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Thursday 29 August 2013

The Problems with Incubators, and How to Solve Them (Sramana Mitra)

The Problems with Incubators, and How to Solve Them

There is a very real knowledge gap in the early stage start-up game, on both sides of the table. First-time entrepreneurs lack the seasoning to captain a steady ship through turbulent waters. Inexperienced friends and family (and, increasingly, crowdsourced investors) lack the ability to gauge the viability of a business, or to mentor naïve entrepreneurs.
This knowledge gap, I have come to believe, is best filled by savvy incubators. However, there are over 7,500 business incubators around the world. Most of them fail.
The first business incubator in the U.S. opened in 1959 and is still operating. In the last couple of years, we have seen a renaissance in the incubator business. Pioneered by YCombinator, Silicon Valley's flagship incubator led by Paul Graham, incubators have come back with a vengeance. YCombinator has seen some significant successes, including Airbnb, Dropbox, and Heroku. It has fueled a bit of an incubator bubble, I must admit. Incubators are now a global phenomenon, and there isn't a major city in the world where an incubator isn't cropping up.
For incubators to live up to their full economic potential, they need to overcome two pitfalls: they need to provide real value, not just office space, and they need to measure success in more than just outside funding.
Adding Real Value
During the dot-com era, every law and accounting firm decided they were going to become incubators. Many of those efforts failed. Charles D'Agostino, executive director of the Louisiana Business & Technology Center at Louisiana State University, offers some analysis: "Incubators do work, but they must be more than a real estate entity offering executive suite services. Effective incubators provide business counseling and management assistance to their client firms. The value-added business services differentiate them from an office suite."
Indeed, as I investigated why incubators fail, I was astounded to find that many incubators assume that cheap real estate, co-working spaces, used furniture, plus a phone and Internet connection equate with business incubation. Jim Flowers, president of the Virginia Business Incubation Association, says, "They mistake cheap floor space for meaningful program content."
Well, it isn't. Neither are discounted legal services, accounting, or other kinds of commodity services.
Two things determine whether a business can get off the ground successfully and sustainably: a validated market opportunity with customers willing to pay for a product or a service; and a product or service that addresses such an opportunity. The only incubators I consider "real" are the ones that help entrepreneurs achieve these two goals.
Adds D'Agostino, "Incubators must evaluate the management capability of the entrepreneurs and assist in finding management for these companies. Especially when the entrepreneur is a technologist lacking business skills, it is critical that the incubator assists the owner in finding managers that have the skills necessary to manage a successful entity and take it to the next level."
My take is that technologists can, actually, be taught these skills. Hiring managers may often be expensive, but high IQ engineers have historically been very good at picking up business skills with the right mentoring. So getting to the next level is well within their capacity, and the role an incubator ought to play is to guide them in that process.
The only "next level" worth getting to for a start-up is a validated business idea that has the endorsement of reference customers, and a product that caters to their needs. The rest — an office, legal documents, QuickBook files — don't build valuation or business value. The benchmark incubators should be measuring themselves against is simply their success in helping clients validate businesses, gain reference customers, and complete at least a minimum viable product.
Success is More Than Funding
Most incubators use funding as a success metric, which is a somewhat flawed criterion. Over 99% of companies should operate as organically grown, self-sustaining businesses — bootstrapped, without external financing. For them the goal is to achieve customer validation, not financing. Yet if the incubator uses financing as its success metric, it will try to force inexperienced entrepreneurs into an unnecessary financing round. And more often than not, they will fail.
YCombinator has mitigated this by partnering with venture capital firms like Sequoia, Andreessen Horowitz, and General Catalyst, such that every single company in their portfolio gets $80k in seed financing as they graduate from the incubation program. But most incubators in the world do not have that luxury. Nor do they have the deal flow deserving of such guaranteed financing.
Of course, where funding is appropriate and relevant, helping entrepreneurs connect with angel investors and venture capitalists is an important service. Equally important is to provide education on what is and isn't fundable.
Will this new generation of incubators perform better than the previous ones?
It remains to be seen.
My primary conclusion is that incubators need to be decoupled from financing. While they need to continue to act as a bridge to capital, predicating their success on getting businesses funded will keep them focused on trying to find the less than 1% of start-ups that are fundable. In other words, coming to the rescue of victory!
The other 99%, then, continue to be ignored.
A scalable incubation model for the other 99% is a requirement for the next rev of capitalism.

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