04/10/12

Incubators don't work - and it's fine

A few weeks ago I had the great fortune and pleasure to pick Jed Christiansen's brain for a good two hours. Jed is probably the one person on this planet with the best data set about incubator and accelerator programs around the world, the companies which go through them and the possible reasons why some incubators are so much more successful than others.

I fundamentally believe that most incubators (which seem to shoot up like mushrooms after a rainy late summer day) are destined to fail - and I also believe that it doesn't matter.

Let me explain - and start with a disclaimer: The following is especially true if you're building your incubator outside of the US and more specifically outside of Silicon Valley. With that out of the way - the reasoning is simple: The math doesn't work.

Most incubators take a rather small chunk of equity for their investment and services (often in the sub-5% range). I believe the reason for this is that some of the super-successful incubators such as Y Combinator have "poisoned the well" by introducing these terms (and they do work for them - more about that later) and forcing the whole industry to follow suit. Also incubators usually take founders stock - i.e. stock without any preferences or protections as are often found in seed and VC rounds.

What happens is this - by the time a company has an exit, they have often gone through a couple of rounds of financing, diluting the original founders shares by 50% or more. Which means that the initial 5% our incubator held become a mere 2.5% or less. Now apply the typical VC logic that out of 10 companies you can count yourself lucky if one or two of them hit it big, three to four do okay and the rest goes under. Now - in most areas of this world a "good exit" is considered something in the $10m range (even in large markets such as Germany there aren't that many $10m exits). Take into account that a portfolio takes time to mature (somewhere around 5-10 years for the companies to go through their growth phases and come to an exit) and start doing the math, the picture is rather bleak.

Here's an example calculation: An incubator runs a class of 10 teams, investing $15k into each team and spending 3 months of intense work with them, running the incubator with three people as staff. Assuming that these people have opportunity costs of $150k p.a. (meaning that the people running the incubator could find work at this rate somewhere else) and taking into account costs for office space, etc. you easily have invested $350k into this batch of 10 teams. Five years later you might (this is a risky proposition - no guarantee that anything comes out of it!) make 2.5% on one $10m exit ($250k) and another 2.5% on three $3m exits ($225k), bringing you to about $.5m in returns. Potentially. With a rather high risk. The math just doesn't work that well.

And that's precisely why I think the incubator model doesn't work. To make it work you would need to do two things - take a higher percentage of equity in your first round (much to the grumbling of the founders) and have the ability to protect your position by being able to do follow-on investments (i.e. you invest alongside other investors in the next rounds to prevent dilution of your equity position) - which requires money most incubators don't have.

Now - why this all doesn't matter...

Here's the thing: As much as I think this is bad news for people building and running incubators, it's perfectly fine for entrepreneurs and the economy at large. The worst outcome of this scenario is a bunch of failed incubators - which in turn have taught and enabled hordes of people to become entrepreneurs. And who knows - even if their first startup didn't work out, they hopefully learned a lot and will be better off for their next one.

With all that being said - here's another disclaimer: The well known and established incubators such as Y Combinator, TechStars, 500 Startups, SeedCamp and some others will be fine. They have built their models around these dynamics, have created very specific value propositions for themselves and thus their teams and they have unparalleled access to the market.