Inside Open Source #6
All things Open Source: Interesting reads, startup news, trivia and views from Europe and beyond
Welcome to issue #6 of the Inside Open Source Newsletter
Every month I write about interesting developments in the European Open Source ecosystem and related topics that I come across. Check out this month’s issue below and subscribe if you like what you read :)
This month’s topics:
🧠Why pre-seed open-source startups should choose their investor wisely
🧠Why pre-seed open-source startups should choose their investor wisely
In recent years, open-source unicorns like MongoDB, Elastic, Databricks, Cloudera, Confluent, Segment, Fastly, Neo4j, Couchbase etc. have built compelling investing narratives for VCs. So open-source became “hot shit” for VCs, first in the US and now increasingly in Europe as well.
With increasing investment activity across all investment stages and more and more funds that integrate open-source in their investment focus, it is less about finding an investor but the right one. But it’s still very hard.
Being one of the few pre-seed VCs with a focus on dev tools and open-source in Europe, I thought it might be helpful to share some of my thoughts on this.
Observations from the German pre-seed & open-source funding environment:
Many VCs have historically invested in Seed and Series A rounds. With increasing international competition at the Seed and Series A stage, a lot of VCs realized that they have to change their investment strategy to maintain access to good or even the best deals. Enter the stage: exploratory pre-seed investments. It is quite common for VCs to invest with relatively small checks in a lot of pre-seed startups to reserve a spot in their Seed rounds - if the company is not performing well, the small investment is written off and this failed bet has just a minor impact on the VC fund’s overall economics
VC funds that historically focused on “low tech” and consumer startups increasingly move into untapped territories (machine learning, dev tools, infrastructure, open-source etc.)
Apart from the negative effects that explorative pre-seed investments can potentially have (read up here), these developments lead to an increasing number of potential investors for pre-seed companies and in particular open-source start-ups. Obviously, that’s good for founders because it reduces the friction in accessing capital. But some issues have also arisen under the surface.
Many VCs talk the talk but don’t walk the walk
Take a look at the backgrounds of most VC decision-makers in the DACH region. There are actually only a handful of people who do not have a classic business background. Many VC partners were “made” in the first German startup boom of the mid-2000s. They started e-commerce and consumer startups or worked at Rocket Internet before switching to the investor side.
For open-source and really technical companies this can lead to some obstacles when navigating the fundraising landscape:
As venture investing is a highly subjective and qualitative process, it’s much easier for investors to build conviction for an investment opportunity if they have some experience in the particular market the startup operates in. Investors see successful and unsuccessful founders and products come and go throughout the years and are able to pattern-match new opportunities. They have built a network to validate key business hypotheses and they have a good gut feeling about the known and unknown unkowns of a business —> they can quickly build up the confidence and conviction to pull the trigger on an investment. For most VCs out there this does not apply to open-source companies and real tech companies! If a VC partner has done 30-40 investments in e-commerce, consumer tech and lightweight SaaS in the last 10 years it’s really hard for him/her to build up a differentiated perspective on open-source tech startups.
From my experience, a lot of junior employees at VC firms are the key driver in this investment area and actively look for open-source opportunities. And although there are many funds where juniors have a strong influence on the decision-making process, compared to other verticals (SaaS, marketplaces, etc.) it can be really difficult for them to convince a fund’s partners and push these deals through the investment committee.
I observed that in many cases founders spend a ton of time with highly engaged Analysts or Associates but the Partners wrapped up the process pretty quickly when they came on board.
What does that mean for open-source founders?
Look at a VC’s portfolio and see if they have done investments in open-source or dev tools before - if not, ask them why
If you talk to a VC junior who is excited about your company, try to get transparent information about the decision-making process, who the key person is you have to convince in the end and how you can get him/her on board as soon as possible —> if the decision-maker has no obvious tech affinity, dig deeper on why you should move ahead with the fund
Go-to-market SaaS benchmarks kill open-source startups
Obviously, it is important for every startup to get investors on board who have worked with similar companies in the past. It can be super helpful for founders to work with a VC that understands a startup’s business model, product, market, competitors, execution challenges etc.
For open-source startups, this benefit is just as important as for any other company.
However, if you flip the scenario and look at the implications of having an investor who does not meet these criteria, I think there are big differences for open source startups.
Especially for pre-seed companies, it is particularly important to have investors who understand the milestones that need to be achieved in order to reach “Seed-readiness”. With the rise of exploratory pre-seed investments (see explanation above), it is most likely that the fund that invested in the pre-seed round will subsequently lead the Seed round if the decision-maker is happy with the startup’s performance.
And this is exactly where problems arise.
Traction is one of the most important metrics Seed investors will look at when evaluating an investment opportunity. For “classic” SaaS startups, there are well-known benchmarks for good go-to-market performance. SaaS companies that can generate 10-25k monthly recurring revenue in a reasonable timeframe (<12 months) after their pre-seed round will most likely be able to raise their Seed round. This is common knowledge at every VC firm out there.
For open-source startups, two main factors are skewing the timeline for a commercial market entry compared to most SaaS companies:
extensive pre-launch R&D efforts
early community building as a key mechanism for product/market validation
Simply put: most commercial open-source startups need more time to build their product and they “give it away for free” in order to get a feeling for potential users (and various other reasons)
I won’t dive into the aspects of why this early community building is such a key pillar of the market entry strategy of open-source startups but you can read up here, here and here.
Looking at the differences in the commercialization timelines of open-source startups, it should be obvious that the milestones for “Seed-readiness” have to be adjusted accordingly.
So, if an exploratory pre-seed investor is evaluating to lead a Seed round of an open-source company and doesn’t incorporate these factors, a follow-on financing is highly unlikely.
Founders of open-source companies should be aware of this when raising a pre-seed round, especially since there are so many investors out there who increasingly want to explore open-source investment opportunities.
So if you are an open-source founder and receive an investment offer from a VC who does not have a tech or open-source investing background, ask about the milestone expectations for the next round!
“Seed-readiness” for open-source startups
From my perspective, investors should look at these critical milestones to evaluate the “Seed-readiness” of commercial open-source startups:
Github Launch with functional code and great documentation - tech works and is out there
Engaged and growing community (500+ GitHub stars & forks/downloads) - developers are interested and use the product
First production deployments in real companies —> product is creating business value in real applications
When a company can tick off all these points within a reasonable timeframe, the founders substantially de-risked many key aspects of their business and are on a good path to capture the value they are creating.
Open-source VCs in DACH
The venture capital environment for open-source companies in the DACH region is quite young. There are no VC firms that have an extensive track record of backing iconic open-source companies that became global champions. But there are some great VC funds out there who really know their stuff and are a great fit for early open-source founders.
Here are some funds that I would advise every early-stage open-source founder to talk to:
First Momentum Ventures
(disclaimer: this is where I try to find the next Elastic 🤓)
I hope you enjoyed this month’s issue - if you like what you read pls share it with your common-minded friends and colleagues!