VCs Try Partnering for Successful Incubation –

Incubators are a token of a dark past, a relic of entrepreneurial hubris from the dot-com days. Even today, executives and managers of such entities are reluctant to call their organizations “incubators,” preferring instead the euphemistic “accelerator.”

“There’s still a bad taste in the mouth when you say the word incubator,'” says Paul Krasinski, CEO of strategic advisory firm Lion Strategy Advisors in New York. “What was critical about incubators in the past is that they didn’t provide a lot more value to VCs. It was lots of entrepreneurs, and one after the next they were still synthesizing businesses almost on their own with some general access to resources. Today that’s changing dramatically.”

While not the venture funds in miniature of yesteryear, the incubators of today fill a vital role. They have partially stepped into the void left by VCs that have been scared away from early and seed-stage investing. “Globally, the amount of early stage venture money going into early stage companies has declined substantially vs. the point it was five or seven years ago,” says David Coats, managing director with Hamilton BioVentures in San Diego.

Seed and early stage investments suffered a serious decline with the bursting of the tech bubble in 2000. According to Thomson Venture Economics (publisher of VCJ), seed and early stage venture investing hit a zenith in 2000 with more than $9.4 billion put to work, up from $7.2 billion in 1999. The next year saw seed investing drop by more than a third. That dropped to $1.6 billion in 2002 and again to $1.3 billion in 2003. Preliminary year-end data show that it remained flat in 2004.

“Look at [incubators] as a place in the food chain,” says Stuart Ellman, a general partner with RRE Ventures in New York. He says that incubator seeding comes in at the most raw part of a company’s cycle when it is truly too early for venture capital. “There’s a place for it,” he says.

Team Effort

Today’s incubators are a diverse bunch that range from small operations sponsored mostly by individual investors, to entrepreneurial clusters housed by VCs, to groups that have evolved into stand-alone venture funds themselves. One popular model that has emerged is an incubator backed by multiple venture firms. These groups may not have a fund of their own, like the traditional dot-com incubator model, but they have exclusive arrangements with a small circle of venture firms that cover expenses and allow for the incubator to have some equity stake in the portfolio companies that are funded. Incubators that have operated under this model include Accelerator Corp. of Seattle, Vesalius Ventures of Houston and the Innovation Factory in Atlanta.

The magic number of partner firms in these incubators appears to be three, because it allows for diversity of opinion but is not too large to be cumbersome. “Going with more than three gets to be unwieldy in terms of managing a closely knit group of LPs in this type of environment,” says Josh Grotstein general partner and co-founder of incubator SAS Investors.

Accelerator, which added Amgen Ventures and OVP Venture Partners to its network this past November, purposely limited the number of partners in its network and turned away other interested VC firms. Carl Weissman says he held out for firms that brought the kind of tech background that would be beneficial to the group, citing OVP’s experience with nanotechnology as a prime example. “We could have brought in more funding but we also would have brought in more voices in the investment decision process,” he says.

Another option is for multiple VCs to create an actual fund to support an incubator. That’s what Canaan Partners, Rho Capital Partners and Sevin Rosen Funds have done with SAS Investors (formally Silicon Alley Seed Investors). The three firms act as LPs in SAS’s $40 million fund and also get a first look at its portfolio companies. SAS focuses on seed and early stage companies in the Mid-Atlantic and Northeast United States.

SAS has found success in getting outside validation for its companies, like Enpirion, a Bloomsbury, N.J.-based power service provider. This past December, Enpirion closed a $17 million Series B round led by RRE Ventures and Columbia Capital. Intel Capital also invested along with Canaan and SAS.

Motivation

There are a number of reasons that VC firms enter into these incubator partnerships, though most view it as a way to gain advantage finding new technology in early stages of development. “Definitely the deal flow is much more focused,” says Ram Velidi, a partner at Sevin Rosen. He says that incubators like Vesalius are attractive not just because of their focus but also because of the people behind them. Vesalius, he points out, has a specialized team of practicing physicians that “understand the pain points of the industry.” Most of the venture partners involved with Accelerator Corporation came to the organization through working relationships with Dr. Leroy Hood, president of the Institute for Systems Biology and a member of MPM’s scientific advisory board.

“The reason we’re interested in [incubators] is because it’s really difficult for a fund our size to do early stage deals when you have as much capital as we need to put to work,” says Kurt Wheeler, a general partner at MPM Capital.

Wheeler says he likes the partnership incubator model because it helps validate ideas in the early stages and gather other VCs who want to back the company. “The reason you like working with a group is when a company comes out you have a group of venture guys that are least half committed to the deal. When you’re a sole backer of an incubator, you have to look for validation outside. You’d rather have infant mortality in some of these than not. If someone’s not going to back these companies at an early stage then you better think again about validation of the companies.”

Risky Business

The danger in the partnership incubator model, Coats says, is if one firm makes a greater number of deals and gets a disproportionate amount of return from its investment in the incubator. He says that Forge insulated against this by mandating that two of the three venture partners must agree to fund a portfolio company.

“There are two things to be careful about,” says SAS’s Grotstein. “On one hand you do not want to be perceived as a captive of those [backing] funds, that they will be doing every deal. You also don’t want to send the signal that if they’re not investing it’s not a good deal.” He adds the key to a successful incubator is finding the balance between the network of backing VCs and the appeal to the outside venture industry.

VCs also say that you shouldn’t set up incubators to exist forever. Create them, give them a focus, let them do what they’re supposed to do and then wind them down. That’s what MPM did with Scout Medical Technologies, Wheeler says. It invested between $5 million and $7 million in the solo project. Scout brought MPM the kinds of deals it was looking for and had a short, sweet life, exactly as it was designed to, he says.

Another risk to keep in mind for a partnered incubator is that the interests of the VCs involved may change over time. That’s what happened with Forge Medical Ventures, says David Coats a managing director at Hamilton BioVentures who managed Forge. Forge was set up by Mayfield, Enterprise Partners and Johnson & Johnson Development Corp. in 1997. After about two years, both Enterprise Partners and Mayfield pulled away from doing life science deals, so Forge was left out in the cold. Coats says he now prefers to have incubators backed by a single venture firm in the form of an expanded entrepreneur-in-residence program.

Bottom Line

It’s still too early to tell whether these multiple venture firm incubators will be successful. Even though Vesalius, which has been around since mid-2002, still hasn’t funded any companies, its VC backers say the quantity of deals generated is not the benchmark for an incubator’s success. “Vesalius will be wildly successful if we make one investment they have surfaced,” says Blake Winchell, a managing general partner with Fremont Ventures. “That’s all we expected from the beginning and what we expect now. … The purpose of our investment was to generate a lot of deal flow.”

Generating deal flow and acting as an extra arm of due diligence for the firms makes the investment worthwhile, particularly in the highly specialized and risk-laden areas of life sciences, where today’s incubators are most active. The cost of participating in one of today’s partnership incubators amounts to a few million dollars over several years, depending on the size and scope of the organization.

“The financial cost is non trivial but it’s not huge in dollar terms,” Winchell says. “The time cost is definitely something you need to take into consideration. To do this right you need to spend time on [the potential deals]. That’s why you don’t want to have five of these things going on at the same time.”

While the incubator has undergone a lot of change, it is far from extinct. Venture capital firms have used them to maintain contact with the early stage companies and help streamline due diligence.

It is a space that continues to evolve. “I don’t know if anyone has figured out the perfect incubator model when you have it sponsored by more than one venture capital fund,” says Coats. “But you want the early stage investing to be an integral part of what you’re doing.”

While VCs may partner with an incubator and never see a big, fund-making investment through the group, the minimal deal flow and risk aversion that these incubators bring is worth the price for VCs to get a leg up on early stage investing. That trouble may arise from having too many chefs spoiling the pot has not soured the venture community on the basic partner incubator model.

Incubators Revisited

Part 1

While closely associated with the excesses of the VC industry’s recent past, incubators have changed their shape and continue to feed important deals to their venture allies. VCJ is revisiting incubators to see where things have gone since the collapse of the bubble. This story examines incubators backed by a network of traditional VC firms. Future articles will look at incubators sponsored by state and local governments and groups that spin out technology from universities.

Select Incubators

Accelerator Corp.

www.acceleratorcorporation.com

Founded: 2003

Backers: Amgen Ventures, ARCH Venture Partners, MPM Capital, OVP Venture Partners, Versant Ventures, Alexandria Real Estate Equities (NYSE: ARE), the Institute for Systems Biology.

Focus: Biotechnology

Portfolio Companies: None

Exits or Follow-on Funding: None

Investment Pool: $15.3M available from a total of $21.8M in committed capital.

Notable: Any venture firm may invest in any company that Accelerator recommends with or without the participation of the other partners. Cost to participate is a flat monthly fee.

Innovation Factory

www.innofactory.com

Founded: 1999

Backers: Carlyle Group, Schroder Ventures, Versant Ventures

Focus: Medical devices

Portfolio companies: Acufocus, Cerebral Vascular Applications, LipoSonix, NeoVista, Neuronetics

Exits or follow-on funding: Acufocus raised Series A and Series B rounds for a total of $10M; Neuronetics raised a $10.5M Series A round; and LipoSonix last year raised a $27M series C round led by Three Arch Partners, with new investors Delphi Ventures, Essex Woodlands Health Ventures and Pinnacle Ventures also participating.

Investment Pool: $30M.

SAS Investors

www.sasinvestors.com

Founded: 2001

Backers: Canaan Partners, Rho Capital, Sevin Rosen Funds.

Focus: Seed- and early stage tech companies in Mid-Atlantic and Northeast United States.

Portfolio companies: Enpirion, HydroGlobe, Kirusa, Lemur Networks, Multispectral Imaging, Predictive Power, Protonex Technology, Reactive NanoTechnologies, Tacit Networks.

Exits or follow-on funding: Most portfolio companies have received outside VC funding. Enpirion raised a $17M Series B in 2004 and Tacit Networks raised $16.9M Series B in 2003.

Investment Pool: $40M

StarTECH Early Ventures

www.startechev.com

Founded: 1997

Backers: More than 30 VC firms including Austin Ventures, Capital Southwest Corp., CenterPoint Venture Partners, Chisholm Private Capital Partners, Crescendo Venture Management, InterWest Partners, Sevin Rosen Funds.

Focus: Early stage IT companies.

Portfolio: includes Advent Networks, Airimba Wireless, Globe Ranger, Inoveon, Mirage Networks, Reata Discovery, SensorLogic.

Exits or follow-on funding: Last year, Reata Discovery raised a $12M Series C and Metreos raised a $3.8M Series A.

Investment Pool: $30M

Vesalius Ventures

www.vesaliusventures.com

Founded: 2002

Backers: Fremont Ventures, Guidant, Sevin Rosen Funds, Vanguard Ventures.

Focus: Telemedicine (medical informatics and technology).

Portfolio companies: None

Exits or follow-on funding: None

Investment Pool: NA

Notable: Looked at 165 potential deals in its first year. VC backers want to invest between $250K and $5M in early stage companies that Vesalius finds suitable.

Source: Original research by Matthew Sheahan

Next month: Regional and state and local government sponsored incubators.

Email: matthew.sheahan@thomson.com