A startup incubator is a very common and essential term in the startup ecosystem. With the number of startups increasing exponentially every year, incubators play a significant role in assisting and guiding startup founders through this challenging journey.
However, the term often creates confusion regarding its definition, structure and revenue model. So, here is a guide answering all your questions about startup incubators, their work and how they differ from startup accelerators.
What Are Startup Incubators?
A startup incubator is a program designed to help early-stage or seed-stage startups grow and sustain themselves by providing them with the space, equipment, and support they need. Usually, incubators help startups in their early stages with minimal to no traction and make them more competitive when it comes to securing venture capital.
Startups in an incubator typically receive free office space, utilities, computers, equipment, and access to incubator services and events. Sometimes, they also offer mentorship, business coaching, and other services, as well as the opportunity to network with people who can help their business grow. Some incubators are even connected to accelerators, which provide companies with funding and other resources to help them grow faster.
In addition, startups that enter an incubator may receive preferential treatment when applying for funding from venture capital firms. This is because venture capital firms or angel investors often have connections with startup incubators.
Business incubators are quickly gaining popularity in various industries. For example, in 2017, Google invested $1 million in an incubator called Y Combinator. Other examples include Techstars, 500 Startups, Techstars Chicago, and Startupbootcamp. The Y Combinator program has helped create hundreds of successful companies, including Dropbox, Airbnb, Reddit, Stripe, and GitHub. Startupbootcamp London and Start-Up Chile are also well known for helping startups grow.
Types Of Business Incubators
While all incubators share the same goal of assisting startups in their early stages, they are divided into the following types:
- Non-profit corporations: Most renowned incubators are non-profit organisations run by academic institutions, NPOs, government agencies, etc., to help young students or assist economic development in society. For example, the Berkeley Skydeck is the educational business incubator from the University of California, Berkeley and the Venture Incubation Program is a 12-week incubator program for Harvard students. Another example of a non-profit corporation is Mass Challenge.
- For-profit development institutions: some firms also develop incubator services to profit while assisting startups or creating an investment opportunity for themselves. They usually provide investments or fundings to startups in exchange for equity. Some popular examples include Tech Ranch, WiSTEM or pyros, etc.
How Do Startup Incubators Work?
While startup incubators are usually flexible when it comes to helping companies by providing them with various facilities and mentoring them, they work in a structured manner to ensure the proper growth of different startups they work with.
Stages Of Progress In An Incubator
Generally, startups participating in an incubator go through the following four stages including:
- Recruitment: startup incubators have a recruitment process where the potential members go through the whole application process. At this stage, the incubators analyse the startup potential, the idea, the team, the potential market, etc. Usually, the startup founders have to interview and convince the leaders to take them in.
- Onboarding: once a startup gets accepted in the incubator program, the onboarding process begins where the incubator informs startup founders about its working and some rules to be followed. Moreover, during this period, the incubator also gets to know more about the company and its needs.
- Beginning the program: this is when the program starts, and the incubator starts helping the company with mentorship, networking opportunities, funding, etc. An incubator program usually goes on for as long as the startup needs assistance. It can take anywhere from 3 months to two years. However, the specifications are generally clarified beforehand.
- Networking with the alumni: even when the duration of the program finishes, the incubator provides startups with a vast network of alumni. As a result, the startup founders now have access to experienced entrepreneurs who can interact with them and guide them for their future endeavours.
What Are The Variables That An Incubator Depends On?
The success of a startup incubator depends on a lot of variables, including:
- The total number of startups in the program: incubators generally take in a cohort of preferable startups with growth potential and nurture them. This is because the more the number of startups they invest in, the more are the chances that some of them will succeed and eventually make up for the money lost in unsuccessful startups.
- The number of startups that fail within the first two years: it is a very well established fact in the startup ecosystem that most of the startups are bound to fail. Early failures give incubators no chance of exit, and they lose all their investments. Furthermore, they have to make up for their loss through other startups they invest in.
- The time it takes to get a return (or liquidate the equity): even if a startup doesn’t fail and shows certain growth potential, there could be unprecedented delays in liquidating the equity or getting a return from them. As a result, investors usually try to get an exit as soon as possible.
How Do Startup Incubators Make Money?
Usually, startup incubators are non-profit organisations funded by the government, academic institutions or private corporations. They take in a cohort of startups in their early stages and offer them services without asking for any equity in return. This is because they usually receive government grants or funding from universities or private organisations.
Why do these organisations invest in incubators, you ask?
Well, there are several reasons. For example, academic institutions want to help their students and alumni grow their startups by providing long-lasting connections to investors and mentorship from experienced entrepreneurs. At the same time, government or private sponsors invest to get access to startups in their early stages or help in the economic development of the society as a whole.
Furthermore, some private organisations run a non-profit incubator service as a front to fund ideas around their products or services to advertise themselves and create an ecosystem in their favour.
How Do For-Profit Incubators Make Money?
For-profit incubators usually demand equity in the early-stage startup for their services. More often than not, such incubators even provide funding or access to VC firms, accelerators, and so on apart from the standard services.
They look for potential exits or liquidity events once a startup gains enough market value and traction or when it goes public. This provides them with huge returns on their investment.
How Does Equity Convert Into Money?
Equity represents the number of shares of a startup. An incubator can easily convert this equity into money through an exit. An exit is when the incubator sells this equity or shares to another entity. This entity could be the company itself, another investor, some private company or even the common public.
There are many ways to get an exit. For example, if the startup an incubator has invested in goes public or declares an IPO, the incubator can sell its shares to the common public and get a massive return on its investment. Furthermore, sometimes there is a buyback when the company repurchases its own shares. Another way to get an exit is to sell the shares to a larger investor when the company starts a new funding round.
What If The Startup Fails?
There is no doubt that an incubator can earn loads of money by taking equity in startups. But, it is also highly plausible that most of the startups don’t make it. For example, according to Forbes, 90% of the startups fail during the first five years of their incorporation. So, how do incubators make money if the startup they have invested in fails?
Well, they have various other ways of making money, including:
- Participation fee: such incubators usually charge a recurring fee from participating startups to cover their costs. Even though it doesn’t generate much revenue, the price helps incubators sustain themselves and the startups they support.
- Multiple startups: another important thing to keep in mind is that incubators take in a cohort of early-stage startups with unlimited potential to grow. So even if a small fraction of them succeeds to get traction or enough market value, the incubator will be able to get a significant return on its investment.
- Multiple sources of revenue: incubators, non-profit or for-profit, have numerous revenue streams coming from different sources. They don’t depend on just incubation services for their profits. For example, incubators develop a lot of connections and relationships that help them generate revenue by selling their services, providing consultation, tilting the market in their favour, etc.
- Royalties from IP commercialisation or licencing: apart from equity, some incubators also demand a percentage of earnings from startups they incubate. But, it is not very easy to earn through royalties as it involves loads of legal arrangements and cash investments. Therefore, this is not the most used revenue source for many incubators.
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An enthusiastic human being with determination and zeal to explore new ventures. Tanya is an entrepreneurial spirit searching for changes and learning to exploit them as opportunities and impacting people for good.
Very nicely and simply explained.