Incubation 2.0

Back in the boom days of the Internet, incubators sprang to life at a torrid pace. During the dot-com era’s peak, there were nearly 700 for-profit incubators, according to the National Business Incubation Association. The vast majority of them collapsed when the bubble burst.

Now, after years out in the cold, the notion of gathering a brood of promising entrepreneurs and nurturing them into full-fledged companies with capital, advice and office space is hot again. In the past few years, nearly a dozen new incubators have set up shop, including Accelerator, Seedcamp, Startup@PARC, Techstars and Y Combinator.

Incubators may be back, but they don’t want to be called by that name. “That term is too closely tied with 10 years ago,” says David Cohen, co-founder of Boulder, Colo.-based Techstars. “Those people basically were glorified landlords. I’m OK if you call us a hatchery or something like that. But we just don’t fit the classic incubator model.”

“Incubator is a bad word because people use it to mean 1,001 different things. It’s kind of sloppy,” says Paul Graham, co-founder of Y Combinator, which runs programs for promising entrepreneurs in Cambridge, Mass., and Mountain View, Calif. “We call ourselves a ‘seed-funding firm’ or a ‘seed champion.’”

It is no surprise that the new breed of incubators prefers to avoid comparisons. The first generation of incubators, which featured firms such as CMGI, Internet Capital Group (ICG) and Idealab, left behind a smoldering heap of failed companies and burned investors.

CMGI posted combined net losses of $6.8 billion in 2000 and 2001, while ICG recorded net losses of $3 billion during that same period. And Idealab was sued by its investors. Ultimately, the suits were settled, but Idealab’s reputation never fully recovered.

Vive la différence

So what is different this time around? For starters, a lot of the new players are taking a different approach to choosing their contestants. They are more influenced by Simon Cowell than Arthur Rock.

“Just as ‘Idol’ contestants audition their skills before a panel of judges, startups wanting the benefits accelerators provide compete for slots on the accelerator’s ‘team,’” reads a new report from the Kauffman Foundation called Finding Business “Idols”: A New Model to Accelerate Startups. Firms such as Techstars and Y Combinator don’t necessarily disagree with that comparison—they do go through hundreds of applications before deciding which entrepreneurs to invite into their programs.

To recruit its latest class, Techstars looked at more than 300 applications from entrepreneurs with Internet-oriented technologies. It then chose the 10 most promising ideas and invited the winners to Boulder for a three-month boot camp. In Boulder, the young entrepreneurs got office space, technology resources, approximately $15,000 in cash and access to around 40 different mentors to guide them through every phase of the startup cycle, from refining a business plan to raising more money to getting a product to market.

It’s possible we could hit a Google, and it’s possible we could hit zero.”

Paul Graham

Ravikant is currently raising $10 million for his seed fund and plans to invest anywhere from $100,000 to $500,000 in dozens of Internet companies. So has he joined the fold and decided that the incubator 2.0 approach is not flawed after all?

Not exactly. Ravikant believes that, unlike outfits such as Techstars and Y Combinator, he can attract the best entrepreneurs, more seasoned people exiting places like Stanford and Google who are already highly connected and who would be extremely reluctant to give up 5% of their company in exchange for three months of mentoring.

Another problem with incubators, past and present, is their volume approach to investing, says Paul Kedrosky, a venture capitalist and executive director of the Von Liebig Center at the University of San Diego. “You really have to focus on just a few ideas at a time, otherwise you end up with a bunch of guys languishing in the basement.”

The Von Liebig Center is a university incubator that is chartered with pulling innovative technologies out of the University of San Diego’s labs and turning them into viable companies. Since its start six years ago, the incubator has invested anywhere from $25,000 to $250,000 in 15 companies and has seen several successes. For example, it incubated NetSift, an information security company that was bought by Cisco for more than $30 million.

Idealab is one incubator that seems to have learned not to stretch itself too thin. At the peak of the bubble, it had offices in five cities and was minting a new company every month. The sole purpose, it seemed, was to leverage the Idealab brand and gallop through the IPO window.

Today, Idealab produces no more than one company a year. “We tried to do too much,” admits company spokeswoman Teresa Bridwell. “We’re at our most successful when [founder] Bill Gross is intimately involved with every project.”

Easy as 1-2-3

Drawbacks and doubters aside, the new generation of incubators is gaining in popularity. Partly, that’s because technology shifts have made it really easy to launch startups. Computer power is cheap. Open-source software is free. Promotion via the Web is also free, so there is no need to hire marketing or promotions people. And with advances in programming languages, it is now possible for a couple of founders to write all the code they need without bringing aboard a team of expensive developers.

Given those tools, many more smart young people are launching startups straight out of school. Many others are leaving the cube farm early in their careers to turn an idea into a technology. Instead of going to work for Microsoft along with 10,000 other programmers—and seeing their work averaged out with 10,000 other people—bright technologists are starting their own companies. That being the case, one could argue that there is an urgent need for new incubators to vet these entrepreneurs and give them the coaching they need. VCs simply don’t have the time—or the inclination—to fill that role.

“What else are they going to do when there are so many startups?” asks Graham. “How are they going to evaluate them? We’re kind of the answer.”

A lot of incubators are focused on this notion of a physical space in which people all go to work. I think tying up capital in office space at the seed stage of a business is a bad idea. Nowadays people work anywhere they can get WiFi.”

Saul Klein

Speeding up biotech

Even a business as notoriously capital-intensive as biotechnology is starting to use the incubator model. Accelerator is an incubator that developed out of the Institute of Systems Biology (ISB), a nonprofit research institution. It identifies emerging biotechnologies at universities, research institutions and life sciences companies around the globe and brings them to Seattle, Wash., where they take advantage of the facilities and expertise at ISB.

Accelerator includes a team of five business veterans who handle everything from incorporating to accounting. Providing the capital—$21.8 million so far—is a syndicate of five venture firms: Amgen Ventures, Arch Venture Partners, MPM Capital, OVP Venture Partners and Versant Ventures.

Since its inception in 2003, Accelerator has backed six companies. “Of those six, three have finished their time at Accelerator, one we shut down and two have raised significant series B rounds,” says Accelerator CEO Carl Weissman.

The Series B success stories are VLST, which is developing a treatment for inflammatory and autoimmune diseases, and Spaltudaq, which is developing a cancer treatment. VLST raised $55 million, while Spaltudaq pulled in $29 million.

Accelerator is now putting together financing for its next graduate, which will leave it with two residents.

European flare

The incubator 2.0 trend is spreading not only to traditionally resistant industries, such as biotech, but also to regions that do not have a thriving culture of entrepreneurship, primarily Europe.

London-based Seedcamp is running a program similar to Y Combinator and Techstars. It holds a talent show of sorts, chooses the five top entrepreneurs and invites the winners for three months of intensive coaching. Applicants to its first session, now underway in London, came from over 40 countries in Europe and beyond—the U.K., Germany, Scandinavia, France, Ukraine, Russia, Israel, China, India, Latin America, and South Africa. There were even a couple entries from the United States, says Seedcamp founder Saul Klein, who is also a general partner at Index Ventures.

“This is really about the European community standing up and saying, ‘We want to help make it easier for young entrepreneurs to get their businesses off the ground,’” Klein says. “There is no reason if you are a European entrepreneur not to think big, not to take risk and not to go for it. One really does not need a lot of money to kick-start a business. We’ve seen what Y Combinator has been doing and we’re impressed with that model. We just want to apply a European flavor to it.”

As an investor, you want people who are the most entrepreneurial, and in this environment nobody is waiting around for an incubator to show them the way.”

Naval Ravikant

A good part of Seedcamp is coffee-flavored. Klein is not a big believer in the traditional incubator insistence on putting young entrepreneurs together in a shared space. He started an initiative called Open Coffee Club—which meets for two hours every Thursday to talk business at Starbucks—and he hopes to bring that same informal energy to Seedcamp.

“A lot of incubators are focused on this notion of a physical space in which people all go to work,” he says. “I think tying up capital in office space at the seed stage of a business is a bad idea. Nowadays people work anywhere they can get WiFi. A lot of seed businesses are a combination of Starbucks and apartments.”

Another aspect of old fashioned incubators that Klein does not like is the idea that they can provide a shortcut around the business-development process. He has raised 10 million euros for three years’ worth of Seedcamps—that’s at least 15 more companies—and he plans to stay involved in his graduates’ maturation through the Seedcamp network.

Each of Seedcamp’s winning teams is given 50,000 euros (roughly $71,000), access to a network of venture capitalists and mentoring from successful European entrepreneurs. In return, Seedcamp gets 10% of the companies. The VCs who contributed to Seedcamp’s 10 million euro founding fund get first crack at investing in the new companies.

Just here to help

VCs involved with the new generation of incubators appreciate the convenience they provide. In effect, people like Klein, Graham and others are doing a lot of the legwork for venture capitalists.

“I would not say VCs are stupid or anything,” Graham says. “Later stage investors have to deal with really different problems, like how to hire a VP of marketing or how to take the company public. We don’t know shit about that.”

And VCs are happy to have the new incubators pick through the enormous volume of next-generation entrepreneurs, scrub them, dress them up nicely and trot them on stage at their demo days.

The VCs attending have yet to find the next Google. But it’s not out of the question, Graham says. “It’s possible we could hit a Google, and it’s possible we could hit zero,” he says. “We still don’t know. We invested in at least one startup that has a chance of being super big like that: Loopt. They’re one of the hotter startups in the Valley at the moment.”

(Loopt was incubated by Y Combinator in 2005 and has since raised nearly $20 million in three rounds from New Enterprise Associates and Sequoia Capital, including about $12 million this past July.)

Hit or miss, though, Graham and his colleagues feel a certain affection for all their offspring.

Says Klein: “Do I have any companies I’m particularly excited about? That’s like asking me do I have a kid I like more. They’re all great. I can’t wait to see them all succeed.”

As for the new incubator model itself? This new batch is confident they won’t lay an egg.