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The long and winding road of business incubation

What exactly is an incubator?

Well, that is exactly where the problem starts: incubators are a very heterogeneous group. Technically, incubators are entities that offer a number of services to entrepreneurs who were unable to get them otherwise, and get compensated at least in part by receiving equity stakes in the "incubee". The original model consisted of providing mostly floor space and a high speed Internet connection as well as shared secretarial and printing services. From there, it extended to providing all kinds of other services like consulting, coaching and mentoring. The major question that arises then is: what is the value of putting into an incubator "structure" services which are otherwise available independently? Why give away 20 to 50% of your equity to get an office if you are an entrepreneur? In many instances, it is not clear what the value added of the incubator is. Incubators were often the ultimate posterboys of the internet economy, in good and in bad, suffering from the same inflated expectations and flawed business models…

The second problem, which is finally coming to light, is that there is an adverse self-selection process at play. Who is going to go to these one-stop entrepreneurial service providers? Mainly those that so desperately need the services that they could not care less about the costs (especially if those are paid in shares of dubious value at this point), which means a lot of first time entrepreneurs with half botched ideas. First time entrepreneurs have no experience and their projects need a lot of help. If you are not a first time entrepreneur, you probably don't need to go to an incubator. You already have the networks and the connections, and you can get access to pretty much all you need to launch your project. When incubators got started, say looking back to Bill Gross at IdeaLab!, the adverse selection was not an issue: all the ideas were internally generated!! Moving to external idea sourcing was not an insignificant change: it created a huge problem for incubators!

The third problem plaguing incubators has to do with them being in the seed stage funding business. The seed business life cycle is not twelve months; it is more like four to five years, if not more. You need a lot of money to carry a project that long. A lot of the incubator models were fundamentally flawed because they assumed that there would be liquidity events extremely quickly, which rarely happened in the past and is even less likely to happen going forward. Nobody was ready to carry projects that long. Incubators were often pure "greed" plays, happy piggy-backers on the internet gravy train. When there was so much money to throw around, nobody really cared about their value creation. But when the gravy hits the fan, everyone suffers…

Another issue has been pointed out and partly addressed by Gorilla Park. There is an inherent conflict of interest if you are both the incubator and the financier of the start-up when you get to the second round of funding. You are coaching the firm, trying to increase its valuation and at the same time, as financier, you are trying to finance it at the lowest possible value. Gorilla Park attempted to solve the riddle by restricting its initial investment to human capital (man-days, basically…) and voluntarily abstaining from doing second rounds…..

Another common problem is: What services can be provided that are not commodities? A lot of people who labelled themselves incubators really had nothing to offer. There were people doing financial engineering calling themselves incubators. To get such services you only have to ask a bank.

Incubators where created to fill a perceived gap: that some people with great ideas were not getting enough support and funding and hence that society was loosing out by not taking to fruition some great projects. Beside the fact that this has never been supported, it did imply that if getting a more entrepreneurial economy was an important economic objective, it would be important to create structures to support them, incubators or else. Nothing wrong fundamentally with that concept, but a few pragmatic issues. First, I'm not completely convinced that there are that many people that fall into the category of entrepreneurs with great ideas but no support and who are unable to attract money and attention. When this happens, what you generally have is an entrepreneur with a bad idea not worth supporting, but nobody has told him/her (there is no gain for being the messenger of the bad news) or he/she stopped listening a long time ago. People with that kind of profile have a lot of problems, and tend to grow very frustrated, blaming investors and the economy for what is essentially their problem. It is not about inefficient market and unavailability of money or services for these types of businesses: it's about inappropriate supply of quality projects. It is amazing how few people are willing to face the fact that 90% of the projects presented in the form of a business plan are bad ideas or bad opportunities not deserving of funding….

Seen from the perspective of society, one of the major ideas, at least in Europe, is that innovation should be encouraged. Innovation is more than coming up with ideas. It's a question of making them happen. From that perspective, the process of incubation should play an important role.

In other words, in the translation of ideas and concepts to real opportunities and businesses. That was the very nice idea: you have people who have concepts but may not have the experience or the inclination to get involved in the implementation work. To make life much easier for them, you provide them with the marketing support, the office space. You are supposed to give them more time to focus on the true innovation. I have nothing against that. The problem is the overstatement of what that provision of services was really worth. I don't want to convey the perception that I am against this type of activity. Quite to the contrary: I am a true believer in it, and practitioner of it, but I want people to understand what they are getting into. Incubation is a nice business: Just don't expect it to be a moneymaking machine. It takes a lot of patience and you are going to have to provide real value to the incubees. A lot of so-called incubators were not doing that. If you ask some entrepreneurs who took the bait and worked with incubators what the problems were, at the top of the list you find lack of attention and absence of competence of the incubator. Many were good at selling themselves to entrepreneurs and investors. They were extremely poor at delivering the services. They did not have the relevant networks, did not understand the industries they were getting into. They may have had some money to invest but when it came to services, they were extremely poor. Right now there is a good cleansing taking place. There are some really competent incubators who try to provide real services for the money, but it is a tough business. That is the one message that people didn't want to hear.

One of the ideas of business incubation is that it accelerates the process but in so doing don't you create heavily assisted entrepreneurs who are not really entrepreneurs?

Let's go back to the first implicit assumption in that statement: that it is intrinsically desirable to accelerate the process. This was based on the idea that there would be a first-mover advantage. We now realise that the first mover-advantage, especially in the Internet world, probably doesn't exist. What you have is a first mover disadvantage. The first mover has to educate the consumers and to face all the introduction costs. The first-mover advantage only means something if you are able to slam the door in the face of the next mover into the industry. The problem is that in the Internet world that is not what happens. The barriers to entry are extremely low and there is very little you can to do to stop people coming on to your turf. So your first-mover advantage is ridiculously small. That raises the question as to whether moving so fast carries such a huge premium. It is still important. Clearly we need to move quickly, but I don't think moving a month faster is necessarily of any value.

Assisted entrepreneurs? That is an issue. Particularly when you see some of these incubators trying to formalise their processes. In other words, come up with recipes. Some were very good at creating a series of very formalised steps that they would take the entrepreneur through. There is a danger that you provide too much structure for something that, by nature, is a bit "out of the box", if not "off the wall". Structured process probably would have killed most of the killer applications of the last 5 years…

Assistance is also expensive. People only take the assistance the first time around. Once they have done it - with or without assistance - and learnt the ropes, they won't come back. I don't know of a case of an entrepreneur who made it with an incubator and then went back to the incubator to do a second project. The good news then is that good entrepreneurs graduate from incubators unscathed, but the bad news for incubators is that the good ones never come back.

You make it sound like a learning process...

It is shared learning. The entrepreneur moves in. He learns from the incubator as much as he provides new ideas to the incubator. When the entrepreneur realises that the incubator is learning from his actions, he might feel even worse about giving thirty or forty percent of equity away….

You talked about the dangers of over formalisation, but in a learning process there is necessarily a certain formalisation. The difficulty with the innovation process is that you start from the ultimate freedom and move towards a situation that is inevitably constrained. In the process there are necessary formal steps that you have to go through.

At IMD, we developed a 1-week program for corporate new ventures called "new venture booster". We definitely took a "stepwise" approach to the process of developing a venture but it is not constraining the process: it's just saying that there are a certain number of elements that need to be in place before you can claim to have a satisfactory business model. We force people to address those issues. But that doesn't go to the point of forcing a type of business model on them. I have seen a number of incubators, particularly those who specialise in specific areas, who say, for example, that they have a certain way of selling software, or a certain way of approaching the customer, or of pricing and it is applied across the board to any project that the incubator deals with. Such an approach could be detrimental to the project. This is the classic issue of the hammer looking for another nail to hit, or the scientist with a great answer trying to find the problems it could apply it to….

What are the financial models for incubators?

Historically, the initial model was based on generating the ideas internally, seeding them and priming the pump very quickly, taking projects from ideas to quick exits. That meant either a good trade sale or an IPO which was possible because markets were willing to take projects before they were even half-baked. You then used that money to reinvest in other ventures. The idea of the very short incubation period was flawed in at least two respects. First that you could take a project from an idea to something that can be sold to the market or to other investors in a very short period of time. It's not that short. It's not twelve months. It is more like three-five years. Then there is the idea that you would be self-funding very quickly. It takes a lot of money to seriously grow companies. That takes us back to the question of the model of equity for services. Does that make sense in any business? It is not clear.

You talk mainly about the commercial incubators, but a large number of incubators don't work on that basis.

That's correct. Some very early models of incubation were based on non-profit institutions. Those were what I refer to as "entrepreneur centric" entities, designed to help entrepreneurs because it was deemed a desirable public objective. It was a public good, provided to support the good of society. This was to a large extent self-interested public philanthropy!. These not-for-profit, economic development incubators suffered from a number of serious problems as well. It was not always clear that those who were providing the coaching and mentoring had any real business sense. In many instances, those were public servants. But who is best able to provide incubation if not an entrepreneur himself? He's done it and understands what is needed to be successful. A lot of incubators, then called "regional development agencies" or other fancy names, were mostly run by well-intentioned public servants, sometimes consultants and politicians. Those were not the right kind of persons to provide advice. Some of the frustration of entrepreneurs sprang from that. You may have got your seed round, but you were not getting the real support because the incubators didn't understand the problems of start-ups. How can you claim to incubate business if you haven't done one, or two or three yourself? There's a problem of credibility.

From a practical stand point, some people thought that incubation meant seeing the team an hour every week, giving them a nice office, a little bit of seed money and possibly a ten-minute phone call every day. Until they realised that this is not the sport that incubation is about. To use a sports analogy, it is not lawn tennis at Wimbledon; it is more like mud rugby at Lansdown Road. You are in the dirt with your entrepreneur all day long. They are not going to take ten minutes of your time; they are going to take ten hours of your day. And it's now, not tomorrow.

On top of all that, you had the problem of exits. Not in terms of money, but rather in saying "stop". When should I kill a deal in my incubator? There is a terrible conflict there. You build a tight relationship between the incubator and the incubee. Whereas the truth is that two thirds of the projects under incubators die. Just like most of those under venture capitalists. A venture capitalist never has second thoughts. If something is not working he pulls out the Smith and Wesson and shoots the project out of its misery. For an incubator, things don't work the same way. You work very closely with the person; you build a relationship. Think of the term itself: "incubating" feels like cocooning, personalized support, warm and fuzzy. It becomes very difficult for a lot of them to say, "That's it! We're stopping here! End of the road, terminus, you are on your own…." Feels like total treason…. Such a choice has a very negative effect because if you start killing two or three of your early projects, who is going to come and join your incubator?

What would you consider to be criteria for an incubator to be successful?

I'm a true believer in the need for incubators but I'm very critical of a lot of activities that are taking place. First, you need to be realistic about the financial objectives. It is no different from doing venture capital or entrepreneurial work. It is high risk, potentially high reward if you have the patience. But before you get there you are going to have to invest a lot of money and a lot of time. Second, to be a good incubator you need to be realistic about how many companies you can incubate. To be honest, I wouldn't be involved with more than two or three at any one time. More than that, you are not going to be able to provide the kind of service that they deserve. That puts it outside the range of industrial activities. We're back to craftsmanship. Which is really what entrepreneurship was about to start with. The most efficient incubators today don't even call themselves incubators. They are some of these well-connected, very involved angel investors. They take extreme pride in the projects they are helping. They are there any time of day or night for their proteges. They'll do two, maybe three projects at a time. The problem is that this model does not scale very well. The big model for the Internet was scalability but in the incubator space you don't have scalability. It is still very much a craftsman's type of activity.

I guess you could have an incubator with a large number of coaches to handle more start-ups... The trouble was that most incubators had a very small number of people who were at the same time the general partners, the fundraisers, and the administrators as well as being the coaches. That doesn't work. What's more, how easy is it to find coaches of high quality and high integrity that are willing to coach projects rather than be entrepreneurs themselves? Why would you get all the hassles of "new venturing birthing" with very few of the upsides? One of the key competencies you'd expect to find in a coach is the entrepreneurial mind, but such a person can't resist getting involved in a good project. So how do you hold on to them? They'll walk with the opportunity.

You said that one of the major failings was absence of necessary competencies. What would you see as the required competencies?

Most of the time they don't understand the entrepreneurial process. A lot of people coming from consulting and banking, for example, thought that because they had seen big money or had provided advice to big companies they would be able to advise start-ups. You need to have entrepreneurial experience. A lot of those people assumed there was nothing special about start-ups. In a start-up there are constraints you don't have in an established, larger operation. You are dealing with individuals and small teams of individuals. You are not dealing with an infinite supply of specialities. You have very constrained resources. I've never seen a start-up that had enough money. There's also a certain frame of mind. In the US they talk about the "bootstrapping" mentality: trying to do things with as little resource consumption as possible. How do you make things happen when you have very little on the ground? How do you single-mindedly pursue opportunities, without even considering the resources that you have? The pursuit of opportunities is the true definition of entrepreneurship. Start-ups are necessarily small and innocent. They are going to have to fight a lot of competition. Risks are present everywhere - on the product side, on the market side. There are a lot of limitations. The start-up is very easy to hurt and to kill. If you haven't lived it, I don't see how someone could help them. You can provide functional help, in finance for example, or marketing. But that doesn't mean you understand the whole problematic of the start-up.

I tend to become a bit over-aggressive about this subject when I see people giving a fundamentally good field a bad name. They spoil the game for everybody else. It is the same with venture capitalists. There are a lot of very incompetent people moving in, loosing a lot of money so that venture capital as a whole ends up with a bad name. In incubation there was an extremely large proportion of people who didn't know what they were doing. But fundamentally incubation is a great business but not for the fainthearted or the late convert…

Benoit Leleux, Stephan Schmidheiny Professor of Entreprenurship and Finance at IMD, Lausanne Swizerland.
Interview Alan McCluskey.

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Created: July 11th, 2001 - Last up-dated: July 11th, 2001