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 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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