The slowdown in venture capital funding for Linux and open source-related vendors continued in the third quarter as disclosed funding deals were down 41.6% to $77.8m*, compared to $133.3m in the same quarter last year.

The news is not all bad however, as there are indications that the downward trend is cyclical, rather than spiral. The level of investment via seed and Series A funding rounds actually increased for the second quarter in succession, while the big money for established vendors went on M&A activity rather than venture funding.

There were ten deals with disclosed value in the third quarter, giving an average deal size of $7.78m, compared to 11 disclosed value deals in the third quarter of 2006, and an average deal size of $12.1m.

During the first nine months of the year $266.7m was invested in Linux and open source vendors, compared to $339.6m in the same period last year, which was a record year for open source investments.

Those are the numbers, but what to make of them? Do they suggest that the VC community has fallen out of love with open source? Certainly there is not the feverish interest that there was last year, but you have to look beyond the numbers to get a better idea of what is going on.

The third quarter of 2006, for example included significant deals for SpikeSource ($24m Series B), Linux Networx ($37m Series C) and EnterpriseDB ($20m Series B) while the biggest deals in the third quarter of 2007 were Jive Software’s $15m and Purple Labs’ $14.5m (PDF) - both Series A deals.

Those two deals helped push the proportion of funding invested in Seed and Series A deals to over 50% in the quarter, the first time it has been that high since the first quarter of 2006 (see chart) and the second successive increase following a period of overall decline (albeit with peaks and troughs).

Based on that overall decline, Gianugo Rabellino, CEO of Sourcesense previously questioned whether the VC industry might have “filled the checkerboard and… moved to something else”. The increase in entry level funding deals suggests that his fears might have been unfounded, with new start-ups cropping up to take up the open source mantle. Other startups raising funding in the quarter include DimDim, Open Kernel Labs and the MailCo Thunderbird project.

All of which means that there was a marked decline in Series B or later funding rounds. Consider however, that $500m was invested in XenSource by Citrix, and $350m in Zimbra by Yahoo! in the form of acquisitions during the quarter.

As Ann Winblad of Hummer Winblad Venture Partners recently mentioned, those deals are likely to increase VC interest in open source going forward. Meanwhile Larry Augustin previously predicted there will need to be a few larger deals and IPOs before we start to see a significant increase in investment.

*For the record, Q3 figures include the full $12m raised by JasperSoft, $11m of which was announced in late June. Removing that $11m from the Q2 figures means that VC funding deals in Q2 totaled $88.5m, an increase of 19.6% on $74.0m in the second quarter of 2006.

Click here for the latest update on VC funding figures.