Trying to understand incubator math

Editor’s note: This is a guest post by Jesse Rodgers who is currently the Director of Student Innovation at the University of Waterloo responsible for the VeloCity Residence & he is also the cofounder of TribeHR. Jesse specializes in product design, web application development and emerging web technologies in higher education. He has been a key member of the Waterloo startup community hosting StartupCampWaterloo and other events to bring together and engage local entrepreneurs. Follow him on Twitter @jrodgers or WhoYouCallingAJesse.com.

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Incubators are not a new addition to the financing and support for startups and entrepreneurs. On the surface, incubators and accelerators seem like a low cost way for VCs and government support organizations to cluster entrepreneurs and determine the top-notch talent out the accepted cohort. The opportunity to investing in real estate and services that enable companies where the winners are chosen by the merits of the businesses being built. It feels like a straight-forward, relatively safe bet to ensure a crop of companies that are set to require additional growth capital where part of the products and personalities have been derisked through process.

However, its not as simple as putting small amounts of investment into a high potential company. An incubator is a business and it’s sole purpose should be to make money.

What are the basics of an incubator?

The basic variables in setting up an incubator business are:

  • Cost of the expertise, facilities, services and other overhead
  • Amount of $ to be invested/deployed
  • Number of startups
  • Equity being given in exchange for cash
  • Return on the total investment

There are cost of operations: real estate, connectivity, marketing, programs and services for the entrepreneurs, and the salaries of the individuals to find the startups, provide the services and build successes. These costs are often covered by governments, in exchange for the impact in job creation and taxation base. We’ve seen a rise in incubators that are funded on an investment thesis, where an individual or a set of “limited partners” provide the initial investment in exchange for an investment in the companies being incubated.

How much do incubators cost?

The goal is to efficiently deploy capital to produce successful investments. I’m going to explore how incubators make money by making a few assumptions based on the incubator/accelerator models we’ve seen in Toronto, Montreal, Palo Alto and New York.

Basic assumptions:

  • Capital Investments: 10 startups x 20k = 200k invested with an assumed ‘post-money valuation’ of $2.2MM
    • This means you now own 9.1% in 10 startups each with a post-money valuation of $220k
  • Support Costs: 10 startups x $10k = $100k
    • This is the cost of real estate, furniture, telecommunications, internet connectivity, etc.

Alright, we’re planning to deploy $200k and it need to provide approximately $100k in services just to provide the basics for the startups. We’ve spent $300k for the first cohort and and that is before you pay any salaries, host an event, etc.

Additional costs:

  • People:
    • $100k per year salary for one person to rule them all. Call them executive director or dean or something.
    • Assuming you’re not doing this to deploy your own capital, the person or people in charge probably need to collect a salary to pay their mortgages, food, etc.
  • Events - Following the model set forth by YCombinator or TechStars we have 2 main types of events. Mentoring events where the cohort is exposed to the mentors and other industry luminaries to help them make connections and learn from the experience of others. The other event is a Demo Day, designed to bring outside investors and press together to drive investment and attention in the current cohort, plus attract the next cohort of startups.
    • Mentoring event: $1k for food costs with 25 founders
    • Demo Day: approximately $5k
    • Assumption: 10 mentoring events plus a demo day per cohort adds $40k.

The estimated costs are approximately $340,000/cohort. Assuming 2 cohorts/year plus the staffing salary costs, an incubator is looking at $780,000 that includes 40 investments and a total of $4.4MM post-money valuation. If we assume that I’m a little off on the total capital outlay, and we build in a 30% margin of error this brings the annual budget to appromimately $1MM/year to operate.

How do incubators make money?

Incubators make money when the startups they take an equity stake in get big and successful. The best exits for an incubator come when one of their startups is acquired. Why acquired? Because the path to getting acquired path is shorter than the path to going public which would also allow the incubator to divest of their investment.

Let’s do the math. If your running an incubator hoping to get respectable returns on the $1,000,000 you’ve laid out above, let’s say it’s not the mythical 10 bagger but a more conservative 3x, the incubator needs one of the companies to exit at near $30,000,000. It can be one at $30MM or any combination smaller than that totalling $30MM. This needs to happen before any dilution and follow-on funding for your cadre of companies. You have to assuming that they can make it to acquisition on the $10,000 and services you’ve provided. For more on incubator math, check out there’s an incubator bubble and it will pop.

The bad news is that it isn’t as simple as that. Startups are not just something that exist in a vacum. There are a lot of unknown variables that can make or break an incubator.

  • percentage of startups that fail (or turn into zombies) in the first two years after investment
  • time frame return is expected
  • how many startups currently produce that kind of return annually
  • total number of startups that receive investment in any given year
  • total number of acquisitions in any given year
  • avg. number of years a startup takes to get to acquisition (because they aren’t going public)
  • avg. price a startup sells for (I bet those talent acquisitions drag the average way down)
  • what do VC’s currently spend on their deal pipeline?

It is the unknowns that are where the gamble exists. You can tweak the numbers all you would like but assume startups have a no better fail rate then any small business. The common thinking on that is 25% of businesses fail in the first year, 70% in the  first five years? If just more than half of those companies are alive in one year you are doing well. If one out of those 20 is acquired in 5 years and you get 3x return do you succeed? Do you have to run the incubator for the 5 years at $1MM/year to be able to play the odds?

Maybe this is why so many incubators focus on office space, it’s easy to show LPs what they are getting for their $5MM for 5 year investment, plus an impressive number of “new” startups that have been touched by the program (often without an exit, you know the way incubators make money).

What am I missing?

Editor’s note: This is a guest post by Jesse Rodgers who is currently the Director of Student Innovation at the University of Waterloo responsible for the VeloCity Residence & he is also the cofounder of TribeHR. Jesse specializes in product design, web application development and emerging web technologies in higher education. He has been a key member of the Waterloo startup community hosting StartupCampWaterloo and other events to bring together and engage local entrepreneurs. Follow him on Twitter @jrodgers or WhoYouCallingAJesse.com.

  • http://fraserharris.tumblr.com/ Fraser Harris

    1. You’re missing the filter.  They get to pick 10 startups out of X applications, filtering for highest probability of success. Unless you believe that startup success is really blind luck, that should improve the odds that at least 1 of the startups exits.

    2. The other part you are missing is that VCs will subsidize the incubators in exchange for deal flow.  For example, Greg McAdoo, a Sequoia Capital partner, invested $2M into YCombinator.  He does a mentoring session with each company before Demo Day, which gives him an advantage over other funds.

    Paul Graham: “Top tier firms like Sequoia already have a de facto right of first refusal on the entire startup market. They already see every deal. So if Sequoia passing on a deal deterred other funds from investing, they wouldn’t be able to invest in anything.

    Which in turn is why Sequoia was willing to invest in us without imposing any conditions. Because the top tier funds already see every deal, it’s in their interest merely to increase the number of startups, just as, because Google has such a big percentage of the search market, it’s in their interest merely to increase Internet usage.

    Sequoia does get an early look at all the startups, but this was not a condition of the deal. They always have. (All the speakers get an early look at the startups; it would be hard for them not to; and since winter 2006 the VC speaker has always been Greg McAdoo.)”

    http://news.ycombinator.com/item?id=897194

  • Sechrest

    The thing that you are missing is that the first couple of incubators have the ability to cherry pick the applicants, so the normal failure curve does not apply directly. You also are not adjusting for the software cost model changes that have happened, which lower the risk, and increase the rate that startups get acquired early.

    Random incubators in random places that can not cherry pick the applicants are going to have a serious problem generating revenue and will need another source of cash. 

  • http://davidcrow.ca/ davidcrow

    @thecodefactory sent me a journal article about creating sustainable incubator business http://www.osbr.ca/ojs/index.php/osbr/article/view/1212/1160 

    “This is patient money that is willing to wait 5 to 7 years for a return on investment, has a desire to help the local community, and is very likely actively involved in the incubation process.”

    Not sure that the money is always patient, or actively involved in a grassroots, bottom-up community. They are looking for top-down and guarrantees.

  • OverHere

    I think the cost base is considerably lower than your estimation. (You don’t need $10k per startup in overhead costs, for instance, as much of the initial equipment outlay can be used by subsequent startups.) 

    Nonetheless, the biggest issues one must consider to make incubators profitable:
    1. deal flow. High quality business opportunities don’t grow on trees.2. a material stake (including follow-on rights) in funded companies so that the accelerator’s position isn’t diluted out of existence during subsequent funding rounds3. timing of exits of funded companies… accelerators can’t afford to wait too long for returns on their portfolio. Cash is king, for funders and funded.4. repeatability. Knock off steps 1,2&3 continuously, which increases the chances of producing a return above and beyond less risky alternatives for the accelerator’s stakeholders. (And, presumably, to pay some amount of income to those who run the accelerator, before returns on equity materialize.)
    5. the human element. How good are the incubator’s founders? Do they have the wisdom and ability to actually make a difference? (Can they materially improve the probability of the startups chances of success?)

    Taken as a whole, you can see that incubators are an extremely tough proposition!

  • http://twitter.com/GilKatz Gil Katz

    Maybe the incubators are the best entrepreneurs.. :)

  • http://twitter.com/GilKatz Gil Katz

    Building an eco-system is the best business.. technically the incubator could get a nice portion of their investment back over time just from rent and commissions on third-party services, tax credits, etc.. and don’t forget the rent for the Starbucks inside that same building.. and 10% of hard-working startups. Maybe to understand this math you need to think in terms of real estate and service fees, then comes the glorified exit game. Also, sometimes the math actually does not add up. Sometimes everything is based on a third-party bet, usually supported by tax payers, and it pops when that runs out. Nevertheless, it is good for incubators to be around to support innovation.

  • http://twitter.com/dpmorel Dan Morel

    I have a lot of smart friends who I respect on the accelerator/incubator side.  Somehow though, I never understand incubator math from the entrepreneur side.  9% for $20k, 6% for $15k, it just doesn’t feel worth it.  I’m not even a guy who cares much about giving up valuation… I just want to know I’m getting my money’s worth.

    I feel like one could build a much more “custom-fit”, rockstar advisory board for much less than 6%.

  • http://twitter.com/#!/georgelbowen George Lucas Bowen

    Cherry picking 
    Follow on investment opportunity for successful incubator grads (double down on your wins and cut loses)

    PR!!!!  The whole class of companies are featured regularly.  You can’t pay to get that PR as a startup without the incubator behind you.  This is both PR to consumers and early adopters but PR to potential M&A companies looking for a low priced team or product for a need.  Then they have the network of people to capitalize on any M&A interest.  The PR is diluting as there are just too many to talk about now…

  • http://twitter.com/GilKatz Gil Katz

    But then the entrepreneurs are paying for it.. 10% of their company (+/-) in exchange for PR. When the company is not really worth much then it can be a good deal. If the product really is very innovative or valuable then that would be a news story anyways when following standard PR practices. One of these is co-promotion with larger entities, but usually you don’t have to give away 10% of your company for that co-promotion.

  • http://twitter.com/#!/georgelbowen George Lucas Bowen

    Startups pay for everything through equity if they aren’t self funded.  Whether or not an incubator is good for a startup depends on their needs and shortcomings of the founding team.  It’s just a tool they could use or not.

    From the perspective of running a successful incubator it’s the combination of filtering and promotion that increases the probability of faster growth and exits from the companies that go through their system.  They are just betting that their hands on approach, network and PR will increase their returns by more than the cost of running the incubator.  It will no doubt increase the potential success of the companies, but by enough to justify $1mm a year in additional expenses based on the above assumptions, I think only a few can justify that.

  • http://davidcrow.ca/ davidcrow

    But you are a rockstar, or at least you play one on the mobile Internets. I think a lot of folks are looking for permission or someone to say it’s ok to do things like put together an kickass advisory board. 

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  • http://www.designsreview.com/ website feedback

    What is missing is that the first couple of incubators have the ability
    to cherry pick the applicants, so the normal curve of error is not
    directly applicable. They also are not adjusting to changes in the
    software cost model that have occurred, reducing risk and increasing the
    rate of new companies that are acquired early.

  • Nick

    Incubators are fine but they are not for everyone. Even 5% for 50K is not much when you worked on something for many years. It is true that you may lose the connections that investors have, but still it feels very hard to do that.

    How would one go about finding advisory board members when it doesn’t have any connections?

  • http://www.getsnappay.com/ Jim Rudnick

    @David…thanks for that link to the osbr.ca site….that too is a great piece and like the one above, worth consideration. We here in the Hamilton area, involved with our own newly birthed startup community are also looking at the creation of a new Incubator here…and this is exactly the kind and type of info that we will add to our research! If anyone knows of any other links to that kind of data, we’d be muchly pleased to receive same, eh! :-) Jim

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