There Is an Incubator Bubble—And It Will Pop

8/12/11Follow @wroush

This week we published the third annual edition of the Xconomy Guide to Venture Incubators. It’s the only source we know of where U.S. entrepreneurs starting technology, life sciences, or energy companies can survey all of the early-stage mentoring and investment programs open to them in a single document. (You can buy the downloadable file here.)

It’s a great resource, and I wanted to take a moment to recognize and thank our Cambridge, MA-based associate editor Erin Kutz for pulling it together. Erin had a huge job on her hands this year, for one simple reason: the nation has startup fever. While the rest of the economy slowly fizzles, investors, foundations, regional economic development authorities, and other organizations have been setting up incubators, accelerators, and similar programs for startups at a blistering pace.

When we published the first edition of the incubator guide in 2009, it included 20 listings. The second edition in 2010 had 34 listings. And this year’s edition has a whopping 64—and that’s not counting incubators in Europe and other regions, or the seven programs we removed from the list because they’d changed their operating models.

In any market where the number of new businesses triples in the course of two years, you know that something unusual is going on. (And make no mistake—most venture incubators are businesses, founded and funded by people hoping for real returns, whether social, financial, or both.) You naturally begin to wonder whether a bubble is forming, in the classic sense of an episode of vertiginous growth disconnected from economic fundamentals such as market demand. And since bubbles are, by definition, unsustainable, you wonder what’s going to happen when they pop.

If you ask me, there is clearly an incubator bubble. Whatever your opinion about the existence of a bubble in the larger world of Internet startups—Sarah Lacy and Dan Primack offered interesting, opposing views on that this week—it’s hard to imagine that today’s tepid consumer and business markets have room to absorb all of the products and services offered by the hundreds of new startups that the incubators are now churning out each year.

It’s a given that only a few of the startups going through the incubators will strike it rich while the rest languish or die—that’s the nature of the startup game. What I’m saying is that without higher-than-normal success rates, many of the incubators themselves could find it difficult to stay in business.

Here’s why. Most of these operations are organized along the Y Combinator model: they provide startups with $15,000 to $25,000 in seed funding and about 12 weeks of mentorship and product development assistance, and in return they take an equity stake, usually around 6 percent. They profit when incubated startups get big and successful enough to be acquired. (As far as I know there isn’t a single example of an incubated company going public.) Doing the math, let’s say you’re the founder of an incubator and you fund 20 companies a year at $25,000 each, in return for a 6 percent stake. To achieve respectable returns on that $500,000 you laid out—let’s say a 3x return, not even figuring in your operating costs and the value of the time you put into mentoring the companies—you need one of your alumni companies each year to achieve an exit in the $25 million range (or two at half that, and so on). And that’s assuming your stake isn’t diluted by later funding rounds. It’s quite a gamble, and I just can’t see the economics being very compelling for any but the largest, best-funded, most prestigious incubators—i.e., Y Combinator and TechStars.

Indeed, the current profusion of incubators may exacerbate the very problem that incubators were invented to solve in the first place: the difficulty of getting a new company off the ground. The more startups that these programs launch each year, the harder it is for … Next Page »

Wade Roush is a contributing editor at Xconomy. Follow @wroush

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