your working capital requirements without raising funds:
With your savings. In other words, the benefits you’ve been able to set aside from years past. But when your sales double from one year to the next, you would need to make huge economies to fund the next year.
You can borrow from the bank. But these are not the loans they prefer to make because if you can’t pay them back for any reason, they won’t be able to sell your product stock and would lose more money than if they sold materials or real estate.
Getting money in advance from your clients. This is crowdfunding, or pre-sales. When you have more sales than the capacity to produce, you can invite your clients to pre-buy their products while you develop your workshops, teams, and capacity to make more. People are ready to wait a few months for something they want to buy and support. Without crowdfunding, we could only sell whatever we have in stock, and your sales would stagnate. We’ll cover crowdfunding more in-depth later.
Getting a loan from your suppliers. Your suppliers are also interested in developing their businesses, and supplying growing companies enables them to grow. As you grow, so will your requirements for their products. They might charge you a higher interest rate than a bank to ensure a higher rate of return for themselves, but both of your interests will be aligned to make it work.
Getting better payment terms from your suppliers. Another way suppliers can help you improve your cash flow is by extending your payment terms in exchange for an extra percent per invoice. Going from paying your suppliers in 10 days, 90 days, or even 120 days can allow you to invest that cash into growing your company to sell more to your customers and buy more from your suppliers.
But let’s not get ahead of ourselves. Funding needs and options vary wildly depending on your business's stage. This could be divided into more stages, but for the sake of simplicity,, I’m going to simplify this to 4 stages and their common funding sources.
Basic and Applied Research (R&D):
This is often led by universities or private-public partnerships and funded by governments and universities through grants or public loans. This stage holds the most risk since the chances of new research finding a commercial use can be pretty low. That’s why venture capitalists, banks, and other private investors don’t like participating in this phase.Idea vetting and pre-commercial testing (ideation, prototyping and market validation):
This is the phase where research has found some first applications. This phase is led by an entrepreneurial team ready to test this idea, take it to market and see if it can find a sustainable business model. This is generally funded through the entrepreneur's personal funds, through friends and family, lines of credit, business angels, and ideally through crowdfunding. This stage still holds a lot of risks, but less than the previous R&D phase.Establishing commercial viability:
Once the idea has found its first viable applications and customers, it’s time to find enough traction and sales to make this a viable business, build enough stocks, invest in machines, employees, and new projects. Business angels, venture capital funds, public or bank loans, crowdfunding (product pre-sales), and crowd equity (selling shares of the company to the community) can fund this stage.Large-scale deployment:
At this stage, the idea is well settled and less prone to risk, as it has been proven in the market and has the potential to scale to new applications and markets. For that, it's going to need lots more funding. There are different paths to fund this phase: Exiting to the community (crowd equity), selling the company to an established company in the industry (merger and acquisition), selling the company’s shares on public or private equity markets (Initial Public Offering or IPO), or bank debt.
Source: Inspired by The Entrepreneurial State, by Mariana Mazzucato
Let’s look at an example from France of what this looks like for startups that adopt open source principles.
1083 is a company that manufactures aesthetic, locally produced, and sustainable jeans. The founder, Thomas Huriez, had some retail experience, and he couldn’t stand the ecological nightmare of jean manufacturing. And since it was too hard to find jeans manufactured locally to change anything, in 2013, he decided to rebuild the French jean industry that had little by little outsourced its manufacturing to other countries and disappeared in favour of low-cost globalisation.
The first step for 1083 was launching a crowdfunding campaign for its open source jeans through Ulule. They were looking for 100 pre-orders, and got 936. This success gave them the starting point they needed.
But they’ve always suffered from having more demand for their jeans than they can produce.
So through their transparent marketing, where they keep their customers updated on any manufacturing delays they experience, they’ve built a solid and trusting relationship with their community. This trust allowed them to establish a pre-sale system where customers would always order, knowing they would wait for a few months. This presale system allowed them to get the cash in advance to buy the materials and the machines, train and hire the people, and build their local manufacturing capacity.
Each time they launched a new product, it came with a crowdfunding campaign to gather the necessary funds to launch a new production line.
After selling over forty thousand jeans, which is very respectable but still felt like a drop of water in the French market, the company decided to launch a crowd equity campaign with their customers. They raised 1.083.000 euros to keep funding the industrialization of a circular way to extract cotton from used jeans that can later be reused in new jeans.
Ok, now you’ve got the big picture of how funding rounds can play out.
Today I’ll look into what private investors look into, but if you’d like me to dig deeper into other funding sources, like banks, public grants, crowdfunding or crowd-equity, let me know in the comments.
A/ What investors look for
This is the million-dollar question. Before asking for funding, it’s important that we get inside the investor’s shoes. If you can do this, you’ll be able to get investors to listen to you.
So what’s in it for them, and what does their world look like?
Investors are either investing their own money, or investing for others. And normally, they invest in multiple projects as if they were bets.
Imagine they invest 10 euros in 10 projects, 8 euros will go down the drain because these are high-risk investments, and eight companies won’t do particularly well.
So they’ll be left with 2 euros. And these two euros are the ones they hope will multiply their investments by 10, so that 5 years later they can get 20 euros where they first put 10 euros.
And this is a 15% return over 5 years. That’s certainly nice, but nothing to be crazy about if you think about it.
But to invest in 10 startups, they have to have the available funds to invest when an opportunity arises.
So imagine you’re a poker player, and when you get a full, you have no money to play.
If business angels and investors want to keep playing, they need to have money available, because otherwise they will have nothing for when great opportunities arise.
But what is an opportunity for them?
An opportunity is investing in big companies, but only when they are still small.
They want to understand what the vision for the project is and how it will become big. And they look for the difference between someone looking for a miracle and a visionary.
The miracle seeker is the only one to see something.
And the visionary is the one seeing things others are also seeing, but don’t know how to reach them.
And one way to show that you’re not a miracle-seeker is to show that there are many others who have tried earlier, just like Odoo came after SAP, Wordpress came after Blogger, Gitlab came after Github, or Mattermost came after Slack.
And how do they evaluate if they are going to invest in a project?
Here are the main areas they look for: Does it solve an existing real problem? Is it a viable project? Is the team able to build this project and tackle this problem ? And is it worthy of investing?
Let’s look at each of these in more detail.
1/ Is this a viable project? Is this market clear and defined?
Regardless of whether the project is open or not, investors will want to understand who the people behind this market are and whether the product fits the market.
Normally, investors go looking for big markets to tackle, and for product-market fit.
But with open projects, investors can’t just look for product-market fit. They have to look for 3 things to happen at the same time.
Is there a product-market fit? Is their project-community fit? And is there a value-market fit?
Sounds complex? Don’t worry, it’s actually quite simple, and each of these “fits” creates virtuous cycles among themselves.
Let’s see how this works:
1/ Product-market fit, is about the adoption of the open source product by users. This is measured by downloads, starts on Github and usage.
Peter Levine defines it this way, and gives a word of caution:
“Once you have a project leader and active group of collaborators, the next phase is to understand and measure product-market fit. In this process, project leaders need to crystalize: what is the problem the open source project helps to solve? Who is it solving that problem for? And what are the alternatives in the market? Without a clear understanding of your users and their use cases, projects can be pulled in many directions and lose momentum.
When the above questions are answered, you’ll observe organic adoption, as measured by the number of downloads. Product-market fit is the precursor to later sales engagement. Ideally, OSS users become top-of-funnel leads for value-added products or services.
While working on product-market fit, it is important to think about what will delineate your commercial product and how you will deliver value that someone is willing to pay for.
A common pitfall is that sometimes an Open product can be too good. The product-market fit may be phenomenally good, such that there is no need for value-market fit, meaning there is no natural extension to drive revenue. As a result, while you are driving organic adoption, you and your community should consider carefully what you may expect to commercialize in the future.”
To measure product-market fit, investors will also look into the “quality” of partners, users and use cases. The actual companies and users using the product and their production use cases are even more important than the speed of adoption:
How many users trust the project enough to use it in production?
What’s the size of the users and their budgets? Larger companies are more likely to have the budget and scale of smaller ones. Do users have access to a budget with high potential to pay over time?
Does the project have influential users who can drive new tool adoption?
Is there a large addressable market, or is it serving a niche audience?
Is it sticky? Is the open tool integrated into the user’s day-to-day workflows?
2/ Project-community fit. This is about the potential of an open project to attract a community of contributors. This community can be either promoting, sharing, contributing ideas, data, code, translations, filing bugs or organising events on their own.
To show that you have project-community fit, you can measure its mass and traction by looking at its following and popularity. For software projects, we might be looking at GitHub stars, the number of collaborators, the growth of the Slack/Discord community, or the number of pull requests. But depending on the nature of your project, it can be any other meaningful contribution to the development and diffusion of the project.
And most of the time, the community gathering effort is an effort that has to be driven by the project leader, who is generally the CEO of the commercial entity.
“Achieving project-community fit requires high touch engagement and continual recognition of the developer community. The best project leaders will reach a delicate balance between inclusion and assertion — making clear decisions to provide project direction while making sure everyone’s voice is heard and contributions are recognized. When this balance is struck, the project will sustain healthy growth and attract more people to contribute to and distribute the project. and distribute the project.”, says Peter Levine, a developer, entrepreneur, and investor who works with open source for more than thirty years.
For example, Matt Mullenweg, Wordpress CEO has always been in direct contact with his community, both to encourage it and to show the roadmap, the values and the principles Wordpress was going to follow.
3/ Value-market fit, is about finding a value proposition that customers want to pay for. And this fit is measured by revenue, although this measure is less important when looking for pre-seed or seed rounds, according to Jordan Segall, an investor at Redpoint Ventures.
This is generally the last stage, and often the hardest to achieve.
While product-market fit is often driven by individual users, value-market fit typically centres on departmental and enterprise buyers.
But there are other business models, like the ones below:
The secret to value-market fit is to focus on what customers care about and are willing to pay for, not what you can monetise.
Often, value-market fit is less about what the product does and more about how it gets adopted and the type of value it drives. The value open source products and services provide is not just their functionality, but also their operational benefits and at scale features.
So when thinking through a commercial offering, some questions to consider are:
Does your product solve a core business problem or provide clear operational benefits, for example, reliability, scalability, lowering risks, driving better decisions...?
Is it hard to replicate or find alternatives?
Do Teams or organisations need something that is not available in the open source offering?
What’s the usage and retention rate of users?
What’s the conversion ratio of a free user to a paid user?
What’s the annual contract value or Life Time Value (LTV) of a customer?
What’s the Net Promoter Score (NPS) of paid users?
Ok. Now we have the main ingredients. Let’s put all of this together with a couple of examples.
The first example is MySQL. When MySQL launched, they developed an open source database solution that had over 15 million users of their product and 15 thousand paying customers. So 1 paying customer for every 1,000 users.
Sharing the product in open source drove their massive adoption both of contributors (community-project fit) and of users (product-market fit), but things got interesting when players like Facebook started growing so fast that they had too much to do and hired them to maintain their databases (value-market fit). And this is what made Sun Microsystems buy MySQL for $1 billion.
And the second example is Adafruit. When Adafruit launched, it started as a series of free video tutorials on how to hack electronics together. Little by little, Limor Fried, the founder, started getting more and more followers (product-market fit) asking her to sell the kits she was using (value-market fit), and this led to more and more people offering their own tutorials and hacks to create new use cases for her kits (community-project fit).
But you have to keep an eye out because if these three ingredients, community-project fit, project-market fit and value-market fit get out of sync, it can lead to 3 sorts of failures:
The open source user doesn’t lead to a buyer. In this case, you have great product-market fit, but no value-market fit.
In the second failure mode, your open project growth falls behind your enterprise sales. Here, your product-market fit may not be that great.
In the third, your commercial offering kills your credibility with developer communities. There is likely too much proprietary and not enough open source, and your open source project withers.
This might seem like a lot of balls to juggle together, but there is a way to keep it simple and prevent these failures. Mainly focus on the top of your funnel, the one that drives project-market fit, community-project fit and value-market.
Invest first in your developer community, open source projects, and users ahead of formal marketing and sales.
And to keep yourself in check, never lose sight of these three central questions:
Who are your users?
Who is your buyer?
And how are your open source and commercial offerings providing value to each other?
2/ What’s the competitive advantage?
Now you have the elements an investor needs to understand the viability of your market as an open source product: community, adoption and buyers.
But that’s still not enough. They are going to need to understand your competitive advantage so that no competitor can enter the market and turn your idea into a commodity.
Because at the end, you’re either different, or you’re cheaper.
And for open projects, if your code, processes, data, design or whatever else you’re sharing is not an unfair advantage, what is?
The answer goes back to what we saw that makes open source so powerful to begin with: Community and how you think about the development of your project. Independent open source companies have four big competitive advantages:
In software or hardware, enterprise customers don’t want vendor lock-in.
They want to buy from people who have written the code or built the project.
Big companies don’t have your expertise.
The community and ecosystem built around the founders who started the project
When you combine those four things, you have a real competitive value-add that no closed alternative can equal.
This is what has allowed Adafruit, Sparkfun or Arduino to thrive despite the relentless competition from Chinese copycats.
Or how TED talks have built a media empire that keeps the summit in front of other conferences all over the world.
Or how Wordpress has stayed strong against simpler, more polished or more robust alternatives like Squarespace, Drupal, Joomla and plenty of others. And this competitive advantage is also the reason why we have not yet seen big clouds fully displace stand-alone open source companies.
If you could gather this kind of community or expertise, would this competitive advantage allow you to stay relevant and face any competition?
3/ Who forms the team?
The third thing an investor will ask you is who forms the team. Is the team experienced? What’s their relationship with the community? Are there complementary profiles with different skill sets, or does everyone have the same background? Is the founder alone, (in which case he doesn’t have a team)?
For example, having a diverse team with a technician or product developer, a salesperson, a community manager and a businessperson (someone who understands a balance sheet, how to hire, how cash flows, how to lead and motivate, knows how to talk to a bank, etc.—everything that involves running a business) is more important than having 3 technicians but no one who is going to take care of sales, the community or hiring. That’s not a team, but the same person 3 times.
Is each person in the team capable enough to do what they have to do and fulfill its role?
That doesn’t mean they have to have a lot of previous work experience, but they have to understand how to do the role they’re meant to fulfill. It might also be necessary to have some previous industry knowledge or contacts to understand the ins and outs of the industry the company is going to develop itself.
When opening a project, if you do the community-fit part well, you might find the profiles you need among the community itself and form a solid team.
4/ Is it the right timing?
The fourth criteria investors will be looking at is timing. What signs can you share to show that it’s the right moment to launch this project?
Entrepreneurs have to prove in some way to investors — and to themselves — that they are going to be able to make it work in this moment for any reason:
Because a window of technological opportunity has opened
Because a given breakthrough has made it possible to do something that was previously impossible
Or whatever other reason you have realised
For that, it’s important to know the previous tries and to understand why they failed and what has changed, which makes it not impossible to make it this time.
B/ Is this an idea that is worth investing in by an investor?
If you’ve been able to show that you’ve cleared the four previous steps, now you can show that the project is viable. You have a competitive advantage, a solid team that’s able to build and sell this project, and the timing is right.
Even if you’re not seeking funding, these four points can help guide your own project and see what you might be missing.
But if you go for investors, they will need two more things to establish if this is going to be an opportunity that has enough potential to make their own money: scalability and a clear exit.
Let’s see what this looks like:
5/ Scalability
For an investor (an angel investor or VC) to invest in a startup, it has to have the potential to become very big in a short period of time, otherwise, he or she runs the risk of being stuck in a small company that can pay the salary of the entrepreneur but that gives no returns to the investor and needs to sustain its own business.
This, of course, doesn’t mean that creating an unscalable business is bad business. It’s just that it’s not the right fit for professional investors.
For example, investors had evidence that Unsplash tackled the huge stock photography market, was addressing billions of monthly viewers, was growing at exponential rates, and could keep up with the growth speed. Wordpress was targeting the fast growing CMS and blogging markets. And Red Hat, even if it stayed smaller relative to Windows, Amazon or Google, has always been very strong in the booming cloud market.
But there are many examples of their projects that did get the first four steps right, like Laravel, Ghost, Sparkfun or Adafruit, could perfectly bootstrap themselves without investors and without needing to scale their business at exponential rates.
6/ The exit
The investor is ready to stay in the company for a while, but sooner or later, he’ll want to exit and recover his benefit.
Before he enters, the investor needs to know when he or she’ll be able to exit.
For example, when investors entered into Red Hat, they already had in mind the IPO that was going to happen in 1999 for $3.6 Billion, and when IBM offered to buy Red Hat for $34B, the IPO investors were happy to sell and 10X the value of their IPO’d investment.
But first a word of caution. Here’s where the investor and entrepreneur have opposing interests.
The entrepreneur has put all his sweat, hopes and energy into this project and is putting all of its skin in the game.
But for the investor this is like a public bond, or real estate: an investment for which the only possible success is having his investment multiplied in a rather short time frame.
And in many contracts, the investors will insist that they are the first ones to be paid since they are the ones risking their money. So if your company didn’t grow fast enough when they want to sell it, you might be left holding the bag.
So that's why you should also seriously consider getting your customers to fund your business. Get your cash flow to fund your business. Find people who care enough about what you're building and will be ready to pay you up front for your first products just to make sure it gets built.
Once you have this money you can build the next idea. And if you don't run out of cash. No one can tell you what to do.
But if you see that all six elements we covered are there, or you are in this to build a fast growing company and sell it, finding investors might be an option to keep in your sleeve.
Conclusion:
So now you know everything I should have known when I started my journey as an entrepreneur looking for startup funding. I hope you can use it to avoid the mistakes I made and create a great project that creates an incredible impact on the world.
A few more resources that might help if you’re preparing your pitch to VCs:
Other useful Resources
So How Many Stars Is Enough? A Data Driven Guide to Fundraising as an Open Source Founder, by Jordan Segall
Can My Open Source Company Raise Series A? by Amanda Robson
Making Money from Open Source, by Amanda Robson