6 Oct 2020

Atomico’s take on Open Source: 5 reasons to build an OS company in Europe now

Open-source had not traditionally attracted a lot of attention from VCs because there were very few successful cases of product-first, revenue-generating Open-Source (OS) companies. This changed about three years ago.

My personal journey in this space started in 2015 when I began to look at investment opportunities in OS companies at Runa Capital. We used to call them “B2G” (“business-to-geeks”) companies. These companies sell difficult to understand products which make them unappealing to the broader investment and user public, but give them untapped potential. I’ve had the privilege of working with the teams from Nginx (web-server used by 36%+ of all websites worldwide) and Keymetrics/PM2 (33k github stars, >70m downloads) and looked at many companies in the US and Europe.

Why did investor and public perception of OS change? In 2017–2018 as the world got a number of vivid proof points for the model, most notably MongoDB and Elastics IPOs, and Github’s and Redhat’s acquisitions. It’s not the case that the fundamentals changed overnight, but that OS as a category became a household term for the tech world. People saw what could be built with the OS.

Source: Elastic S-1 and MongoDB S-1

The trend has accelerated since then, and it’s better than ever to start building open-source companies, especially if you are in Europe. There are five main reasons:

1.Proven monetisation models — There are open playbooks for developing OS projects into commercial opportunities. Data is abundant in S-1’s of public companies e.g. MongoDB, Elastic, overview blog articles, and specific deep dives into business models (e.g. Open Core). Anecdotally, a consistent feedback we’re hearing now from Europe-based OS companies is that after the COVID hit and everyone transitioned to remote setups, customers started to care less about where the company is geographically. While previously, not having sales in the US was cited as #1 reason to lose deals and why people wanted to move from Europe to the US after a Series A raise.

Source: Joseph Jacks via CB Insights

2. Proven IPO and M&A market appetite — With exit multiples within the top quartile of high-growth high-margin cloud companies (e.g. BVP Cloud Index), OS is a very attractive space for VCs, and therefore we see more capital available for OS companies. European companies have even been acquiring US-based startups as in the recent cases — SUSE acquisition of Rancher (rumoured to be valued at $600m-$700m) or Elastic acquisition of Endpoint for $234m.

3. Proliferation of OS use and even development of OS inside of large enterprises, but also spin outs as companies or separate projects. For instance, in the US — Linkedin (Kafka -> Confluent), Uber (Cadence Workflow -> Temporal), or with Europe-born — Spotify (Scio), Yandex (ClickHouse -> Altinity) and Stripe (Sorbet). This massively popularizes OS development.

4. Proliferation of collaboration tools — Tools from Zoom to Slack to Github have made asynchronous and distributed work easier and fostered collaboration between individual contributors. We’ve also seen the appearance of tools such as Gitduck that are tailored for developers specifically in remote setups.

5. Experienced, distributed and global talent matches the philosophy of OS development, so the more companies switch to remote work, the better it is for the OS community. Moreover, many more experienced people from companies such as MongoDB (e.g. Jetstack) and RedHat (e.g. Tidelift) are ready to take on new challenges of building and scaling open-source companies. We can’t wait to see more people from Elastic, Nginx, MariaDB, SUSE, and many other companies in Europe do the same. FWIW Europe now has at least 3m+ contributors on Github which is more than that number in North America. Though previous analysis in 2016 and our own recent analysis unanimously showed that geodata is inconclusive for many Github accounts, it’s still a very positive trend. In any case, for Europe specifically, there are many talented developers outside of large tech hubs who don’t have access to a mature capital and talent markets or where work from home capabilities are still lagging behind. Moreover, one can also leverage high-skilled talent at a lower cost base. These developers are looking into OS as an opportunity to develop their portfolio and community recognition.

Source: Patrick Liebig via LinkedIn

Given all these factors, European OS is on the rise in terms of company formation and funding. A comparison of absolute numbers of startups in the US and EU on Tracxn shows 3.5x more VC-backed OS companies in the US vs EU. In 2019, OS funding in the US was 10x more that of Europe. One shouldn’t expect parity in the nearterm, and building an OS-first company is definitely hard.

However, despite all the successes we regularly read about in the news, the road can be bumpy. We’ve seen some companies that pitched in 2015–2016 sadly go out of business, while others have thrived. Time to failure might differ depending on where the company fails to reduce the risk factors. Sometimes those factors become a roadblock when companies try to raise an investment round, but often companies get credit ahead of their stage and challenges get kicked down the road. Based on 75+ conversations that I’ve had with OS entrepreneurs, the most likely reasons for a failure are:

  • Open-source model is far-fetched — as the OS becomes more popular, some teams pitch their solution as “We are like company X, but Open-Source”. Unfortunately, many times there is not a clear ‘why’ an OS replacement of X is much better positioned to create value, therefore teams struggle to get community adoption.
  • No credible way to build a product rather than a feature — Enterprise customers usually have very good price consciousness (many times based on “gut feeling”) and therefore they won’t buy something that can not be productised and doesn’t have an entire set of features.
  • Tech Leadership challenge — The founding team might have very good technical capabilities as individual contributors (IC), but it takes much more to build a tech-focused organisation. The transition from being an IC to being a Tech Leader is a challenge that founders have to overcome.
  • Strong technical team, but no one to support commercially — It’s not expected that a founder will be a “jack of all trades” , i.e. be brilliant engineers and also outstanding sales people. But finding the talent to complement founders’ gaps is a critical milestone as the company prepares for scaling.
  • Failure to monetise in a right way — Some companies fail to find a scalable monetisation strategy, others struggle to build enough value into the paid product so people are just perfectly happy to use the OS version. Regardless of the reason, if everything else is right, this specific risk usually materialises only at Series B and later.

Understanding how and when to minimise the risks above is key. In the second post we’ll explore different sources of risk as OS-companies grow from “someone’s side project” to scale up Series C+ company. We will also introduce a Risk Matrix that we find helpful not only when evaluating investment opportunities in OS companies, but also when advising entrepreneurs what to prioritise between rounds. In the meantime, If you are building an OS company in Europe, we’d very much love to hear from you — please reach out to sasha@atomico.com.