There Is an Incubator Bubble. And It Will Pop.

In any market where the number of new businesses triples in the course of two years, you know that something unusual is going on. (And make no mistake—most venture incubators are businesses, founded and funded by people hoping for real returns, whether social, financial, or both.) You naturally begin to wonder whether a bubble is forming, in the classic sense of an episode of vertiginous growth disconnected from economic fundamentals such as market demand. And since bubbles are, by definition, unsustainable, you wonder what’s going to happen when they pop.

If you ask me, there is clearly an incubator bubble. Whatever your opinion about the existence of a bubble in the larger world of Internet startups—Sarah Lacy and Dan Primack offered interesting, opposing views on that this week—it’s hard to imagine that today’s tepid consumer and business markets have room to absorb all of the products and services offered by the hundreds of new startups that the incubators are now churning out each year.

It’s a given that only a few of the startups going through the incubators will strike it rich while the rest languish or die—that’s the nature of the startup game. What I’m saying is that without higher-than-normal success rates, many of the incubators themselves could find it difficult to stay in business.

Here’s why. Most of these operations are organized along the Y Combinator model: they provide startups with $15,000 to $25,000 in seed funding and about 12 weeks of mentorship and product development assistance, and in return they take an equity stake, usually around 6 percent. They profit when incubated startups get big and successful enough to be acquired. (As far as I know there isn’t a single example of an incubated company going public.) Doing the math, let’s say you’re the founder of an incubator and you fund 20 companies a year at $25,000 each, in return for a 6 percent stake. To achieve respectable returns on that $500,000 you laid out—let’s say a 3x return, not even figuring in your operating costs and the value of the time you put into mentoring the companies—you need one of your alumni companies each year to achieve an exit in the $25 million range (or two at half that, and so on). And that’s assuming your stake isn’t diluted by later funding rounds. It’s quite a gamble, and I just can’t see the economics being very compelling for any but the largest, best-funded, most prestigious incubators—i.e., Y Combinator and TechStars.

Indeed, the current profusion of incubators may exacerbate the very problem that incubators were invented to solve in the first place: the difficulty of getting a new company off the ground. The more startups that these programs launch each year, the harder it is for any one of them to get noticed by investors, journalists, or customers. The problem is evident even within the microcosm of Y Combinator. The first class of Y Combinator startups I covered, the Summer 2010 group, included 36 companies. The next crew, Winter 2011, had 43 startups. The Summer 2011 class, which will wrap up its session this month, includes more than 60. One side effect of this growth is that the time allotted for each company’s Demo Day pitch keeps getting shorter and shorter. Another is media exhaustion: assuming it doesn’t get any bigger, Y Combinator alone will soon be minting 120 companies per year, which means I could spend two days a week writing about YC companies and I still wouldn’t be able to cover them all.

Of course, there are many good reasons for the incubator boom. At a policy level, the U.S. has no choice but to try to innovate its way out of the current economic doldrums. As numerous studies by the Kauffman Foundation and others have shown, most economic growth comes from startups. So communities like Detroit, where economic reinvention is an imperative, have every incentive to set up incubators to support local entrepreneurs. And there is obviously no shortage of interesting and important problems waiting to be solved by entrepreneurs, from the cosmic (global warming) to the casual (the damnable inefficiency of online dating, to pick just one example).

At a practical level, incubators are a pretty good way to organize the energies of young entrepreneurs who might not go the startup route on their own, and would likely wind up as code monkeys at larger (and less innovative) tech firms. There’s also an established set of incubation practices—a startup curriculum of sorts—that can provide substantial help to companies negotiating their bumpy early stages, from incorporation paperwork and product prototyping to customer development and investor outreach.

But just for the sake of argument, let’s say I’m correct that there isn’t room in the market for 64 venture incubators and all their progeny. What happens when the bubble bursts and half or more of these groups have to shut down? Will the outcome be as catastrophic and long-lasting as the bursting of the last incubator bubble back in 2001? Yes, there was an earlier wave of incubators. They bore little resemblance to today’s Y Combinator-style startup schools; most were lavishly funded startup factories like Bill Gross’s Idealab that launched only a few offspring per year and took gigantic stakes in each—30 percent or more. (Read this 1999 Forbes article by none other than Om Malik for a quick refresher on that era.) But after that first wave of incubators imploded in the dot-com crash, nobody dared to touch the model for another half-decade.

I don’t think that’s what will happen this time around. For one thing, there’s less money at stake. Even if you funded 100 companies at $25,000 each and they all failed, you’d only be out $2.5 million. Y Combinator, once again, is a bit of an outlier here—Start Fund’s spray-and-pray strategy of investing $150,000 in every YC startup means that principals Yuri Milner and Ron Conway are now risking roughly $9 million per YC batch. But despite the higher stakes, I think the most reputable and best-funded incubators will survive just fine, while many of the others will be forced at some point to gracefully step aside. You’ll know this has happened only when they stop putting out requests for new applications. (All the more reason to buy our guide and study the differences between the incubators.)

I’ll be particularly interested to watch the development of the non-Internet incubators—those applying the incubator model to new markets like healthcare (e.g. San Francisco’s Rock Health) and cleantech (Greenstart in San Francisco and CleanLaunch in Colorado). The classic 12-week incubator curriculum was initially developed for Web startups, whose products are a lot easier to build, test, and revise than, say, implantable medical devices or rooftop solar arrays. It’s not clear yet whether participating in an incubator program can give a healthtech or cleantech startup enough of a boost to make the incubator’s investment worthwhile. I hope it can, because innovation in these areas is needed more urgently. But right now, that’s still just a hope.

Post Script: This year we published the third annual edition of the Xconomy Guide to Venture Incubators. It’s the only source we know of where U.S. entrepreneurs starting technology, life sciences, or energy companies can survey all of the early-stage mentoring and investment programs open to them in a single document. (You can buy the downloadable file here.)

It’s a great resource, and I wanted to take a moment to recognize and thank our Cambridge, MA-based associate editor Erin Kutz for pulling it together. Erin had a huge job on her hands this year, for one simple reason: the nation has startup fever. While the rest of the economy slowly fizzles, investors, foundations, regional economic development authorities, and other organizations have been setting up incubators, accelerators, and similar programs for startups at a blistering pace.

When we published the first edition of the incubator guide in 2009, it included 20 listings. The second edition in 2010 had 34 listings. And this year’s edition has a whopping 64—and that’s not counting incubators in Europe and other regions, or the seven programs we removed from the list because they’d changed their operating models.

So, don’t be surprised if Xconomy’s 2012 Venture Incubator Guide doesn’t have quite as many listings as this year’s. Still, even if I’m right and it turns out that 2011 was the high-water mark for the incubator movement, there’s still a lot for the incubator founders and the participating entrepreneurs to be proud of—namely the hundreds of companies that might not have entered the world otherwise. Only the luckiest and/or smartest startup founders will hit the big time, but the rest will get some great experience and will be a in a better position to try again, if they have the persistence. Which, alas, is a trait that no incubator can teach.

Wade Roush is Xconomy’s chief correspondent and editor of Xconomy San Francisco. This post originally appeared at Xconomy.

6 replies »

  1. Looking at total startups and not just incubators, I am quite certain that there are more m-health companies managing disease via apps than there are total adverse medical events that have been avoided by people using those apps.

  2. Well said Wade…

    My instincts are with you. As I tweeted today, “can the creative (entrepreneurial) process be ‘institutionalized’? Pixar, yes! Incubators, the jury is still out.” via @2healthguru.

    It seems like a growth business in it’s own right and must have as it’s core DNA not just survival but considerable success as an institution.

    Yet, how much of entrepreneurial ‘success’ is serendipitous? From v 1.0 business plans to ultimate market success or failure, the model, assumptions and more often than not, structure morph many times (some time to the degree that what is seeded vs. succeeds are two entirely different matters). Granted, business plans, dog and pony pitch fests strengthen and affirm discipline and focus, but what about the intangibles of market vision, latent wisdom, and general street savvy?

    As someone who’s been ‘rejected’ by three health incubators in 2011 @TumorBoard, a virtual peer based and crowd sourced online version of a traditional hospital based tumor board, I’ve pondered the question of what and how the incubator crowd visions ‘innovation’.

    We’ll see. It may just be my blindness, poor execution or perhaps time may demonstrate the rejections as a badge of honor.

    Thanks for the piece and Xconomy guide.

  3. I guess it depends on how you define a ‘bubble.’ It is going be very daunting though for these incubators because scaling to $25M in annual revenues in the health IT market is tough and tougher still for companies that are solely focused on the U.S. healthcare market.

    Imagine it will take even any incredibly successful company at least 5-7 years after there incubation funding to even hit that annual revenue number. Basing this largely on mobile-focused companies is even more challenging and perilous especially non-enterprise focused applications.

    I imagine what is going to happen is that an incubator will get one or two companies that do $5-10M annually in business and VCs/investor suck air on their total investment over the next 4-5 years.

  4. Interesting look at incubators. I’m like you and interested to see how the healthcare incubators will do since they have unique needs. Plus, there is only so many places for a healthcare startup to get exposure. The Techcrunch Disrupt events don’t do a healthcare startup justice unless they’re a consumer play and even then it can only fit so well.

    I agree there’s probably a bubble of incubators and that a number of them will fail. The competition between incubators is going to be really interesting as well. However, there’s also going to be some new interesting models that are built around those unfunded startup companies/entrepreneurs that come out of the incubator programs. As far as companies, at the rates their investing in incubator companies, it won’t have an impact for bad on the economy, but likely will have a tremendous impact for good.

    One concern I have with incubator programs is whether it will discourage entrepreneurs going after really big ideas. As you say there hasn’t been an IPO from an incubator company (although one will likely happen sooner or later). The reason for this is that many incubator companies focus on small ideas instead of really big ones.

  5. Look up percentage of start up companies that do not have assistance fund and more importantly experience and companies (individuals) that do not.

    There is risk in all new start up and ideas and if we want to avoid all risk then no new company would emerge people will fail and they will learn from their mistakes and be better for it.
    looks like someone explained this to you at a bus stop Wade.

  6. Hardly a bubble, Wade. You answer your own question here. If there are 100 companies in incubators @ 25K each it’s only 2.5m and even at 1,000 it’s only $25m.

    A bubble is when a major collapse takes down legitimate activity and in fact the whole economy with it. We saw that in the stock market tech bubble in 2001-2 and the housing bubble in 2006-8.

    There may be too many incubators to get every company in them on Xconomy or Techcrunch. There may even be too many blogs covering these new companies (although we hope not for our, THCB and Health 2.0 News sake! But using the word “bubble” here is a cheap attempt to get coverage which actually obscures a sensible discussion.