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?

The Backwardization of Risk/Reward in Startups

I’ve always thought it weird that there is a perception that risk is front-loaded for startups, i.e. the person(s) who start it take all the risk. In some ways, the risk of starting a company (especially a web startup) is lower than ever:

there are great grant/tax credit programs like IRAP and SRED
there are more incubators, angels and providers of small seed funds than ever
its faster than ever to go from concept to commercialization -> you can have paying customers in < 6 months

It just isn’t as hard as it once was to raise $20-$50k and/or have a company generating a few thousand dollars in revenue to cover the early founder(s) costs. The big “risk” is that your life & business align to this cost structure. Your business needs to be able to run with only 1-3 people at first. Your life – no fancy sports cars, no big mortgage, no massive piles of credit card debt, etc. I’d hypothesize, there is a strong parallel between managing personal finances and being able to start a company.

Another big “de-risker”. You have control as the early founder! Only you can lay yourself off. And you control the culture and lifestyle of the company, i.e. you are a lot less likely to hate your job or get fired for hating your job or leave suddenly or have a heart attack or just generally hate life.

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Reward-wise, you have a huge chunk of the reward. Shares, not options. Big founders cut. Maybe no vesting. Dividends. There are a lot of paths for you being well rewarded for the risk you took. On top of that, your experience as a first-time entrepreneur will make the second time around all that much smoother, it’ll be easier to raise money, easier to hire, easier to find business partners, and so on. You can have a career as an entrepreneur.

Now, lets compare that to what is traditionally thought of as the “low-risk” employee, lets say employee #8. Poor employee #8 takes on massive life risk, and often gets very little in reward.

Reward-wise, they get something like .5% of the company, so on a typical $20-$30mm exit they get $100-$150k. Hardly life-changing money. If you are a super-star in the company you may get granted up to 1 or 2% but they’ll be vested over an annoyingly stupid schedule such that you’ll have to be at the company for 6-8 years to “earn” them.

Now compare that to all the risks of being employee #8:

you are far more likely to get laid off than any of the founding team
you are far more likely to get laid off than a non-startup job
you may simply not get paid a few times… missed payroll is no uncommon event
you probably in fact took a pay cut, or at best, you’ll miss out on bonuses when there are a few tight years
you will likely work a lot longer hours
there’s no “fast” trade-off, you’ll need to work there 4-7 years to earn your $100-$150k stock option reward, and you may have given up way more than that in time & salary to get there

So, in summary, its a lot better to start your own company than to be employed by a startup. And in many ways its less-risky and better to start your own company than to “have a job”. And I wish I could make more people take the entrepreneurial leap themselves because its simply not as scary as it seems.

ExtremeU 2011

Our friends over at Extreme Venture Partners have announced the recruitment for the Summer 2011 Cohort of the Extreme University. We written about the past programs:

The program has historically taken entrepreneurs that need to develop and grow. It has provided them with funding, space, education, access to some of the best entrepreneurs, marketers, business developers and engineers around. While the timeline for success has been different, the companies like Visibli, Uken Games, and Locationary have grown into 3 very strong, very hot Toronto based startups.

The 2011 Program has been updated based on the learnings from the past 2 years. Accepted entrepreneurs get:

Seed capital
Mentorship
Collaborative office space and shared resources
Shared Expertise
Network and Connections

We can argue about if this is fair market value or not, when compared to other seed programs. The Extreme Ventures team is revamping the details of the program. The changes take one of the best programs available and make it even more compelling for eager, resourceful entrepreneurs. It will really redefine incubator programs.

Why do I say that? Well I spent the first 3 months of development at Influitive living in the XtremeLabs space with the 2009 & 2010 cohorts. I chose to bring my startup and cofounders into this environment because it is the best in Toronto. There is an energy, a vibe of entrepreneurship, community, support and shared pain. There are world-class people like Fred Wilson that visit at the invitation of your office mates (thank you William). XtremeLabs and Extreme VP are launching world-class efforts like Hatch Labs with IAC will continue to bring the best in the world through the space. It is a great environment with the best people I have worked with anywhere – looking at you Farhan Thawar (@fnthawar) and Rick Segal (@ricksegal). All entrepreneurs can benefit from just being in the environment.

Who are they looking for?

We fund technology-oriented companies, with a focus on web or mobile-based software, but we are open minded to different ideas. We are looking for smart and fast-moving teams to participate. Typically all members of the two-four person teams will have strong technical abilities. We are looking for founders who have a unique understanding of a real customer problem and an innovative idea for solving that problem.

If you’re a startup looking for my personal favorite shared space and program you should consider applying to ExtremeU.