There Is an Incubator Bubble—And It Will Pop

8/12/11Follow @wroush

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any one of them to get noticed by investors, journalists, or customers. The problem is evident even within the microcosm of Y Combinator. The first class of Y Combinator startups I covered, the Summer 2010 group, included 36 companies. The next crew, Winter 2011, had 43 startups. The Summer 2011 class, which will wrap up its session this month, includes more than 60. One side effect of this growth is that the time allotted for each company’s Demo Day pitch keeps getting shorter and shorter. Another is media exhaustion: assuming it doesn’t get any bigger, Y Combinator alone will soon be minting 120 companies per year, which means I could spend two days a week writing about YC companies and I still wouldn’t be able to cover them all.

Of course, there are many good reasons for the incubator boom. At a policy level, the U.S. has no choice but to try to innovate its way out of the current economic doldrums. As numerous studies by the Kauffman Foundation and others have shown, most economic growth comes from startups. So communities like Detroit, where economic reinvention is an imperative, have every incentive to set up incubators to support local entrepreneurs. And there is obviously no shortage of interesting and important problems waiting to be solved by entrepreneurs, from the cosmic (global warming) to the casual (the damnable inefficiency of online dating, to pick just one example).

At a practical level, incubators are a pretty good way to organize the energies of young entrepreneurs who might not go the startup route on their own, and would likely wind up as code monkeys at larger (and less innovative) tech firms. There’s also an established set of incubation practices—a startup curriculum of sorts—that can provide substantial help to companies negotiating their bumpy early stages, from incorporation paperwork and product prototyping to customer development and investor outreach.

But just for the sake of argument, let’s say I’m correct that there isn’t room in the market for 64 venture incubators and all their progeny. What happens when the bubble bursts and half or more of these groups have to shut down? Will the outcome be as catastrophic and long-lasting as the bursting of the last incubator bubble back in 2001? Yes, there was an earlier wave of incubators. They bore little resemblance to today’s Y Combinator-style startup schools; most were lavishly funded startup factories like Bill Gross’s Idealab that launched only a few offspring per year and took gigantic stakes in each—30 percent or more. (Read this 1999 Forbes article by none other than Om Malik for a quick refresher on that era.) But after that first wave of incubators imploded in the dot-com crash, nobody dared to touch the model for another half-decade.

I don’t think that’s what will happen this time around. For one thing, there’s less money at stake. Even if you funded 100 companies at $25,000 each and they all failed, you’d only be out $2.5 million. Y Combinator, once again, is a bit of an outlier here—Start Fund’s spray-and-pray strategy of investing $150,000 in every YC startup means that principals Yuri Milner and Ron Conway are now risking roughly $9 million per YC batch. But despite the higher stakes, I think the most reputable and best-funded incubators will survive just fine, while many of the others will be forced at some point to gracefully step aside. You’ll know this has happened only when they stop putting out requests for new applications. (All the more reason to buy our guide and study the differences between the incubators.)

I’ll be particularly interested to watch the development of the non-Internet incubators—those applying the incubator model to new markets like healthcare (e.g. San Francisco’s Rock Health) and cleantech (Greenstart in San Francisco and CleanLaunch in Colorado). The classic 12-week incubator curriculum was initially developed for Web startups, whose products are a lot easier to build, test, and revise than, say, implantable medical devices or rooftop solar arrays. It’s not clear yet whether participating in an incubator program can give a healthtech or cleantech startup enough of a boost to make the incubator’s investment worthwhile. I hope it can, because innovation in these areas is needed more urgently. But right now, that’s still just a hope.

So, don’t be surprised if Xconomy’s 2012 Venture Incubator Guide doesn’t have quite as many listings as this year’s. Still, even if I’m right and it turns out that 2011 was the high-water mark for the incubator movement, there’s still a lot for the incubator founders and the participating entrepreneurs to be proud of—namely the hundreds of companies that might not have entered the world otherwise. Only the luckiest and/or smartest startup founders will hit the big time, but the rest will get some great experience and will be a in a better position to try again, if they have the persistence. Which, alas, is a trait that no incubator can teach.

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

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