Incubators Abound in the Land of Internet Deals –

Once upon a time, there was an entrepreneur with a fabulous idea who needed help getting it off the ground. He searched and searched, but all that was available was some office space in a venture firm, along with a telephone line, a photocopier machine, and with luck, a second-hand computer, in exchange for a small percentage of equity in his company. Guidance, resources and networking were limited.

But today, that same entrepreneur could walk through the front door of any dozen or so new incubators, and, if approved, find his idea on a virtual assembly line as it travels on its way to becoming a full-fledged company, complete with management team and marketing plan. eCompanies, for example, has a 20,000 square foot office arranged so that the team behind an incubated Internet company can move from cubicle to cubicle as it matures. At the end of the three- to eight-month process, the start-up should be ready for its first round of venture financing, and in time, hopefully achieve an initial public offering or a merger, bringing sizable profits for all.

Various models of incubators – places where entrepreneurs can nest while cooking up their ideas – have been around for more than a decade, but they usually were in the non-profit sector, housed on college campuses, research facilities or by local chambers of commerce intent on generating new business and jobs for their cities. With the surge in successful Internet plays in recent years, however, incubators have been hatching across the United States, specifically geared to nurture the massive growth of dotcom companies and help provide venture firms with deal flow. Venture Economics Information Services, a data company affiliated with VCJ, does not classify or track incubators, but sheer observation can attest to their recent growth. The Cambridge Incubator, Orbit Capital Corp., Startech Venture Capital Network and Internet Capital Group are just a few, each with slight variations of services, including venture capital arms to provide a first round of funding when the time arrives.

“There are a lot more incubators,” says Jake Winebaum, a co-founder of Santa Monica, Calif.-based eCompanies. “Part of the reason is if you do it right, it’s a great way to get a company started very quickly because what you have right now is a huge amount of ideas out there and a huge amount of capital.”

Rick Powell, managing director of Washington, D.C.-based incubator VenCatalyst, agrees, saying that everyone from his mother to the telephone repairman has walked into his office with a new idea.

“It’s just the age that we’re in right now,” he says. “The [venture] money and the Internet being a revolution has prompted people to say, I can make a difference; I can be a dotcom millionaire.’ It’s not completely true or fair, but what we’re trying to do is to capitalize on some of those people by making it easy for them.”

Indeed, the Internet economy has altered the definition of an incubator from a landlord who provides some guidance and networking to a conglomerate that supplies the “bucks, brains and brawn” of building a company, Powell says. In doing so, incubators have filled a void for seed-stage financing created by the venture industry’s enormous growth and its need to pour more dollars into each deal. The result has been an institutionalization of the Internet start-up world, with a strong emphasis on speed to market.

“We were in the wild, wild West, the gold rush [of Internet deals] for the last couple of years,” Powell says. “It’s now much more about having the right partners. It’s not about just throwing up a dotcom and winning. You have to do it smarter and faster.”

Online photo sharing site already was up and running when it approached eCompanies in September to help expand its product line and services, says CEO Tim Kiplin. eMemories’ three founders chose an incubator over a venture capital firm because in addition to capital, the company needed specific strategic, marketing, legal, administrative, accounting, legal and human resource support “to take it to the next level” and eventually land a first round of venture financing, which it expects to receive in the first quarter, Kiplin says. eCompanies will take a majority stake in the company, something the founders find as an acceptable tradeoff for helping eMemories to stand on its own two feet, Kiplin says, adding that incubators are particularly helpful to those entrepreneurs without any start-up experience and who want to focus on developing their products.

Powell says entrepreneurs might end up with slightly smaller stakes in their own companies by choosing incubators over venture financing, but in the end, “We get them there faster and we give them a competitive advantage.”

What it Takes

Most people credit CMGI Inc. and idealab! as the frontrunners to this latest model of identifying, creating and launching new Internet start-ups, and the two serve as prototypes for the numerous new incubators devoted to Internet companies. Since its inception in 1996, idealab! and its venture arm, idealab Capital Partners, have backed some 20 companies such as eToys Inc., Inc. and the CMGI and its venture arm, @Ventures, have funded more than 50 companies, including and Corp.

Internet-focused Softbank Venture Capital follows a similar incubator model, having launched its Hotbank incubator in early December with the idea of “adding value to our entrepreneurs,” says Rayna Brown, a partner at Hotbank, whose parent company is Japan-based SOFTBANK Corp.

“Today there is no shortage of venture capital,” she says. “What there is is a shortage of are all the services and value-adds to help a young company get started.”

Hotbank was created by Softbank Managing Partner Gary Rieschel, who recognized that entrepreneurs in the San Francisco Bay Area were having trouble gaining the attention of big-name venture firms and could use the help of the Softbank brand name. Softbank also needed more deal flow, having recently launched the $600 million SBVC V and increased its staff to seven partners from four in the last six months, Brown says. The early- to seed-stage companies in incubation typically will receive an average of $500,000 and will be chosen based on recommendations from Softbank partners or through a trusted network. Unlike some incubators that take a majority stake in ideas generated in-house, Hotbank takes less than half of a company’s equity. The ultimate goal, of course, is to reap financial benefits once a company goes public or gets sold.

“We believe there are untapped opportunities of businesses that haven’t yet gotten to the Net, and the critical difference for those companies that succeed or fail is time to market,” she says. “If we have all this capital and if we can combine it with our services … why not support an entrepreneur to get to the market faster?”

The key ingredient for a successful incubator is access to its Keiretsu, or family of companies, that can provide strategic relationships and assist one another, Brown says. Softbank, for example, which hopes to back about 20 companies a year, will provide its incubated companies with contacts to all of its portfolio companies and contacts worldwide such as Yahoo! Inc., Geocities, Ziff-Davis Inc. and E*Trade Group Inc., as well as to the venture firm’s partners, all of whom have solid operating backgrounds.

A company’s incubation period will vary dramatically by virtue of its business and product, but Brown estimates a start-up could save anywhere from three to six months in getting its product to market.

Built on the same premise, VenCatalyst’s portfolio is evenly split between ideas generated in-house and those coming from outside, Powell says.

The four-month-old incubator chose Washington, D.C., as its home because 59% of its population is wired for the Internet, and it ranks as the fifth-largest market in the U.S. to receive venture funding, with the technology sector now employing more people in the District than the federal government, he adds.

VenCatalyst, which raises its money from private individuals, will put $300,000 into very early-stage business-to-business and business-to-consumer companies with just an idea or a business plan. Only 10% of the 150 ideas reviewed in the last two months are even considered for incubation, and a smaller number make the final cut, Powell says. VenCatalyst will hire at least three entrepreneurs-in-residence to help evaluate deals and assist companies in the incubator, and that person will be assigned to each incubated company, eventually joining the new entity once it leaves the fold, he says. The entrepreneur-in-residence may decide to stay with the company after its first round or return to the incubator to begin the cycle again.

With a 12-person staff consisting of managing directors, engineers, Web designers, art directors and marketing staffers, the plan is to incubate one company every two months until the middle of 2000, when it will increase to one per month. Companies are expected to spend six to eight months at VenCatalyst, during which time they will receive free office space, equipment, legal support, payroll assistance and employee benefits, along with other perks. In exchange, VenCatalyst will take anywhere from 20% to 50% of a company’s equity, with the incubator getting a larger equity stake for in-house ideas.

Powell views VenCatalyst’s relationship with venture firms as complementary because incubators supply badly needed seed-stage funding and conduct a screening process while preparing companies for their first round of funding.

“When they are ready for the big leagues, we walk them to the venture firms and say, Hey, here’s a company that came out of VenCatalyst,’ and they know these guys must have their act together,” Powell says. “[VCs] love that, and they know the risk is a lot lower.”

Working Together

eCompanies is just one example of a hybrid incubator/venture capital fund devoted to building independent Internet businesses in about three to six months. The firm’s strategy is simple: provide the financial and human resources to set up a company as quickly as possible, says Winebaum, who himself started six companies. The firm will put up $500,000 to several million dollars per company, depending on how complex and large the initiative, Winebaum says.

eCompanies has a staff that comes up with in-house ideas, a two-person recruiting team, a design and production team to build the Web site’s user-end, a technology team to help with the site’s internal engineering and a business development team to help deal with marketing needs. The firm also has a venture capital arm, eCompanies Venture Group, which has a $130 million fund to invest in in-house companies, as well as outside deals like Inc., eWork Exchange Inc. and The vehicle’s limited partners include of Credit Suisse First Boston, Goldman, Sachs & Co., Kohlberg Kravis Roberts & Co., SunAmerica Inc., The Walt Disney Co., EarthLink Network Inc., Sprint Corp. and George Soros.

Not all incubators have venture arms, however, like VenCatalyst and divine interVentures, which was launched in July and invests $4 million to $10 million in business-to-business e-commerce and software deals. But those with venture arms have the added benefit of being the first in line once the company exits the incubator and is ready for its initial round of venture financing.

Another added benefit for a newly incubated company is the chance to gain a higher valuation once it is transformed from just an idea to an actual Web site.

“There is a lot of value created in the first few months of the life of a new Internet company, and we wanted to participate in creating that value,” says Seth Tapper, a member of the New York-based Rare Ventures incubator. “If we get in earlier, we own more of the company, and we can bring our unique talents to bear to help make it a great company.”

Launched in March with $100 million from parent company Rare Medium Inc., a Web design consulting firm, Rare Ventures provides $1 million to $5 million to in-house and outside ideas. The firm has funded 10 external companies and five in-house ideas since its creation, typically owning more than 50% of a company., a Web tools provider that allows its clients to build sophisticated Web sites, is one company that joined Rare Ventures in June and is on its way out, Tapper says. And the recently departed Inc., a source of new music, has just merged with online music publication to form ChangeMusic Network.

Softbank’s Brown says that in the end, both the entrepreneur and its incubator come out winners, especially if a company is as successful as Softbank portfolio company BUY.COM Inc., an e-tailer of a range of products that has a $1.5 billion valuation and plans to go public.

“Is it worth it?” Brown says. “I think the answer has to be yes’ because if you get a valuation of $1.5 billion on a company when you take it public and get those kinds of returns for your investors and the entrepreneur, I think everyone would say this is a win-win.”

Sample of Internet Incubators

Cambridge Incubator, Boston

CMGI Inc., Andover, Mass.

divine interVentures, Chicago

eCompanies, Santa Monica, Calif.

Hotbank, Mountain View, Calif.

idealab!, Pasadena, Calif.

Internet Capital Group, San Francisco, Boston

Orbit Capital Corp., New York

Rare Ventures, New York

Startech Venture Capital Network, Dallas

VenCatalyst, Washington, D.C.