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24-Jul-2000

The Standard, "The Trouble With Incubators"

Source: The Standard
Author: Lark Park

Unlike venture capital firms, incubators are built to bring companies public quickly. But they work better in bull markets than over the long haul.

When Jim Nelson launched Orbit Capital in 1999, he had visions of bringing great ideas to market quickly by coupling venture investments with the business services needed by startups. By June 2000, it was clear things would be different: The affiliate of the $12 billion investment adviser Orbitex Group shut down its incubator operations, focusing instead on venture alone.
"The whole cycle has changed and it's not that easy," says Nelson, Orbit chairman and CEO.

Orbit's about-face reflects the beginnings of a subtle shift in the thinking behind incubators: They're neither as simple nor as lucrative as they appear, and their model may be better suited for bull markets. And if, as many suspect, the bull market of the last 10 years has run its course, incubators will be especially vulnerable to the fallout.

"There used to be an argument for incubators," says Steve Brotman, a venture capitalist at Silicon Alley Venture Partners. "Companies were going public in 18 to 24 months. Now that the IPO market has slowed down, it makes much less sense now."

It's easy to see why so many companies, like Internet Capital Group (ICGE) and Divine InterVentures, were drawn to the incubator model: Take a substantial equity stake in return for providing services and advice that a startup would not readily be able to find on its own. Services can include everything from technology development to office space to legal and accounting services.

The surge in for-profit incubators has pushed their number to 800 from 600 in mid-1999, according to the National Business Incubator Association.

Like venture capital firms, incubators place bets on a variety of startups, increasing their chances to hit it big through a diversified portfolio. But venture firms have more capital at their disposal than do incubators. Most VCs expect to sell or take public their investments after seven years, while incubators look to exit after only two or three.

VCs also rely on personal connections to provide their startups with business services, while incubators take on much of the legwork of turning an idea into a business. That frees startup entrepreneurs from many of the daily details, allowing them to focus on the bigger picture.

A good idea, but given the costs of handling those business services, incubators profit most when they can sell or take their companies to the public markets quickly. Incubators need capital to flow back into their coffers to make or sustain investments. In boom times, they can count on IPOs for income. But in lean times, they must scramble for capital to carry these companies for the long haul.

And that puts many incubators in a bind. "Cash reserve minus overhead," says Brotman. "That's how long they are going to last."

Nelson says some incubators are having a tough time raising money for their own needs. One sign of the hard times can be seen in this month's IPO for Divine InterVentures, which started trading at the bottom of its expected range of $9 to $11 a share on July 11. Divine, which went public after multiple delays, raised $129 million, about half the $250 million it hoped for when it first filed for an IPO in December.

Incubators that went public before 2000, including CMGI (CMGI), Internet Capital Group and Safeguard Scientifics (SFE), are down as much as 80 percent from their highs. Meanwhile, those that filed for IPOs before the spring correction, like Guy Kawasaki's Garage.com and Bill Gross' Idealab, have yet to go public.

Compounding the problem, many incubators have failed to diversify beyond a specific sector. Many chose to become experts in narrow industries because they believed that portfolios with a high concentration of similar companies could leverage a common knowledge base. Now, the least diversified incubators are the most exposed to sector crashes. CMGI's focus on advertising and retail companies and Internet Capital Group's b-to-b focus hurt them when those sectors tanked.

In the long run, that focused expertise may work in favor of incubators as they seek to mimic venture firms less and instead focus on the not-so-glamorous business model of a standard operating company - that is, a business that focuses on day-to-day tasks rather than funding.

"Incubators look a lot like VCs right now, but eventually they'll become coordinated operating companies that continually build on their core expertise," says David Dusenbury, an incubator analyst at Credit Suisse First Boston.

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