Incubators, E-Commerce

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INCUBATORS, E-COMMERCE

An extremely hot phenomenon at the height of the dot-com craze in the late 1990s, incubators are the nurseries in which Internet startups can develop their business plans, products, services, and infrastructures, secured with plenty of financial capital, physical space, and on-hand expertise. In short, incubators are companies in business to support and bring to life new companies, particularly dot-coms.

HOW INCUBATORS WORK

Even before startup entrepreneurs are ready to seek out a first round of venture capital, they need the time and resources to develop their businesses into models that venture capitalists will find attractive. This is especially true for companies seeking to attain venture capital from the leading VC funds, which typically gravitate toward larger projects and have less time for seed investment for the initial development stage. Incubators thus saw a market niche in the business development market to provide an economy of scale unavailable to early-stage companies. Business acceleration is their line of work, in that they take a concept under their wings and nurture it through its early growth period and turn it into a living company. They exchange their initial capital investment and expertise for equity in the startup company.

Incubators are full-service company accelerators, offering everything from finance capital and management expertise to marketing analysis and legal advice. They tend to provide their e-commerce companies with office space, ample facilities and infrastructure, and recruitment services so as to attract executives capable of making the business stand on its own. Typically, incubator firms maintain their own staff to comb over the companies' business plans and implement Web sites and technological infrastructure, while at the same time seeking out venture capital funding and creating equity pools for each client. Once the companies are prepared to stand on their own, they are turned loose to generate their own later-stage venture capital and move toward an initial public offering (IPO). Incubators generate their own profits primarily by reaping returns on their initial investment, as the formerly incubating firm grows and its stock price soars, the value of the incubator's original stake grows as well.

Incubators vary considerably in the degree of control they exercise over their incubating companies. Some incubators concentrate primarily on sheer volume, and therefore have less time and resources to devote to the development of their firms. Others, however, exercise extensive authority over the direction of the companies' development, since the incubator's success depends on the eventual success of their companies and because brining startups to life is, after all, the incubator's area of expertise. In general, this is the main feature distinguishing incubators from venture capitalists. While some VC firms take an active role in guiding a company's development, incubators' activities often border on co-founding firms, and even the most hands-off incubators have more direct participation in the company's early gestation and growth than do venture capitalists.

Successful incubators require more than just a thick wallet and high-powered connections, a fact many incubators in the early 2000s discovered to their dismay. In addition to ample capital, for an incubator to truly generate a sustainable business model, it must be able to provide the kind of hands-on support that will be able to generate excitement about the product or service the business is offering. It also must be able to put the firm directly into contact with its potential customer base. Most importantly, the business must have a long-term plan for profitability and a route toward repaying its benefactor's initial investments. This seemingly obvious rule was often lost during the height of dot-com mania, which had some enthusiasts insisting that the laws of business were forever changed by the new economy. Incubators in the 2000s were likely to be much more sober-minded in their expectations, analysis, and in the practical guidance they offered to incubating firms.

INCUBATORS' RAPID RISE AND FALL, AND BEYOND

The incubator concept was largely popularized, according to Fortune, in 1996 when Bill Gross founded the incubator firm Idealab, which went on to become one of the leading incubators through the dotcom craze. Idealab claimed Internet firms like eToys, NetZero, and GoTo.com as alumnae of its incubation. Another incubator called CMGI quickly emerged as Idealab's major rival, and between them those two companies defined the basic incubator paradigm that others adopted. For a while, in the thick of the excitement over the new economy, and Internet startups in particular, the incubator concept was hailed by many dot-com enthusiasts as a central innovation for company creation in the Internet age. The result was an extremely rapid pace of company development at incubators such as Idealab, where ideas were transformed into viable startups at a remarkable pace, and in great quantity.

Through the Internet market heyday of the late 1990s, incubators were all the rage, and new ones cropped up at an astonishing rate. Even major venture capital firms, such as Benchmark Capital and Kleiner Perkins Caufield & Byersor, set up their own incubator operations or partnered with existing incubators, recognizing that many of the dot-com startups they wished to back required a good deal more hand holding than they were used to providing. Other businesses outside of the traditional equity-funding field also took advantage of the emerging field to spin off incubator outfits. These organizations included the likes of Andersen Consulting, Dell Computer, Hewlett-Packard, Panasonic, IBM, and even a number of business schools at universities such as the University of North Carolina and the University of California-Berkeley.

After the dot-com boom fizzled in the early 2000s, many skeptics eyed incubators suspiciously, seeing them as among the more garish excesses of the dot-com craze. Indeed, following the bust of the technology stock market beginning in March 2000, incubators rapidly disappeared as investors rushed to liquidate their capital investments. Thus, by 2001 the incubator model had largely fallen out of favor, with few investors ready to sink money into risky startups following the drudging many took at the tail end of the dot-com craze, and with the U.S. economy slowing considerably.

The sudden crash of the incubator sector in the early 2000s partly mirrored, and was directly related to, many of the features that led to the abrupt shift in fortune for the Internet industry in general. With investors pouring money into Internet stocks and valuations soaring through the roof, many incubators became convinced that their time was at hand, and that just about any Internet idea could generate enormous returns. As a result, they tended to go overboard by financing shaky ideas and accumulating far too many startup hopefuls under their umbrellas. Once the tech market began to falter, incubators suddenly found themselves with far too many companies to incubate, and realized that they had invested a great deal of money that would never be seen again. These realities scared investors away from the incubators themselves. Ultimately, once the Internet industry fell to earth, there were too few good ideas to sustain the incubators and their bloated portfolios.

Like the Internet market in general, the success enjoyed by many incubators in the late 1990s encouraged hordes of imitators to join the field. Not only were these imitators ill-equipped for the business, they also contributed to a market glut that demanded a shakeout. As Nicole Weber, an analyst of incubators at Framingham, Massachusetts-based International Data Corp., bluntly told InfoWorld, "people who had no business becoming an incubator got involved." In October 2000, Business Week reported that less than one-third of all incubators had managed to turn out even one company, while just under half nursed a company that had proved attractive enough to generate financing from outside the incubator itself.

By fall 2000, just before the industry shakeout really took hold, there were some 350 incubators growing at least 10 businesses under their shell, according to a study by Harvard Business School. The primary survival method for the bulk of these firms was to attempt to merge their struggling companies—especially those in which they had invested substantial resources—with already successful companies. Another strategy was to shut down less promising startups and concentrate their portfolios on those companies with the most thoroughly developed and viable business plans. Co-author and Harvard professor Nitin Nohria told Business Week that less than a third of those were expected to survive into the mid-2000s, while the National Business Incubation Association predicted that about 50 incubators might survive if things go well.

However, this didn't mean that incubators were creatures of the exuberant 1990s, on their way to extinction. Many investors with a more sober-minded analysis of the potential of Internet-based companies, and typically with more thoroughly devised business plans, still clung to the idea of providing breathing room for companies at the seed stage as a valuable and profitable venture. With dramatically thinned ranks due to the massive incubator shakeout, those firms that ultimately survived were likely to perform strongly, as the Internet market recovers from setbacks in the early 2000s and the incubator concept continues to diversify into new areas of business.