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.
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