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How To Build An Incubator That Wins

There has been much talk on the periphery of my vision about building more incubators. Some people say to build 500. Some people say to build one in Baltimore.

Building an incubator is super-hard. To point to the success of TechStars and Y Combinator and think that this demonstrates that building an incubator is easy is simply a fallacy.

First, what is an incubator: An incubator is typically the earliest kind of investor involved in a business. Typically they invest a small amount of money and some amount of in-kind services in exchange for a small stake in the business. Typically these services will include providing office space, some small amount of legal, accounting, and business consulting, and some kind of “graduation party” that is designed to introduce their graduates to potential investors.

More important than the question of what an incubator is, is “What is the value that an incubator should deliver?”

I think the primary value that any investor can provide consists of three areas:

  • Strategic advice/services that improve the viability of the business
  • Helping the business exit
  • Helping the business raise money

Now, that third category could theoretically be part of the first bullet, but I wanted to break it out due to the critical importance of that specific topic.

In my mind, the primary value that an incubator provides to a start-up is that it allows the start-up to raise money at a valuation that is a premium to the valuation that it would have raised money at prior to participating in the incubator – either through the pedigree of the program or the services provided by the incubator, the valuation has been increased significantly.

Why is Y Combinator the hottest thing going on today? Because 12 weeks after you start the program, you are virtually assured of being able to raise $1 million at a $4 million pre-money. The pre-money increases substantially and the odds of raising the money at that price increase. The result: You have to be in Y Combinator if they will accept you.

Is it possible for other incubator’s to replicate this value proposition? It is probably hard – in theory not too hard, but in practice quite hard. You need incubator leadership that is extraordinarily well-connected into the seed stage financing community.

Further, there is the concern that incubator’s model the VC community: The market is a “To the victor goes the spoils” where all of the good deals go to the top 20% of the incubator market, leaving bad deals for the rest of the market. This is not bad for the small businesses – any incubator may be better than no incubator for unsophisticated entrepreneurs, but it means that many of these incubators will discover that their business model is unsustainable. Deprived of “access to good deals” as good deals flee to the TechStars and Y Combinators that can assure them of financing, remaining incubators invest in companies far less likely to succeed, leaving them insolvent.

The first time I got to hear Josh Kopelman‘s pitch for FRC (probably four years ago), he described FRC’s value proposition as, “helping you raise your next round at a substantial premium”. If you don’t think you can do that, then your incubator will fail. It is that simple. The amount of money invested by an incubator typically necessitates raising money shortly after a start-up exits the program, therefore helping your investment raise money is the single core competency most crucial to an incubator. $25,000 does not go far.

Some incubator’s have touted that they will invest more money – in some cases six figures – as a tool for differentiating from programs like Y Combinator. This is probably an erroneous strategy. Funding companies at such an impossibly early stage without traction or the social proof of a round of investors makes placing big bets on relatively fewer companies a strategy that has a much higher beta than current incubation approaches. There is a reason people write smaller checks at an earlier stage.

I want to end this post with a few things that Y Combinator and TechStars have done that seem incredibly smart. While I have bashed the prospects of incubators in this post, if you think you can pull this off, there are some best practices that I would obviously rip off. (Caveat: If you didn’t already know this stuff, then you are probably not going to be able to do it. I have not been funded by these incubators, I do not know anyone who has participated as a company in these incubators, I know basically nothing, but I know this stuff.)

Here is the most important: They involve super angels early. Many different super angels are brought in as “consultants” to spend time with the incubatee’s. After spending a day with a variety of teams, many of these consultants invest in the one or two ideas that they like the best. The result is that the fund-raising begins with very warm meetings and by the time the team shows up for their demo day, they already have prominent investors that are leading their deal.

What are the other best practices of the incubator’s? Discuss.

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