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How crowdfunding and the JOBS Act will shape open source companies

New regulations could mark the end of proprietary finance.

Currently, anyone can crowdfund products, projectscauses, and sometimes debt. Current U.S. Securities and Exchange Commission (SEC) regulations make crowdfunding companies (i.e. selling stocks rather than products on crowdfund platforms) illegal. The only way to sell stocks to the public at large under the current law is through the heavily regulated Initial Public Offering (IPO) process.

The JOBS Act will soon change these rules. This will mean that platforms like Kickstarter will be able to sell shares in companies, assuming those companies follow certain strict rules. This change in finance law will enable open source companies to access capital and dominate the technology industry. This is the dawn of crowdfunded finance, and with it comes the dawn of open source technology everywhere.

The JOBS Act is already law, and it required the SEC to create specific rules by specific deadlines. The SEC is working on the rulemaking, but it has made it clear that given the complexity of this new finance structure, meeting the deadlines is not achievable. No one is happy with the delay but the rules should be done in late 2013 or early 2014.

When those rules are addressed, thousands of open source companies will use this financial instrument to create new types of enterprise open source software, hardware, and bioware. These companies will be comfortably funded by their open source communities. Unlike traditional venture-capital-backed companies, these new companies will narrowly focus on getting the technology right and putting their communities first. Eventually, I think these companies will make most proprietary software companies obsolete.

How are companies like Oracle, Apple, Microsoft, SAS and Cisco able to make so much money in markets that have capable commercial open source competitors? In a word: capital. These companies have access to guaranteed cash flows from locked-in users of their products.

Therefore, venture capital investors are willing to provide startup capital to new business only when they demonstrate the capacity for new lock-in. Investors that start technology companies avoid investments that do not trap their user bases. That means entrenched proprietary players frequently face no serious threats from open source alternatives. The result? Lots of lock-in and lots of customers trapped in long-term relationships with proprietary companies that have little motivation to treat them fairly.

The only real argument against business models that respect software freedom have always been about access to capital. Startups are afraid to release using a FOSS license because that decision limits their access to investment. Early-stage investors love to hear the words “proprietary,” “patent-pending” and “trade secret,” which they mentally translate into “exit strategy.” For these investors, trapping users is a hedge against their inability to evaluate early-stage technology startups. (I am sympathetic; predicting the future is hard.) As a result, most successfully funded technology startups are either proprietary, patented platforms or software-as-a-service (SaaS) platforms.

This is all going to change.

Crowdfunded finance is going to shift the funding of software forever, and it is going to create a new class of tech organization: freedom-first technology companies.

Now, open source projects will be able to seek and find crowds of investors from within their own communities. These companies will have both the traditional advantages of proprietary companies (well-capitalized companies recruit armies of competent programmers and sales forces that can survive long sales cycles) and the advantages of the open source development model (open code review and the ability to integrate the insights of outsiders).

Yesterday, it was a big deal if you could get Intel to invest in your company. Tomorrow, you will seek funding from 500 Intel employees, who are all better qualified to vet your technology startup than 90% of the people in Intel’s investment arm. These crowdfunders are also willing to make a decision to invest in six hours rather than six months.

For this reason, I believe there will be a treasure trove of companies that will soon be born out of open source/libre software/hardware/bioware projects by asking their communities to crowdfund their initial rounds of financing. Large community projects will give birth to one or several different companies that are designed from the ground up to support those projects. GitHub and Thingiverse will become the new hubs for investors. Developers who have demonstrated competence in projects will be rewarded with access to financing that is both cheaper and faster than seed or angel funding.

With this fundamental change in incentive structures, open source projects will have the capital they need to try truly radical approaches to the design of their projects. Currently, open source projects have to choose between begging for capital or living without that capital. Many open source projects choose slow and gradual development not because they prefer it, but because this is what the developers involved can afford to do in their spare time. The Debian and Ubuntu projects are illustrative of the differences in style and result when the same community is “shoestringing it” versus having access to capital. The people running many open source projects know that no angel investor would touch them, so they make slow and steady progress to “good” software releases rather than rapid progress to “amazing” software releases.

These new freedom-first companies will be able to prioritize what is best for their projects and their communities without bearing the wrath of their investors. That’s because their communities are their investors.

This is not going to merely create a class of software that can rival current proprietary software vendors. In a sense, current commercial open source companies are already doing a fine job of that. But those open source companies typically have investors who are similarly desperate for hockey-stick returns. Even they must choose software development strategies that will pay off for investors. This new class of company will prefer technical strategies that will pay off for end users.

That might seem like a small distinction, but this incentive tweak will change everything about how software is made.

The new companies that leverage this funding option will look a lot like Canonical. Canonical is the kind of company you get when the geeks are fully in charge, and you have investors who are very tolerant of long-term risk because they grok the underlying technical problems that sometimes take decades to entirely resolve. Also, the investors probably know what the word “grok” means. But, unfortunately, there are only so many Mark Shuttleworth-types around (one as far as I know, but a guy who can get himself into space can probably be first in line for human cloning, too).

Shuttleworth is famous for reading printouts of the Debian mailing list on vacation as he figured out which Debian developers to hire for Canonical, the new Linux startup he was funding. That kind of behavior is not what most financial analysts do before making an investment, but this, and other similar efforts, allowed Shuttleworth to predict and control the future of a very technical financial opportunity. It is this kind of focus that allowed Shuttleworth to make one great investment and know that it would work, rather than making hundreds of investments hoping that one of them would work. Using the JOBS Act, community members that already sustain that level of research about an open source project can make the same kinds of bets, but with much less money. (It is ironic that so many of the critics of the JOBS Act presume that the crowd is ignorant rather than recognizing the potential for hyper-informed investor communities.)

In addition, companies like Canonical, Rackspace, Google, Amazon, and Red Hat might acquire these new companies. All of these established organizations can afford billion-dollar acquisitions, and they are either entirely open source or they are very open-source friendly. This kind of acquisition potential will ensure that once open source technology companies prove themselves, they will have access to series A and B financing. I also expect there will be several new open source mega-companies that emerge that are even more devoted to community and end-user experience than these current open source leaders.

This new class of company will have lots and lots of hockey sticks and plenty of billion-dollar exits. Companies will achieve these exits precisely because they do not focus on them (it’s very Zen). They will choose and execute visionary technical strategies that no outside investor could understand. These strategies will seem obvious to their communities of users/investors. These companies will be able to move into capitalization as soon as their communities are convinced the technical strategies and execution capabilities are sound. All of this will lead to better, faster, bigger open source stuff.


If you’d like to talk with other people who are interested in getting and giving funding for open source companies, I set up a related mailing list and Twitter account (@WeInvestInUs).

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  • http://www.facebook.com/people/Mark-Fuqua/100000636775167 Mark Fuqua

    Just for my own edification, does the JOBS act require the participating company be FOSS? I am very interested in the JOBS act and crowdfunding…however, I am no fan of open source…and some of my ideas are not software related at all.

    I hope it is not so narrowly focused.

    • Alexander Howard

      @facebook-100000636775167:disqus No, it does not. The Wikipedia entry for the Act is a decent summary: http://en.wikipedia.org/wiki/Jumpstart_Our_Business_Startups_Act and includes links to coverage. if you’re interested in the original source, go here: http://beta.congress.gov/bill/112th-congress/house-bill/3606?q=H.R.3606

    • Ross Reedstrom

      I’m intrigued by your comment “I am no fan of open source”. I usually meet people who are either enthusiastic, or don’t care. Can you articulate your reasons on that a bit?

      • http://www.facebook.com/people/Mark-Fuqua/100000636775167 Mark Fuqua

        I guess it would be more accurate to say I am not a fan boy of open source (the author seemed to be). And personally, if I am going to develop software, making money will definitely be one of the goals. Maybe not most important (I do lots of development work for small amounts of money), but one of the goals for sure.

        They say, ‘if you do what you love, you’ll never work a day in your life’…however, unless you’re independently wealthy, it does help to get paid.

        • http://twitter.com/ChrisHurrell Christopher Hurrell

          you can still sell licences for open source software. Being open source simply means the community can innovate and extend your core offering. Not everybody wants to create their own version of a service, especially if its SaaS.

          • mtpdmblo

            Yes, these license sales are why I feel the label “open source company” is usually close to a flat out lie. Many, many of the open source projects I’ve gotten from so-called “open source” companies are lacking some crucial piece that they withhold unless you pay them money. They prattle on and on about openness, but in reality it’s close to impossible to download their software and get anything done without paying them.You can try it out and do something basic, but once you want to do something more they charge you. And they’ve designed the system that way.

            That’s not to say this isn’t a big improvement over the past. That’s not to say that I couldn’t fork something if things got bad enough, but I’ve grown tired of the blithe promises that someone “open source” is really “open” and really comes with all of the “source”.

          • fred trotter

            This is a good point Christopher, and it is the reason why I called the resulting companies “freedom first”. I do not think this is the kind of thing that a crowd-funded Open Source company will be able to get away with. This would annoy their community investors..

        • fred trotter

          I think it has been demonstrated that it is possible to make money on Open Source, but I think it is also been demonstrated that it can be a struggle without capital.

          It is not a question of whether we want to get paid. It is how much money we have to get paid in order to attract the capital that makes a pure Open Source business model stable…

          Also, labeling me a “fanboy” is something of a distraction. I see the flaws in existing Open Source business models as much as the next person, but I also see that the JOBS act addresses lots of those flaws…

          -ft

  • Greg

    I don’t get this article. Given the individual and aggregate yearly dollar limits in the crowdfunding provisions of the JOBS Act, I don’t see how a crowdfunded company could ever be considered “we’ll capitalized,” especially as compared with Oracle, Apple, Microsoft, SAS or Cisco.

    You refer to Canonical and say this is what a company looks like when the geeks are fully in charge. Actually, when the geeks are fully in charge, you get Debian (not criticizing, I think it’s great). Canonical is what happens when you take a seasoned tech entrepreneur willing to dedicate a personal fortune well in excess of what you would be allowed to raise via crowdfunding.

    • fred trotter

      You are confounding “geeks being in charge” with “design by committee”. There are different ways for geeks to be in charge. Mark’s leadership of Ubuntu highlights his personal approach to a distro, which is pretty different than Debians.

      You are right that Canonical has received much more funding than is available under the JOBS act. It will take a lot of attention from these companies to stay “right sized” in order to take full advantage of these dollars…

  • http://twitter.com/esrtweet Eric S. Raymond

    Well analyzed, but you’re missing the obvious second-order effect – VCs using crowdfunders as a way to get risk evaluations crowdsourced to the populations that best understand the startup’s problem domain.

    Actually, I think what will happen is that crowdfunders will largely replace not VC money in the $15M-and-up range, but angel investing. The most effective VCs will be selective fast followers of crowdfunding trends.

    I may have to blog about this.

    • fred trotter

      I didn’t actually miss it… I just saved it for a follow-on article ;)

      You are absolutely right, I think this is what will happen too. There are some interesting debates happening about how the transition between crowdfunded and VC series will play out… most of which are premature because these are exactly the types of details that the SEC rulemaking could impact. Hard to have anything like reasonable assumptions about what it utterly unpredictable.

      -FT

  • http://www.facebook.com/jcweatherby Jan Carson Weatherby

    Your starting premise is entirely false. Companies crowd funded under the JOBS ACT will be no different from ‘proprietary’ companies. Their shareholders will be just as eager to see profits as any other investor. And the crowdfunding limits ($1-2M/yr) will demand frugality to say the least.

    • fred trotter

      But that is not my premise. Merely funding under the JOBS act will have little to do with being Open Source. In fact there is nothing in the JOBS act that limits funding to technology companies.

      But the JOBS act will provide access to capital from communities and companies that have access to existing communities will do well, to the degree that they learn to tailor their business models in accordance with their investors values. For instance, churches, mosques, synagogues or temples will likely begin to back businesses as community investors.

      It is unlikely that those religious communities will make criteria to ensure that the businesses that they invest stay loyal to their values. It is unlikely that a strip club r bar, for instance, would find investment success with the Baptist community. This is where your point starts to fall down. Religious shareholders will clearly value businesses that operate under their notion of ethics more than profit. In the same way, Open Source communities will place their community values ahead of profit.

      The effect that I am identifying (freedom first companies) is enabled by the JOBS act, but it is driven by existing Open Source community values.

  • Kris Moe

    The biggest challenge for new businesses is the first 500 K. Regulators will have to protect the inevitable gamblers out there but crowd funding is going to unleash the growth of many small businesses that’ll create jobs across the board.