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In Context: Follow the Money; Cathedral Investments in the Bazaar

Oct 20, 2000, 09:06 (2 Talkback[s])
(Other stories by John Wolley)

When you attempt to "follow the money" being invested in Linux startups by established technology companies, you find these "tech giants" are motivated by all sorts of considerations when they pour millions of dollars into high-risk ventures based on a radically different way of making money off of software. What it is very refreshing to note you don't find is an attempt to use these investments to dominate markets. Also of interest: several Linux startups seem to have done quite nicely without any corporate investors."

by John Wolley, Linux Today

In early October, TurboLinux announced it had received $30M in funding from "tech giants" including IBM, Intel, Fujitsu, Hitachi, and SGI, among others. The event was hardly news -- none of the stories about it posted on Linux Today drew as many reads as the press release titled "TurboLinux Tours with IBM to Showcase Linux - 'Mission Possible'. "

It was quite a different story two years ago. The announcement in late September, 1998, that Intel and Netscape were making direct investments in Red Hat was a watershed event in the emergence of Linux into the awareness of the wider technology business world outside of the traditional "Linux community." In the now familiar terminology of "The Cathedral and the Bazaar," traditionally proprietary, "Cathedral" companies were pouring major sums of money into a radically new, open source, "Bazaar" company. Some of the stories about this posted on Linux Today set records for the time for the number of pageviews.

Although the details on the exact amount were not disclosed (as seems to be standard for these investments), it was inferred that millions of dollars were involved. That was enough to pique the curiosity of financial analysts. And it sent a signal to the mainstream technical trade press that something big was going on with Linux.

Investments in startups by established companies are nothing new. It's a reflection of the way companies operate these days, not trying to do everything from scratch within one corporate entity, but forming ad hoc alliances with "partners" whenever and wherever that appears to be mutually rewarding. Established companies like Intel typically invest in startups when they see the possibility that what the startup is trying to do will create or expand markets for their products.

What's different about the established companies investing in Linux startups is the Cathedral/Bazaar divide. With these Linux companies, the startups are trying to implement a whole different business model from what the established companies investing in them are used to, and this translates into a much higher level of risk. It also translates into a much higher potential return on investment, if it the new open source business models do, in fact, turn out to be the "wave of the future," the "disruptive technology" that obsoletes the traditional business models based on proprietary software.

Over the months following the Intel/Netscape announcement, the floodgates seemed to open on investments by Cathedral companies in Linux startups. It quickly provided a potent argument to counter the FUD point about "no big companies backing Linux" -- here were all these big companies putting their money where their mouths were, pouring millions of dollars into Linux companies.

What's the Motivation?
What has motivated the established technology companies -- just about everybody but Microsoft -- to pour millions of dollars into Linux startups that are widely regarded as high risk investments?

  • Microsoft's dominance in the desktop OS and applications markets is so complete that there's little opportunity for other companies to make money selling software in the traditional Cathedral model -- this makes them very open to considering the alternative Bazaar model.
  • Potential Microsoft competitors see a real possibility of breaking Microsoft's Windows/Office monopoly, which would open up enormous markets that have been closed for more than a decade -- the fact that they might have to make their money selling services instead of software isn't a show-stopper.
  • The close working relationships that inevitably result from investments will give the investing companies an inside track on servicing the developing open source markets and making the transition to open source business models, if the Linux revolution really takes off, forcing established businesses to adapt in order to survive.
  • Companies investing in a Linux startup generally receive, in exchange, "equity" in the company -- shares of the startup's privately held stock -- which can potentially be worth many times what the company invested if the startup has a successful IPO.
  • A few million dollars is "small change" to a company like Intel or IBM -- it's even relatively small change to a companies like Novell or SGI, who have been having trouble financially at the same time they've been investing in Linux startups.

What's the Impact?
What is the significance of the money to the Linux startups? Of course, a few million dollars to work with is a nice thing for anyone trying to get a business started, but what's the significance of this money coming from established technology companies, instead of from "angel investors" or wherever else companies get money from before they go public?

  • The association with established, financially successful "tech giants" like Intel and IBM gave the Linux startups instant credibility in the financial world.
  • The big companies that have invested in Linux startups now have a vested interest in seeing those startups succeed -- they have every incentive to "throw a little business their way" and, if necessary, to pump in some more cash, if that's what it takes.
  • When a Linux startup is ready to go public, that backing by "tech giants" greatly increases the interest of the financial community -- it's highly unlikely that the Red Hat and VA Linux IPOs would have been as spectacularly successful without such backing and the investor confidence that it inspired, although Cobalt Networks and Andover.net seemed to do just fine without it.

What's Involved if You Want to "Follow the Money?"
If you were to "follow the money" with Microsoft and its investments in various companies, there's a (surprise!) very sinister dimension to the story -- it looks like MS is trying to buy its way into control of just about everything it doesn't already control: cable, satellite, wireless, content providers, you name it.

The absence of any comparable pattern in the investments by Cathedral companies in Bazaar companies is a refreshing change. What you don't see is evidence of a big company trying to use its Linux investments to dominate a market, the strategy we've come to expect with Microsoft. For example, although Red Hat is the Linux distro in which IBM appears to have made the most direct investment, IBM has been very scrupulous about supporting multiple distros on its products and is pre-loading Caldera on its ThinkPad laptop.

When I first got the idea to try to "follow the money" going into Linux startups for a story, I envisioned tracking down and totaling up the dollar amounts -- how much total from which companies has gone into which Linux companies. I knew the exact amounts were never specified in the press coverage, but assumed it wouldn't be that hard to track down in the investing companies' quarterly reports; after all, they're all public companies so they can't keep these details secret for long. I quickly learned two things:

  1. For whatever reason, the exact numbers are not as easy to locate as I had imagined. The public companies doing the investing are typically doing it through an investment subsidiary, which tends to show up as a single line entry in the quarterly report. I need to do some more research here: whenever information is not easy to get, I tend to suspect someone must be trying to hide something; but so far I can't see what it may be.
  2. The number of companies investing in Linux startups is substantial -- covering all of their investment activities in any detail would require a whole book!

So the rest of this article is not a comprehensive summation of corporate investment in Linux startups -- it's just a summary of the highlights of six "Linux companies:" Red Hat, Cobalt Networks, VA Linux, Andover.net, Caldera, and TurboLinux. The companies are detailed below in the order in which they went public in 1999, or by the likelihood of their going public in 2000 or 2001.

Red Hat
Intel and Netscape made the first Cathedral investment in a Bazaar company when they invested in Red Hat in September of '98.

IBM, Compaq, Novell, and Oracle announced investments in Red Hat during the first LinuxWorld Conference and Expo (LWCE) in March of '99. SAP, the German ERP software house, added its financial backing to Red Hat a few weeks later, followed by Dell in early April.

Novell ponied up a second sum for Red Hat in July of '99.

In August of '99, Red Hat went public. The first day run-up in the stock price set unrealistically high expectations not only for Red Hat, but for all the Linux companies queued up behind it with plans to go public in 1999 and 2000. The IPO made Red Hat a public company -- people and companies wanting to invest in Red Hat today buy its stock on the open market.

In April of 2000 Red Hat turned around and invested some cash in Rackspace.com. Then in May it formed Red Hat Ventures to funnel its investments into open source startups, which "will take $500,000 to $2 million stakes in new companies specializing in open-source software and Internet infrastructure technology." According to the press release, "Red Hat has already taken stakes in a number of key Open Source-related startups, including Sendmail Inc., Rackspace.com, ZoneTrader.com, techies.com and e-smith," prior to creating the venture fund.

Cobalt Networks
Cobalt's pre-IPO funding didn't produce any stories that got posted on Linux Today. A search of CNET's archives turned up one "short take" in June of '99 that described a $36 million round of funding, all from venture capital groups -- no established tech giants participating.

In November of '99 Cobalt became the "second Linux IPO," apparently without any corporate investors pre-IPO, and bested Red Hat's first day performance.

In March of 2000 Cobalt used some of the cash raised in its IPO to purchase Chili!Soft, based in Bellevue, Washington. Cobalt had been bundling Chili!Soft's software on its server appliances to support Microsoft's Active Server Pages (that .asp extension you see on web pages) on the Linux platform -- this allows developers using Visual Basic and other Microsoft tools to develop web server applications for the Linux platform without switching (and relearning) development tools.

In September Cobalt announced that it was being acquired by Sun Microsystems for some $2 billion in Sun stock, a considerable premium over the price at which Cobalt stock was then trading. What happens with Cobalt under Sun's ownership is still an open question, but for Cobalt's investors the Sun purchase was very rewarding.

VA Linux
VA Linux was still known as VA Research when Intel invested in early March of '99, right before the first LWCE. The Intel cash presumably was instrumental in allowing VA to make quickly make three acquisitions: Electric Lichen, at the end of March; and Linux Hardware Solutions, of Wilmington, N.C., and Enlightened Solutions, based in Atlanta, at the end of April.

In June of '99, right after VA Research had changed its name to VA Linux, SGI and Intel joined in a second round of funding that totaled $25 million.

In December of '99, VA Linux went public with a bang -- its 698% first day gain broke all records for first day trading of a public company's stock up to that time.

In February of 2000, VA Linux surprised the Linux community with its LWCE announcement of the purchase of Andover.net "in a cash and stock deal worth roughly $813 million," based on the value of VA's stock at the time. By the time the deal closed in June, stock values had dropped significantly -- terms called for "each share of Andover.Net stock to be exchanged for 0.425 of a share of VA Linux Systems, making the deal worth about $107 million."

In March of 2000, VA Linux fleshed out its hardware offerings by acquiring TruSolutions, a manufacturer of rack-mount servers, and NetAttach, which makes high availability storage devices. At the current VA stock price, the cost to VA in stock and cash was $194 million for TruSolutions and $39.2 million for NetAttach. By September of 2000, VA had turned the NetAttach acquisition into a NAS (network attached storage) product that was ready to launch.

In June of 2000, VA Linux invested in the MySQL open source database project and agreed to host the project on SourceForge.net. In September and October, VA announced plans to expand its marketing efforts in Japan and Europe.

Andover.net doesn't fit the mold of the other Linux startups that have received funding from established companies. Although it succeeded in going public, it apparently did so with the least corporate investment of all the Linux IPOs in 1999 -- none. I checked the archives of ZDNet and CNET to make sure that there wasn't some major investment that somehow never got posted to Linux Today.

Without an exhaustive search on Andover across the 'net, I still regard this as a tentative conclusion, but it does make sense: Andover was strictly a news operation whose revenues came from advertising; it didn't have any products or services that an established technology company could partner their products with, and its success didn't promise to open up new markets which those companies could go after

In June of '99, Andover.net seemed to come out of nowhere, with cash from who knows where, when it purchased Slashdot. This was followed shortly in August with the purchase of a second Linux site, Freshmeat.net.

In December of '99, just a few days after the spectacularly successful VA Linux IPO, Andover.net's IPO took place. Andover's first day run-up of 350% was outstanding, although overshadowed by the 698% racked up by VA Linux a few days earlier. And it was apparently pulled off without any major investment from the established tech giants.

In January of 2000, Andover followed the pattern of other Linux companies that had IPOs by using some of the cash raised on an acquisition: it purchased QuestionExchange, a website which "lets people post questions and others submit bids for answers." This was about the only way in which Andover's story was similar to the other Linux IPOs of 1999.

In February, during the third LWCE, Andover surprised the Linux community with the announcement that it was being bought by VA Linux "in a cash and stock deal worth roughly $813 million," based on the value of VA's stock at the time. In June the sale to VA Linux was completed and Andover stock ceased trading, almost exactly six months after the IPO.

Caldera got its initial financing from a venture capital group in February of '99. In January of 2000 Sun, Citrix, Novell, and SCO joined with two venture capital groups to invest $30 million in Caldera.

In March of 2000 Caldera went public in an IPO that was headlined variously as "Caldera's IPO Makes Strong Debut" and "Caldera IPO Marks First Linux Disappointment" -- its first day run-up was "only" 110%.

In August of 2000 Caldera announced that it was purchasing the Unix and professional services units of SCO.

In September Caldera invested $3 million in EBIZ Enterprises "to develop PartnerAxis, a Web-based B2B entity providing knowledge exchange, Linux product sales, advertising, membership and channel development."

TurboLinux started out as Pacific HiTech, headquartered in Asia. It opened US offices in October of '98 and changed its name to TurboLinux, after the distro, in May of '99.

In October of '99, Intel invested in TurboLinux, along with several venture capital groups. The total amount was not disclosed, but one VC group put up $5.5 million.

In January of 2000 TurboLinux received more than $50 million in another round of funding from more than a dozen companies, including: Dell, Compaq, BEA Systems, Seagate, SCO, Novell, Toshiba, and NEC.

In October of 2000 TurboLinux received additional funding totaling $32 million, from: Fujitsu, Hitachi, IBM, SGI, Dell, and Intel. By latest accounts, this funding puts TurboLinux in position to move on to an IPO, as soon as the market warms up to IPOs again.

Linuxcare got its initial financing from venture capitalists in May of '99. In December of '99 Linuxcare received $32.5 million in investments from Dell, Motorola, Oracle, and Sun, plus several venture capital groups.

In August of 2000 Linuxcare received an additional $30 million from venture capital groups.

Established tech giants have invested heavily in some Linux startups, while others have had to raise all their funds through venture capital sources. The corporate funding has undoubtedly helped those Linux startups which have received it, but several have done surprisingly well without it. Aside from Sun's outright purchase of Cobalt Networks, corporate investors in Linux startups have generally not used their investments to try to control any of the markets in which the startups are involved.

Related Stories -- Andover.net:
TechWeb: VA Linux Completes Purchase Of Andover.Net(Jun 07, 2000)
The Standard: Blinded by Dollar Signs in the VA Linux-Andover.Net Deal(Feb 06, 2000)
CNET News.com: VA Linux buys Andover.Net(Feb 03, 2000)
CNET News.com: Andover.Net to acquire Linux services firm, QuestionExchange(Jan 28, 2000)
CNET News.com: Andover.Net success boosts OpenIPO concept(Dec 13, 1999)
CNET News.com: Andover.net buys second Linux site, Freshmeat.net(Aug 14, 1999)
PC Week: When worlds collide: Andover.net buys open-source site Slashdot(Jun 29, 1999)

Related Stories -- Cobalt Networks:
ZDNet UK: Sun considers ditching Linux [on Cobalt server appliances](Sep 29, 2000)
In Context: Sun's "Linux Strategy" -- What Is It?(Sep 28, 2000)
NewsForge: Sunset for Cobalt?(Sep 27, 2000)
CNET News.com: Sun scoops up Cobalt for $2 billion in stock(Sep 20, 2000)
CRN: Cobalt Acquires ChiliSoft For Web Technology(Mar 25, 2000)
Red Herring: Cobalt burns hotter than Red Hat(Nov 07, 1999)

Related Stories -- Linuxcare:
CNET News.com: Linuxcare looks to future with new financing(Aug 02, 2000)
E-Commerce Times: Linuxcare Lines Up Major League Funding(Dec 15, 1999)
CNET: Kleiner Perkins invests in Linuxcare(May 03, 1999)

Related Stories -- Red Hat:
BW: Red Hat, Inc. Announces Red Hat Ventures Investment Unit(May 10, 2000)
CNET News.com: Red Hat creates investment unit(May 09, 2000)
PRNewswire: Rackspace.com Announces $11.5 Million Investment by Sequoia Capital, Norwest and Red Hat(Apr 03, 2000)
TechWeb: Red Hat IPO Rockets(Aug 12, 1999)
PC Week: Novell invests in Red Hat(Jul 28, 1999)
CNET News.com: Dell tips its cap to Red Hat(Apr 06, 1999)
CNET News.com: SAP invests in Red Hat(Mar 30, 1999)
CNET News.com: Red Hat gains backing from tech giants(Mar 09, 1999)
NEWS.COM: Intel, Netscape back Red Hat(Sep 29, 1998)

Related Stories -- TurboLinux:
Enterprise Linux Today: TurboLinux Smells IPO(Oct 11, 2000)
Enterprise Linux Today: TurboLinux Closes $30 Million Private Funding Round(Oct 11, 2000)
CNET News.com: TurboLinux gets staked more than $50 million(Jan 15, 2000)
CNET News.com: Intel, others take stakes in TurboLinux(Oct 11, 1999)
CNET News.com: Pacific HiTech becoming TurboLinux(May 26, 1999)
Pacific HiTech Opens U.S. Offices: Will Compete With Red Hat, Caldera and S.u.S.E.(Oct 28, 1998)

Related Stories -- VA Linux:
LinuxPR: VA Linux Systems Expands in Europe (Oct 04, 2000)
CNET News.com: VA Linux trying to make inroads into Japan(Sep 29, 2000)
CommWeb: VA Linux Enters The NAS Market(Sep 12, 2000)
MySQL.com: MySQL Goes GPL [& VA Linux Invests](Jun 28, 2000)
InfoWorld: VA Linux Systems acquires server and storage vendors(Mar 16, 2000)
CNET News.com: VA Linux buys Andover.Net(Feb 03, 2000)
CNET News.com: VA Linux storms Wall Street with 698 percent gain(Dec 10, 1999)
Inter@ctive Week: New Funding For VA Linux(Jun 26, 1999)
TechWeb: VA Research Buys Two Linux Companies(Apr 27, 1999)
CNET: VA Research buys Linux consulting firm(Mar 23, 1999)
Reuters: Intel invests in Linux company VA Research(Mar 03, 1999)