Accountancy Age Feature: Internet start-ups warming to incubators

One effect of the internet gold rush has been to establish the importance of incubators in the financing of hi-tech ventures. As a result, the word is being used in a number of contexts as a generic term to describe a variety of organisations, each offering some form of support to start-up companies, often, though not necessarily, in exchange for equity. Incubators can take the form of venture capital groups offering management advice and business support facilities in addition to providing funding.

But other entities are describing themselves as incubators with increasing ubiquity, including: service providers (notably law firms, recruitment firms, management consultants, accountancy firms and merchant banks), and product providers such as software developers. Nonetheless, stretching the incubator definition to include every organisation taking equity in lieu of charging fees is misleading.

While a growing number of models are competing in the same market, those attributes usually associated with incubators include: the provision of office or light industrial space, seed funding, business and marketing support, and some managerial input. The best incubators add technical expertise and facilitate networking and market access.

For a number of reasons, incubators may be stealing some ground from traditional sources of early stage venture capital, including ‘angel’ funding. Factors at play include (an often misplaced) perception that incubators are likely to make a more generous initial valuation of a start-up’s worth, that they provide networking opportunities and market access, a supervisory function, and are more flexible in their approach to exit strategies.

In the US, the expansion of the internet-funding industry has created a market that works very much in favour of the entrepreneur. Currently, industry standards and market practice are being established and re-established with extraordinary rapidity, and there is still scope for considerable commercial and legal innovation.

A distinction is often made between ‘smart’ money and ‘dumb’ money: the latter refers to financial investment without other assistance. ‘Smart’ money offers include a package of services in addition to finance. Many entrepreneurs only need, or believe they need, working space and seed funding. But increasingly, incubators offer not only logistical support but a number of other facilities.The traditional model of incubator, at its simplest, offers working premises (usually for a pre-agreed period of time, e.g. between one and three years) in exchange for some equity in the company. Incubators run along these lines have a history pre-dating the internet industry by some decades and they’ve often been established to promote local community businesses, sometimes subsidised or funded by local authorities or community organisations.

In the context of the internet industry, incubators are likely to be the offshoot of an existing venture capital organisation or a dedicated incubator company. Services that an incubator might offer include:

  • seed-funding
  • physical space
  • process management
  • managerial involvement
  • business and back-office support including auditing, accounting, VAT returns and subsidised legal advice
  • provision of a technical environment, software, hardware, bandwidth and IT support
  • marketing services
  • shared development resources
  • economies of scale.

Virtual incubators are virtual in the sense that while, unlike more traditional incubators, they provide no physical space, they do provide managerial involvement, networking opportunities, software provision and sometimes seed-funding. As the virtual incubator has fewer overheads, it is often able to offer assistance in return for a lower equity stake.

One of the initial difficulties that must be overcome is the valuation of the start-up company, which may well have no assets other than a good idea and some undeveloped software. Also, in the case of most internet start-ups, there is little prospect of short-term profit taking. There is often something of a gulf between the value that the start-up expects to be given and the value the venture capitalist is prepared to give. But in the current market climate, the incubator’s advantage is tempered by the profusion of competition in the funding market.

The most significant facet of a start-up the venture capitalist or incubator will consider is quality of management. Bad management increases the risk-factor of a venture. However, the investor will also look at factors including: existing on and off-line competition, barriers-to-entry by other players, and the projected number of subscribers/site visitors. Incubators will take anywhere between 10% and 80% equity in the incubatee, depending on the project’s perceived risk, how much of the necessary finance is provided by other sources, and the services or facilities the incubator offers. Most incubators take an equity stake of less than 50%, typically between 30% and 40%.

The entrepreneur will want to understand how the incubator’s equity will be diluted when the serious money is invested later. Taking a minority stake is seen by many incubators as a way of keeping the management incentivised and increasing eventual chances of commercial success.

It is usual for the start-up and the incubator to establish a relationship in two parts. If the incubator is interested in the start-up, it takes an initial minority equity stake in return for initial funding. Having done so, it will offer the start-up an incubation contract. In this case, the incubator will usually either charge a fee for services or take an additional equity stake in lieu of fees.

There are a number of incubators which take a much more dominant managerial role in the destiny of their start-ups. Such an incubator is likely to establish a joint venture with the start-up team, place one of its own team as the company’s chief executive, and maintain much greater day-to-day control over the start-up’s affairs.

Incubators usually protect themselves contractually from a premature termination of the relationship by way of a share buy-back or clawback provision. It is usually contracted that in the case of the start-up wishing to sell its interest to another party, the incubator must be given the opportunity (but not be compelled) to sell its shares at the same price.

Incubators are often wary of the over-inflated expectations of entrepreneurs. Consequently, it isn’t unusual for them to argue that the start-up’s management team should be obliged to accept a reasonable, bona fide cash offer from a trade buyer, and not hold out for a (hopeful) hundred-million- pound-raising flotation.

The first principal is that intellectual property rights reside with their creator. Software or technology constituting intellectual property should be owned by the incubatee company (in which the incubator may hold shares). Often an incubator will incubate several new companies working towards providing similar services in different markets: for example, company A may be developing a site devoted to selling white goods, company B may be developing a site that sells shoes. The software developed by one may be of use to the other. The strength of a good incubator is that it will encourage the companies to licence software to one another.

The traditional exit for incubators is the same as that for venture capitalist – to sell their stake at flotation or by way of a trade sale. While sizeable internet flotations have captured the imagination of the press and the market, industry players predict that in the near future, most internet start-ups will graduate to the ‘second rung’ of their commercial existence by way of trade sale to off-line (non-internet) competitors, or be purchased by venture capitalists or corporate venturers wishing to invest in a product that has overcome initial development stages and teething problems. But again, as definitions become fuzzier, so do objectives. Law firms that have foregone fees in exchange for equity may have used their involvement to effect market entry – or to maintain links with a potentially valuable client.

Entrepreneurs should think carefully about their present and future needs before committing themselves to an incubator. It must be realised that by entering into an incubator, there is a substantial dilution of one’s own stake in a company, or company-to-be. The trade-off, of course, is that an incubator could accelerate business development and possibly realise an idea that might otherwise not come to fruition.

Incubators can provide a whole gamut of funding options, facilities, and business services. Obviously, entrepreneurs should consider all options before choosing an incubator, being aware that the market is currently very much ‘start-up friendly’. However, if a start-up is looking for more than seed funding and/or working premises, it should of course look at: what sponsorship/networking opportunities the incubator provides; what other companies and kinds of company the incubator has or is working with; the conditions of premises; provision of software, hardware; and the competitiveness of pricing. Above all, perhaps, it should assess the incubator’s track record in the new media industry and assess whether there is a close managerial fit between the two organisations.

  • Tom Blass is a freelance journalist and Quentin Solt is head of information and communication technology at law firm Berwin Leighton

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