Venture Capital

The Negative Side of Incubators

We are awash in startup incubators. And while some like Y Combinator have strengthened the startup ecosystem, I fear the incubators’ increasingly standardized, demo day-focused financing model are harming entrepreneurs and young startups.  

The most common critique: Truly great ideas don’t come together in the 12 weeks these programs last.

The Takeaway
An oversupply of startup incubators is increasingly distorting company formation and capital raising. High-flying companies come out of demo days raising too much money while the rest don’t quite raise enough to succeed.

Managing towards the arbitrary end date of a demo day forces many entrepreneurs to bunt. It is easy to put together a reasonable-looking business in a few weeks with customer proof points and a well-crafted investor pitch, then raise up to a few million dollars from an audience of hungry investors. It is, however, much harder to put together the beginnings of something truly audacious on a short timeline.

This is compounded by the fact that more investors come into demo days expecting a formula in terms of capital asks and valuation. Rather than encouraging great young founders to work a problem they are passionate about until they crack it, incubators generally encourage them to pivot until they have something neatly packaged for investors on a quick timeframe.

As a friend recently put it to me, “you get a lot of bottle rockets” and very few true “launch vehicles.”

Only Half Alive

Another equally important but less discussed critique is that demo days frequently leave companies awkwardly financed.

Companies presenting to investors at a demo day are products that are compared and ultimately sold by the incubator to investors. Price, valuation and terms all end up falling into a relatively narrow band. With some exceptions, the deal is almost always $1 million to $5 million on a note or equivalent with a $5 million to $15 million valuation cap.

The problem, of course, is that different companies need different things at different times. Those types of terms are easy for the buying VCs and angels to digest, which is why they are marketed that way. But the numbers and terms don’t reflect the needs of the companies, causing problems for the most successful and least successful alike.

For the few companies in a given batch that end up being the belles of the ball, the onslaught of interest from capital all at once frequently sets them up for serious trouble down the line. This is particularly true in the cases where incubators encourage entrepreneurs to not talk to financiers before they “demo.”

For the high flyers, the extra momentum generated from the demo day feeding frenzy frequently ends with companies raising too much money from too many people at too high a valuation and taking too much dilution all at once. Even enlightened entrepreneurs get too easily seduced by high-profile angels and VCs looking to get involved all at once. Many argue that since they give away so much early equity to the incubators themselves, the valuation bump at the end of the program is payback. But no matter what, the whole process ends up being extremely distracting.

The far more common outcome, of course, is that companies come out of demo day limping along. Incubators generate too many half-alive companies that leave their financing open, raising money in dribs and drabs as they go. They’re never quite well enough financed to achieve their goals. The vast majority of incubated companies I see up to a year or two after they exit an incubator are in this state. They don’t have enough momentum to succeed, but with money to pay salaries, they have too many resources to die.

As a friend recently put it to me, “you get a lot of bottle rockets” and very few true “launch vehicles.”

This is, in a sense, because the incubator model works for them. They get to their demo day, and because the incubator’s job is to help source capital for them, they get some, if not all, of what they want. The problem is that underfinanced companies that are always half-fundraising have a very hard time breaking out to do anything interesting. Without the help of an incubator they would have been forced to call it quits.

Important Now

The original incubators, and in particular Y Combinator and Techstars, have played a mostly positive role over the last 10 years.

They more or less open sourced the dark art of forming companies, pitching investors and raising capital. They helped open doors to financiers that truly were shut out a decade ago and helped young founders not get taken advantage of. They also gave talented youth a brand to associate with and a network as a home. That made dropping off of the defined path much more palpable and justifiable to Mom than it once was.

But the world has changed. In a sense, the incubators have won, and most of the lessons they taught and networks they unlocked now stand open and generally available. It is now much easier to start a company, and no longer as heretical as it was in 2005.

At the same time, the incubator model, once a small part of the ecosystem, is becoming more central. The successful incubators have incentives to expand and support more companies. At the same time, an enormous number of subprime incubators have sprung up in their wake, carrying with them all the costs of the incubator model with none of the benefits.  

So, the prevalence of the model continues to expand, while its original value to the ecosystem declines. The distortion that incubators put on company formation and capital raising increases.

There are no doubt some good actors running incubator models, and there is no question that there will be successful companies that come out of incubators going forward. But they are increasingly a negative trade for innovation overall.  

Entrepreneurs should stop assuming incubators are by default good for their business and think about what they are trying to achieve. It is one thing if they naturally find themselves on the “incubator highway”, but it is frequently a mistake to crowd on the path if what they want doesn’t fit.

Sam is currently a General Partner at Slow Ventures and an intern at The Information. He is also the co-founder of Fin Analytics. He was formerly a vice president of product management at Facebook from 2010 to 2014. Prior to joining Facebook Sam founded, a file-sharing platform that was acquired by Facebook in 2010. Before Sam was an associate at Bain and Company. In his spare time Sam enjoys skiing and kite-surfing. He is married to Jessica Lessin, founder of The Information.