Incubator: What's In a Name?

Joseph W. Bartlett, Founder of VC

Incubators are cropping up everywhere (some of which are restructured versions of existing firms), but not all of them are created equally. Before an entrepreneur approaches an incubator, accelerator, etc. to hatch a business, they would be well advised to learn a little about all the birds, odd and otherwise, that fly under the name incubator.

First, of course, is a physical incubator, meaning an enterprise like TechSpace in New York City which makes available real estate on a user-friendly basis. TechSpace has two locations in New York (in addition to locations in 4 other cities) and has scores of tenant companies. It also has an associated fund that invests on occasion in the tenants, taking an equity stake in some, but not all, of their portfolio companies.

TechSpace and other physical incubators will own and rent out a broad expanse of loft space in a downtown area centrally located to public transportation and to late night amusements (for those entrepreneurs who work 24/7 and need some release at the end of a long, long day). The space is split up into small cubicles, the building is wired for broadband services, the space includes common reception, conference, filing and cafeteria services, along with telephone answering and other ancillary administrative services. The space itself can be expensive but it is very efficiently used and, therefore, the resulting expense is within a start up's reach. The firms themselves, crowded side by side, often are able to network. And, the sponsor of the incubator, being the owner of the real estate, will often hold common functions from time to time... a speech by an experienced venture capitalist, for example, in the common areas. Often in connection with the physical (or "walled") space the sponsoring organization will offer professional advice... consulting, legal, marketing accounting, financial management, executive search and technical . plus internet access and computer enhancements. The sponsor typically will not itself generate these services but will have a short list of preferred providers (some of which may actually maintain a satellite presence from time to time in the space), and will arrange for the start ups to meet the vendors on the list.

In contrast, virtual incubator/accelerators have no real estate for rent but aggregate and channel certain value added services to their clients. They in effect surround their clients with all necessary services through either in-house capacity or preferred providers. Again the idea is incubation or acceleration. The entrepreneur comes with the idea, the talent and the energy; the virtual incubator takes over and gets the legal work done, the tax returns filed, the business model refined into a placement memorandum, the technical platform built and the key executive personnel hired. In return, they take an equity stake in the entrepreneur company.

A typical example is Larry Schwartz at NewNetCo. Based in Connecticut, NewNetco partners with VC's, angel investors and professional service providers to provide funding and services to its clients. They have a "portfolio" of companies that have gone from concept to an actual going concern-while being under the tutelage of their services. NewNetCo does not manage a fund or house the companies in a physical space, rather it focuses on turning innovative ideas into working business models.

Both physical and virtual incubators turn ideas into actual businesses by adding value. This value is seen in several services, such as facilitating idea creation; enhancing product and services through managerial expertise; accelerating speed of implementation; providing access to marketing, operations, human resources, technical, and strategy expertise. They also facilitate business development and strategic partnerships; and help to identify new sources of funding. In sum, both physical and virtual incubators can offer more "hand holding" than a typical venture capitalist. These benefits, value added services and speed to market, are ostensibly worth whatever equity the incubator takes in the entrepreneur company.

A third category worthy of mention is what we might call the disguised placement agent-those individuals or companies that raise capital for a fee. Obviously, the most urgent need of most emerging growth companies is investment capital. Everything else is dependent on the entrepreneur's ability to raise the necessary funds. Therefore, a number of self-styled incubators are in fact placement agents, with a patina of other functionalities added to the mix. In this category are firms which will tender you a bit of business advice, point you in the direction of a appropriate law firms and other professional service providers, introduce you to a web site designer with which the incubator has previously done business, give you some clues as to how to hire an executive search firm. After this initial advice, the entity will help facilitate a venture capital financing.

Recently we have seen existing placement agents that attach the label "incubator" or "accelerator" to itself. As a result, the placement agent requires a much larger percentage of the equity than would traditionally be the case. To use a simple example, assume a placement agent is accustomed to raising money for startups on the basis of a 8% cash success fee, a small retainer, and expense allowance, and warrants entitling it to 10% of the equity assuming the target capital is raised. However, take the same placement agent and attach the label "incubator/accelerator" to it, throw in a few services and some mumbled mantras about overall strategic advice, and the picture can change significantly. By calling itself an "incubator," the placement agent may justify, if only to itself, asking for as much as 50% or 60% of the equity in warrants or cheap stock.

A final category is the incubator that actually provides investment capital... a venture capital fund in effect, which styles itself as an incubator. The most prominent members of this category are the public venture funds... CMGI, Internet Capital Group, IdeaLab!, etc. Their principal business, of course, is investing in emerging growth companies, much as, historically, venture capital funds have always invested. The "incubator" label is attached because, in a methodology which SoftBank pioneered, their portfolio companies are expected to network one with the other; the incubator facilitates synergistic relationships. A company seeking web site design services will be in the same portfolio with a web site designer; the incubator will make the necessary introductions for a productive business relationship. These companies have seen a drastic fall in their valuations as investors have questioned whether the incubator itself is a profitable venture.

Whether you are dealing with a physical incubator, a virtual accelerator, a disguised placement agent or a publicly traded entity--it is paramount to know exactly who they are and what services are actually provided. Not all incubators have the same definition and, as is readily evident, not all incubators are created equal.