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Nyenrode Business Universiteit

“Scaling new technology companies from the incubation
stage, to venture funding, to profitability: implications for policy making, investing, education and entrepreneurship”

Dimitris Tsakos, September 2012

This research is supported by:

We examine the incubator ecosystem as a growth enabler for early stage technology companies, in connection with further funding by venture capital firms. Looking at different stakeholder benefits (academic, corporate, private, government) and across various geographic regions, we conclude that everyone
stands to benefit in various ways by creating tightly connected, well-funded ecosystems in a local geographic context. Specific recommendations are offered to investors, educators, incubator managers,
policy makers and entrepreneurs.

Contents
Executive summary .......................................................................................................................................................2
Introduction ...................................................................................................................................................................4
Research problem ..........................................................................................................................................................6
Introduction ...............................................................................................................................................................6
Research questions and analysis methodology ..........................................................................................................9
Conceptual model .................................................................................................................................................... 10
Discussion.................................................................................................................................................................... 13
Incubator definition ................................................................................................................................................. 18
Services offered ....................................................................................................................................................... 21
Different types of incubators ................................................................................................................................... 27
University affiliated incubators............................................................................................................................ 28
Private incubators ................................................................................................................................................ 32
Corporate incubators............................................................................................................................................ 35
Incubator effectiveness discussion ........................................................................................................................... 39
Venture capital definition ......................................................................................................................................... 49
Venture capital performance and economic effectiveness ....................................................................................... 50
The Israeli technology ecosystem experience .......................................................................................................... 53
The convergence among incubator and venture capital investment practices and decisions ................................... 61
Conclusions and recommendations ............................................................................................................................. 66
Bibliography ................................................................................................................................................................ 74

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Executive summary
This paper seeks to examine the whole lifecycle of a technology company, from
inception and incubation to receiving growth funding and reaching survival (profitability).
We will look into the different stages of company development by examining a few of the
most studied institutions that facilitate this process in an economy, namely the
incubator/accelerator environment and the venture investments firm.

By drawing learning points from global experience in this field we will determine key
aspects that policymakers, investors, corporations, academic educators and of course
entrepreneurs can take away from best practices around the world.

We show what the importance of startup firms growth is for an economy and what the
common constituents of the most successful examples of supportive institutions for
entrepreneurship are. By taking an integrated approach among the early inception stage
(incubation) and the further stages of follow-up growth investment, we can show the
whole picture, while focusing on the important elements every stakeholder should be
aware of at each stage.

Our proposed definition of an incubator environment focuses on the basic elements that
entrepreneurs consider critical to their success. We see incubators, therefore, as
organizations that offer business-relevant mentoring to their companies while acting as
a stepping stone that connects them to further venture funding, pending their success
on specific early-stage milestones.

We conclude with the following recommendations for supporting the process of
technology company scaling through incubators and onto further venture funding:

Incubators/accelerators play a substantial role in the creation and survival of new
technology companies, while their connection to further provision of capital is
crucial in venture scaling. Incubator managers should focus on offering

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entrepreneurs what they value, namely mentoring, networking and access to
providers of follow-up venture capital.

Having sound public policies which promote incubators will help in employment
creation and deliver substantial economic benefits. Policy makers must invest in
specific industries that appear strong in the local context in order to build the
initial critical mass, which then sparks additional private investment flows.

Venture Capitalists who invest at earlier stages of a company’s development
have more potential for success. As the capital needs in favored VC industries
are decreasing, this also seems like a natural move to gain an earlier position in
the future winning companies.

Corporations stand to gain by embracing open innovation through setting up
incubator environments. New business models can arise with the support from
the company’s resource base and financial capability, while top-level executive
involvement is necessary for success.

Universities also stand to gain by setting up incubator environments. Except the
practical teaching of entrepreneurship to students, which can get involved in
technology company creation, taking equity stakes in companies incubated
proves to be more profitable way of commercializing technology relative to
licensing contracts.

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Introduction
The adoption rate of new technologies has been reaching high levels, in an ever shorter
amount of time (The Economist, 2012):

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In this world of accelerating innovation we seek to examine what is happening in the
technology ecosystem and how the world is rapidly moving to adopt new,
institutionalized or not, forms of supporting this entrepreneurial potential.
We will delve into the innovation policies of the institutions society has formed, such as
universities, corporations and government, in order to gain insights into best practices
globally that have proven to nurture technology innovation as a basis for new company
formation.
Additionally, we will examine some new forms of specialized institutions or capital funds
that seek to promote technological breakthrough in a unique way, mainly through
combining resources of what is already there (university research, human capital) in
new ways. These are the technology business incubator and the early-stage venture
capital fund.

While these institutions are not ideal for all types of new technology companies, it
appears that their economic results are very disproportionate: the output they deliver is
much higher than if they didn’t exist.
By analyzing what breeds success in this field we will provide recommendations for
different stakeholders in the ecosystem, such as policy makers, incubator managers,
venture investors and of course, most importantly, the entrepreneurs behind it all.

Our report has the following structure:
We first introduce the research problem.
Secondly, we look at the various literature that has been written on the research topic
touching on issues like the various incubator types available and the services they offer.
We also look at literature on venture capital and its performance and effectiveness.
After this, we take a look at the convergence of VCs and incubator investment practices,
a topic that seems to be of interest to the investment world lately.
Finally, we offer our conclusions and recommendations to the various stakeholders in
the industry.

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Research problem
Introduction
A seminal study of the US economy by the Kauffman Foundation (2010) revealed an
important fact - startups, defined here as companies that are less than a year old, are
for most years the only companies that deliver net job gains to the economy over a long
period of time, adding around 3 million new jobs per year and are not subject to the
effects of economic downturns:

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This, of course, could be seen as an unfair comparison, since startups can not dispense
of jobs at their inception while existing firms can at any point of time. However, it seems
that even from age 1, the net result is that firms of that age destroy more jobs than they
add to an economy:

While central policies seek to enable economic growth in an economy, this research
outcome seems to imply that additional focus should be placed on early stage firms and
identify what actions might lead to increased firm creation and survival.

Additionally, Montgomery (2007) uses Kondratieff wave theory to describe how
advanced economies are moving to what we call ‘the knowledge economy’, one that
brings together individuals that focus on knowledge creation and utilization, in specific
geographies. Regardless of the theoretical framework used to portray this development,
we can observe around us how most of the advanced economies of this world like to

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attract the most highly skilled labor force to work on problems that create significant
intellectual property, to be used in turn for economic growth.

Based on this argument of the concentration of knowledge workers in clusters (Porter,
1998) and the importance of startups and their survival rate for creating jobs, we would
like to examine ways for new technology businesses to emerge in a better manner, by
looking into the most studied institutions at the early stage of a new business venture,
namely the business incubator and the venture capital investor or investment firm.

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Research questions and analysis methodology
We propose a conceptual model below for this paper and seek to validate it through
combining existing literature on these topics, in order to provide additional insights for
the technology companies ecosystem. The compilation of this model is based on our
personal perception of what the technology venture ecosystem looks like and examined
literature.
Our methodology, therefore, is confined to existing literature review, upon which we
examine ecosystem participants’ options in order to resolve key dilemmas they face.

These decisions proposed answer our research questions:
Main research question:
- What is the economic significance of newly created technology companies for an
economy?
Sub-questions:
- What does the business incubator offer to a new technology company and what
subset of that creates the highest value?
- How should follow-up investment in a venture be formulated and what are the stages
of financing needed?
- What are the key learning points for fostering entrepreneurial technology ecosystems
that are relevant to each participant?

By answering the previous questions, we seek to come up with concrete
recommendations on what are best practices in order to foster economic growth,
through the support of the technology startups scaling process.

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Conceptual model
Initially we show that we will look at the full picture from the initial idea inception stage
and we will break down the financing stages into two parts:
- the first one, which can be obtained from an incubator
- the next ones (unknown number), which are assumed to be obtained by venture
investors of any type (angels, VC firms etc).

Capital needs of the new venture eventually decrease, since it is assumed to have
reached a level where it is self-funded by its customers.

Important for our research will be to show the connections among the various financing
rounds. Additionally, ways of incentive alignment among the various stakeholders will be
investigated to identify the existing relationships and their significance.

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Our view on the technology company financing lifecycle is as follows:

Seen as a continuum of capital needs required for growth, the financing lifecycle begins
with a first financing round that can or cannot be obtained from an incubator. The
questions that will provide guidance for this decision are presented above.
For the follow-up rounds, what is important to examine is the benefit of continuing to this
stage, having graduated from an incubator program, as opposed to not.
Another point that arises in this context is what does incentive alignment look like for
every stakeholder involved.

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Our conceptual model begins with the identified goal of our ecosystem participants.
These include corporations, universities, venture capital and governments. Combining
their resources in the creation of incubator environments creates a value addition
mechanism, which in turn is reflected in economic output for national economies, as
well as the supported entrepreneurs:

As presented in our model, we look at the goals of different institutions as input to the
value addition mechanism of an incubator environment (or accelerator, as a subset of
incubators). The output of this process is two-fold: the national economy benefits and
the individual also stands to benefit.

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Discussion
We first look into the earliest institution that is used to support company growth, the
incubator.
To get a feel for the number of incubators around the world, let’s look at what central
lobby organizations for the industry cite as numbers:
● The NBIA (2012) reports over 1400 incubators developed in the United States,
up from only 12 in 1980. Of these, around 75% are setup as not-for-profit.
● In Japan there were around 220 incubators in 2000, private and public. The
Japanese view their incubators more as a real estate business and access to
venture capital is limited (Frenkel et al.,2006).
● In Israel there are 24 business incubators (Invest in Israel, 2010) with the goal of
encouraging and supporting industrial research and development in Israel at the
earliest stages.
● The UKBI (2008) talks about 270 incubators in the UK. The UK view on the
incubator policy is the creation of new jobs (Frenkel et al.,2006).
● In Western Europe an EU Commission (2002) study identifies 900 incubators.
Goals for development of this industry vary per country:
○ the German goal for incubators is to foster the creation of new jobs and
encourage entrepreneurship
○ in Spain and Belgium incubators have been setup to attract branches of
international companies
○ in France, the first incubator was setup in proximity of an academic
institution in order to facilitate the commercialization of research output
(Frenkel et al.,2006).
● In Brazil according to Chandra and Fealy (2009) there are around 400 incubators
that are well connected among them and influence the government decisions on
the progression of the sector.

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● In Korea we can find around 300 incubator environments that are closely
affiliated to the government and the education system (Ndabeni, 2008).
● In China, there are around 500 incubators developed with 60.000 employees
working directly in them, in which the government has a central role (Chandra
and Fealey 2009).
● In South Africa we can find around 20 technology incubators. Their key
objectives are economic growth, sustainable employment, technological
innovation and technology transfer, and making South African SMEs
internationally competitive (Ndabeni, 2008).

Over 5000 incubators have been set up globally, according to NBIA estimations, the
bigger amount of which started operating during the 1990s. This shows the emphasis
government policies, in particular, have placed on goals like job creation via incubator
creation.
In this paper we argue that this goal, alone, is by no means sufficient for success.
Incubators have now reached a level of maturity that needs to be further enhanced by
incorporating elements from adjacent industries’ best practices, like the venture capital
industry.

Incubators are clearly being used as a policy instrument for fostering entrepreneurship,
innovation and regional development (OECD, 1999).

Tamasy (2006) attempts to summarize the reasons why incubators are seen as an
attractive policy option to achieve societal and political goals:
● the rise of Silicon Valley in the 1970s and 1980s made it a nice media story
● empirical evidence on the success of small and medium enterprises in the US
called for new policy instruments to mimic this abroad
● it is easy to gain acceptance for this kind of development in a local community

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● the symbolic value and media attention are easy to create, since there is a
specific space that can be pointed to, photographed etc.

Tamasy (2006) uses the NBIA website data to argue that incubators have created over
half a million jobs since 1980, which creates a spillover effect in the economy leading to
the creation of another quarter of a million jobs in related companies.
While the numbers might seem small, let us keep in mind that these are highly paid
positions with significantly higher contribution to the economy than basic, minimumwage positions.
Furthermore, the companies incubated created around 7 billion dollars in revenues in
2001 alone.
Incubators increase the company survival rate to 87% even in the long term, after
incubator exit. This number from Tamasy (2006) is confirmed by the long-term survival
rate of graduated firms in Israel, which is 84% (Avnimelech, Schwartz and Bar-El,
2006).
Also, Hannon and Chaplin’s (2003) UK research shows that managers of firms within or
graduated from incubators find their stay there to have been strongly beneficial to the
further development of their firm.

Incubator environments are increasingly being criticized as to whether they are
delivering their promised benefits to society as a whole (Bakouros et al., 2002; Tamasy,
2006). This fact stems from the increasing policy-maker focus on creating jobs via
investing in incubator development policies, a little like what Israel had done in the
1990s with its Yozma project. The promise is yet to be materialized, or at least the result
is seen yet as inconclusive, some researchers say.
We quantitatively assess the potential of delivering policy goals further on in our study.

The size of the incubator seems to have an effect on the propensity to network with the
entire supply chain, including cross-customer networking, extended network

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collaboration etc. (Becker and Gassman, 2006). This last observation can be seen in
relation to creating a minimum viable critical mass that allows for self-reinforcing
linkages to be created among companies that reside within the incubator environment.

Additionally, it is observed that R&D intensive firms tend to locate in university
environments, something that seems rather obvious given that the university laboratory
and other resources are a distinguishing competitive advantage for these firms. It is also
discussed how university knowledge spillovers are extremely bound by geography. This
can also be observed in everyday life, where we see a few parts of the world
succeeding in becoming an innovation hub (Silicon Valley, Eindhoven, Tel Aviv, Boston)
and the key connector among these areas is the presence of a prestigious research
university institution.

The incubation process for companies is sequential, in that it involves processes that
start from entry selection (including screening by various methods, selecting wider or
narrower industry focus companies etc) to deal structuring (equity participation or
service charges being the main question), to level of involvement (feedback by
incubator staff to all stakeholders) to exit from the incubation environment (under strictly
or loosely defined exit criteria, including performance metrics).

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The above process can be summarized as follows (as proposed by Becker and
Gassman, 2006):

Gassman (2006) shows how the process is continually evolving and refining itself.
There are clear steps in selection, ownership, involvement and exit decisions, as shown
in the diagram.

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Incubator definition
An incubator environment can be defined in different ways.

The National Business Incubation Association (NBIA, 2012) of the USA defines
incubators as follows:

Business incubation is a business support process that accelerates the successful
development of start-up and fledgling companies by providing entrepreneurs with an
array of targeted resources and services. These services are usually developed or
orchestrated by incubator management and offered both in the business incubator and
through its network of contacts. A business incubator’s main goal is to produce
successful firms that will leave the program financially viable and freestanding. These
incubator graduates have the potential to create jobs, revitalize neighborhoods,
commercialize new technologies, and strengthen local and national economies.

The European Commission (2002) proposes the following definition:

A business incubator is an organisation that accelerates and systematizes the process
of creating successful enterprises by providing them with a comprehensive and
integrated range of support, including: incubator space, business support services, and
clustering and networking opportunities.
By providing their clients with services on a 'one-stop-shop’ basis and enabling
overheads to be reduced by sharing costs, business incubators significantly improve the
survival and growth prospects of new start-ups.

A successful business incubator will generate a steady flow of new businesses with
above average job and wealth creation potential. Differences in stakeholder objectives
for incubators, admission and exit criteria, the knowledge intensity of projects, and the

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precise configuration of facilities and services, will distinguish one type of business
incubator from another.

Hackett, Sean and Dilts (2004) define it as follows:

A business incubator is a shared office space facility that seeks to provide its clients
(i.e., ‘‘portfolio’’ or ‘‘client’’ or ‘‘tenant companies’’) with a strategic, value-adding
intervention system (i.e., business incubation) of monitoring and business assistance.
The incubator can control and link resources that assist in the development of its clients’
new ventures, and simultaneously helps contain the cost of their potential failure.

Hansen, Berger and Nohria (2000) view it as follows:
An incubator is an entity that “hatches” new ideas by providing physical resources and
support to nurture the growth of new business ventures, which can either be an
independent start-up, or an internal corporate venture.

Tamasy (2006) adds the following definition:

Technology-oriented business incubators can be defined as a property-based initiative
assisting technology-oriented businesses to become established and profitable during
the start-up phase. They support these businesses by providing shared premises (in
one or few locations), business advice and office services.
The role of technology-oriented incubators is to provide a supportive environment
needed by new businesses to transform science into commercially viable innovations.
Planned by-products are successful businesses and, induced by intra- and interindustry
linkages, regional growth. Therefore, technology-oriented business incubators merge
the concept of fostering new

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businesses with growth potential (entrepreneurship) with concepts of the
commercialization and transfer of technology from universities to the regional business
community.

Avnimelech, Schwartz and Bar-El (2006) compile the following definition:

Business incubators assist new ventures to grow and survive during the early stages,
when they are most vulnerable. The principle of the incubation concept is that
premature
ventures require temporary support to gain strength and become more efficient. The
role of
business incubators is to provide a supportive environment, where new entrepreneurs
receive training and assistance in business management and marketing, various other
business services, and access to seed capital.

It is clear that contemporary definitions vary on their focus as to what an incubator can
be defined as.
Also, any research that focuses on incubators stumbles upon the problem of nonstandard semantics. The term ‘accelerator’ has recently been deemed to describe pretty
much the same concept as far as the company’s life stage is concerned, whereas a
reason for the new term can be given by NESTA (2011) which sees the term ‘incubation’
being akin to ‘life support’, therefore one would rather be associated with the upside
provided to companies than the prevention of the downside.

For our purposes, we refer to the general term incubator and use the term accelerator to
describe a specific subset of incubators, as described in later sections.

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Services offered

Aldrich (1999) suggests that companies new to a market face a competitive
disadvantage due to lack of legitimacy as a viable provider of service. This, in turn, will
not allow it to become self-financed from its customers quickly enough to survive.

Therefore, incubators must be able to resolve these issues at the early stage where the
company still has a lot of convincing to do on its ability to serve the market it targets.
O’Neal (2005) proposed the following services that can be offered by incubation
environments:
- access to external funding sources, including private companies and public sector
agencies
-access to university resources
- access to external entrepreneurial support organizations, including the research
libraries they might have developed
- facilities management, like cleaning services or catering
- business operations assistance, like providing a secretary or dealing with payroll,
staffing or other admin issues
- foster interactions between co-workers and the entire supply chain, including
customers of other companies, incubator staff, mentors, university resources

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Gassman and Becker (2006) also run an analysis on incubators of all types included in
the 2001 European Commission study and come to the following results:

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The above analysis of EU incubators by Becker and Grassman (2006) shows some
interesting results.
Firstly, while for-profit incubators hold many more informal feedback and periodic
meetings with stakeholders (such as the people who fund their operations), they monitor
their portfolio companies much less frequently even than not-for-profit incubators. This
seems slightly absurd, taking into consideration that an average for-profit incubator will
take around a 20% stake in its companies, thus having plenty of vested interest in its
success. The need to develop more clear monitoring strategies is therefore evident.

Additionally, Gassman and Becker (2006) make an important point about the quality of
staffing of the incubator. The manager and its staff largely determine the quality of
resources provided to the tenant firms.
This has been identified as far back as 1977 (von Hippel, 1997) in a study that
connected access to incubator personnel and a new venture’s success.
To derive the highest value out of its staff, an incubator must focus on their educational
or professional background. For-profit incubators tend to attract personnel with more
experience in real estate management, while not-for-profit ones will attract people with
more of a personnel management or education background.
Also, for-profit incubators attract staff that has more experience in business consulting
as well as management of their own companies (ex-entrepreneurs).

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Combined with further research we show that the human capital element is a key
determinant at this early stage for any incubator looking to provide value to its
companies.

Ndabeni (2008) proposes the following benefits for the ecosystem from the presence of
incubators:

The findings here are supportive of our conceptual model for our study. Various
stakeholders participate in the ecosystem with varying agendas and incentive alignment
is important for reconciling these and co-operating.

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Additionally, she takes a look at the factors contributing to an incubator being
successful:

The factors seen as important are far broader than just financial support and
participation: they include softer factors, like access to networks, as well as harder, like
the proximity to other relevant companies to the cluster.

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NESTA (2011) views the incubator ecosystem as beneficiary to the following:

The different stakeholders shown above can be seen as the input factors to our
conceptual model, which we extend to include the government. NESTA (2011) helps us
show the various benefits different stakeholders might receive from participating in this
ecosystem.

We further elaborate on the value-add to different stakeholders in the ecosystem after
we examine the different types of incubator environments more closely.

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Different types of incubators
In the US, the breakdown of incubators by ownership structure looks as follows:

The above table displays the distribution of sponsors for incubation environments. The
degree to which the private sector is involved is relatively small, regardless of the
private examples being the most popular today (YCombinator, Techstars).
Clearly the private sector jumps into industries that fit its own investment pattern:
shorter development lifecycles, small investment requirements, critical mass for
diversification and a promise of high growth for a decent financial return.

Our analysis will focus on three different types of incubators: university related,
corporate affiliated and privately run.

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University affiliated incubators

Access to university resources have a significant impact on incubated firms as a
resource for company growth. Technology incubators, for example, use university
research as a means to monetize on opportunities that arise thereof.
As shown in Coopers and Lybrand (1995), incubated firms with access to universities
enjoyed:
- productivity rates two thirds higher than their non-university incubated peers
- 21% higher annual revenues
- 32% more recent bank loans
- 23% more major capital investments
Additionally, around 70% drew interns from the university graduates resulting in 40% of
companies getting employees from the university ranks, while 44% of the firms used
faculty members to add to their technical knowledge.

While these factors must be seen in context as to bringing success instead of mere fact
of investment or productivity, they remain significant in showing how university access
can improve a firm’s access to resources.

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O’Neal (2005) proposes the following model for evaluating success in the university
incubator environment:

The success factors suggested here are interesting for our analysis: it appears that
interacting with other companies and clients in the ecosystem, as well as providing
access to external funding and other resources have a significant impact on results. We
elaborate further on this finding in our study.

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Additionally, O’Neal (2005) takes a look at the metrics that seem to be important for
these environments using the example of the University of Central Florida incubator:

What’s important to note here is that an incubator’s success can be measured by a few
categories of impact:
- job creation numbers
- intellectual property acquired
- clients and client size acquired
- total revenue generated
These can act as a metrics checkbox for incubator environments in any context,
regardless of their university affiliation.

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Finally, O’Neal (2005) looks at the maturity level of new companies coming in and goes
forward to identify possible aspects to which an incubator would have things to add to
the new firm:

The above model shows how a new client might need various types of support in order
to flourish as a stand-alone company. Starting with some technical or IP capabilities,
there are a multitude of further capabilities that have to be built or acquired.

Clearly there are plenty of aspects of the company to which a university incubator can
add value. Shown in the second box, we can see some of the resources an incubator
can offer its client companies in assisting them to build additional capabilities.

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Private incubators
Gassman and Becker (2005) view privately run, for-profit incubators as start-ups that
aim to gain fast profits from other successful start-ups they assist. Their main income
stream is from taking equity participation in the companies they support rather from
rental agreements (European Commission, 2002). However, there are also global
networks of not-for-profit private incubators established, such as The Hub, which
encourages social entrepreneurship (The Hub, 2012) and is funded mainly from
charitable organizations and, of course, equity participations in its tenant companies.

Private incubators are usually built because of exceptional skills within one person, or a
team of people, that can use them for private benefit. As shown in Aerts, Matthyssens
and Vandenbempt (2007) the incubator manager and his applied criteria can be highly
telling of the potential success of the firm. The ideal criteria weightings for admittance
are shown to be a balance between founding team competence and market size for
their product, without overemphasizing on either.
Building on this, YCombinator utilizes its manager’s (Paul Graham) expertise to fund the
internet technology startups that are becoming the most successful today, at their
beginning stage.

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As evidenced by Seed-DB data below (Christiansen 2012), YCombinator seems to have
reached critical mass and is now self-sustaining its funding efforts by money that is
made on successful exits:

Private incubators that are most successful follow the accelerator model. This is an
approach that is tailored far more to investors than the typical incubator model.
The accelerator model (also the definition for the difference between accelerator and
incubator programmes we use in this research) implies that companies are admitted in
cohorts or classes and follow a standardized, short period process.
The critical mass theory of YCombinator’s success can additionally be supported by the
fact that the size of its alumni network is now such that can be seen as a competitive
advantage, since all alumni will be willing to support fellow companies that graduate
from the same program (Geron, 2012), thus creating a virtuous reinforcing circle effect.

Accelerators are on the rise lately and even later stage VC firms are creating their own
accelerator, in order to obtain early access to the most promising companies (Takatkah

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2012). Techstars, for example, also shown in the above table, is setting up a network of
accelerators in different parts of the world to take advantage of innovation that comes
from anywhere, supported by funding from a venture capital firm called Foundry Group
based in Boulder, Colorado.

Paul Graham, manager of YCombinator, says that the value-add of his company is not
so much the funding, which is small, but the intensive mentoring for the full 3 months of
the program (Metz, 2012). Additionally, the success of this accelerator has led venture
capitalists to pledge guaranteed follow-up money to all graduates of the program.
While in the program, around ⅓ of the companies admitted will change the direction of
their initial plans substantially (Metz, 2012). This comes to show that the mentoring
provided probably adds significant firm value, since a whole new direction that the
founding team could not think of is chosen.

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Corporate incubators
Corporate incubators are specialized corporate units that hatch new businesses by
providing physical resources and support. They support external start-ups or internal
entrepreneurs with a promising business idea or technology.

As discussed in Becker and Grassman (2006), incubators sponsored by a big corporate
deal with the need for outside-in innovation or “open innovation”, as described more
recently. This is a departure from the notion of internal product and business
development by the firm’s employees in an R&D facility, where problem solving
orientation might be minimal.
Companies also try out this innovation setting in order to utilize old patents in new ways,
either by developing a new product or tackling a new market.

Corporate incubators are run usually for-profit, in contrast to the prevalent model of notfor-profit which has existed since the 1960s and relies on government funding for the
promotion of social goals, like job creation. They have, therefore, managed to create a
professional knowledge flow to achieve profits from their involvement in new ventures.
Corporates seek to take a percentage in the new venture for either pure monetary
purposes in a future sale, or some sort of strategic for with the existing portfolio. In the
latter case, a successfully incubated company will be bought out fully and integrated
into the corporate’s business units.

Except the multitude of firms mentioned in Becker and Grassman (2006), a Lord Young
(2012) paper describes how Telefonica has committed 150 million GBP to create a
network of incubators around the world, to support the creation of highly innovative
companies with the goal to create products that their customers will buy. Additionally,
they see benefits from simply working with talented and nimble entrepreneurs.
This initiative is telling of the convergence among corporate venture capital efforts and
incubator-stage initiatives, a development which we further examine.

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Becker and Gassman (2006) also find that around 56% of incubators will provide only
about 20 to 50 minutes of advice to the companies in residence. This can be seen as an
inefficiency in time allocation, if we assume that mentoring and advice are one of the
most critical value-adds a company would look for in an incubator environment.

They also differentiate corporate incubators into 4 different types:
- Fast-profit: Main goal here is to commercialize existing knowledge that has not yet
been utilized inside the company, with the aim to spin of a new venture and create a
new business opportunity.
- Leveraging: This type seeks to bring core business unit R&D efforts closer to market
and accelerate further business growth.
- In-sourcing: Main aim of this incubator type is to scan the market for new technology
developments and acquire knowledge about them by investing in teams that will build
products based on these.
-Market: This strategy seeks to create products for a market that is complementary to
the corporate’s existing ones, without an orientation to necessarily integrate the new
venture into the company’s existing portfolio.

The mentoring process within the incubator has been essentially tailored to interfacing
with the company’s internal resources. R&D, legal, finance or other business units are
part of a predefined process of advice provided to the firm. This enhances the
incubator’s effectiveness (Becker and Gassman, 2006).

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Gassman and Becker (2005 and 2006) show that the benefits of corporate incubator
environments can be summed up into:
- tangible: financial, physical and explicit knowledge flow
- intangible: tacit knowledge, access to networks, marketing and other expertise, prior
knowledge of customer needs and co-branding effects

What is important in these settings is the continuity of resource transfer to the incubator
corporate unit once there are changes in the people running the business. A common
problem (Gassman and Becker, 2006) is that these are many times seen as pet projects
of the heads at a given time period, and thus C-level involvement and support are
critical to the continuity of these venturing efforts.
In close connection with the above is the strategic positioning of the incubator unit. If it
is positioned next to the main corporate center, this can be seen as a sign of strategic
importance. On the other hand, if it is located in some other area, the provision of

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additional resources towards it and the networks created with other R&D company
facilities will be a key determinant in the importance placed on it strategically.

To sum up the description of the corporate incubator, we see how key individuals keep
playing a significant role in the quest for differentiation. We also see how processes are
being optimized in order to provide mentoring and other resources to the new venture
that is being pursued. There are a lot of lessons to be learned by the standardized way
of running corporate incubators and connecting them to further funding.

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Incubator effectiveness discussion

Maital et al. (2008) summarize the value-add by incubators down to the following three
elements:
- they must emulate real market conditions, while protecting participating firms from the
adverse effects of the market
- resolving the key constraint for success. This can be access to funding in India, while
Israel for example might face a lack of skilled management and Brazil is facing the
challenge of excessive bureaucracy (Chandra and Fealey, 2009).
- mitigate the effects of local and global cultural elements. This is closely associated
with the varying approaches to risk taking in different countries.

To debate the effectiveness of incubators, we take a real options approach
(Rosenberger, 2003) based on the previous segmentation we have presented (type of
incubator).

For universities, real options include paying a little upfront for setting up a technology
licensing office or setting up an incubator environment themselves, in order to
commercialize technology produced. The cash flows out provide the university with an
option either to cash flows coming in at a further stage as licensing fees, or an option to
equity participation in the companies that come out of the incubator.

Bray and Lee (2000) make a significant literature contribution here by giving some
advantages of taking equity in companies instead of licensing out:
- increased flexibility. The manager can structure deals in a different manner as needed.
- the possibility of still owning something valuable even if technology is replaced. This
hedges against the technological development risk.
- the reduced time till revenue generation compared to licensing.

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- the full advantage of those few big hits. In the study it occurs that even if a portfolio of
equity owned by a university does not produce big hits, its expected value will be
around the same as if when it entered licensing deals. On the other hand, if any of the
companies prove to be a big success, then the university share can fully enjoy the
upside of this investment.

Todorovic and Suntornpithug (2008) conclude that universities with a higher
entrepreneurial orientation will benefit more significantly from the move to less
traditional activities like spin-offs and incubators.
In Phan and Siegel’s (2006) research we see how more tacit elements of the
university’s culture play out. Universities with a more encouraging mentality towards
entrepreneurship, like MIT, will be far more effective in their technology transfer policies,
even regardless of the presence of local VC or the even the percent commercial
orientation of the institution (percent of budget derived from industry). We also see how
a high turnover in the managers of a technology transfer office impedes its processes
and we would argue that a more institutionalized form of this connection like an
incubator, could yield better results in this process.

From a human capital perspective, Phan and Siegel (2006) observe a lack of
entrepreneurial and marketing skills in technology transfer offices. This can be seen in
contrast to the multitude of skill sets people bring to an incubation environment,
including technical as well as other softer skills (marketing, business development etc).

Additionally, there is the option for the university to teach entrepreneurship to its
students by using the theoretical models taught in the classroom, or add practical
elements by co-locating companies with the students and encouraging interaction.
Todorovic and Suntornpithug (2008) show that the theoretical approach is inadequate
for teaching entrepreneurship and is almost a contradiction of the ‘doing’ mentality an

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entrepreneur requires. Practical examples of this include Harvard Business School’s
statement that its MBA class will be given money to build a company before graduation
as a prerequisite to the program (Byrne for CNN Money, 2012), or Stanford’s non-profit
incubator that accepts students wanting to build their first company, providing great
access to funding, mentoring and other resources (StartX accelerator, 2012).
In the European context, Klofsten (2000) examines the application of a practical, handson entrepreneurial training in Sweden which yielded advantageous benefits to its
student participants, exceeding what they would get from solely learning theory.

Finally, there is an ecosystem benefit effect here, since it is shown that the occurrence
of big hits from university portfolios encourages further investment by the local venture
capital industry (Bray and Lee, 2000).

For the government, we look at broader goals like job creation. While this might not
intuitively prove success from a private standpoint or even to liberal policies advocates,
even a country so advanced in the field as the US still provides governmental money
with the sole goal of economic development primarily through the creation of jobs
(Chandra and Fealey, 2009).
An interesting question would then arise: how costly exactly is it to create jobs by setting
up incubators?
Again using our real options approach, let us examine the costs of creating different
types of jobs in an economy.

A critical study by Grant Thornton for the US Department of Commerce Economic
Development Administration (NBIA, 2009) reveals that promoting job creation policies
through incubators is far more effective than building roads and bridges, industrial parks
or commercial buildings, making it the most cost effective use of public money for policy
promotion in this field!

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In Europe, similar stats from the European Commission (2002) study show the following
picture:

A quick calculation would reveal an average cost of one job creation of about
(14000*0,48/48,7)= 137 Euro per job, which is strikingly close to the American result.

The results seem extremely encouraging for the promotion of job creation through
incubators. Nevertheless, we would like to see further research on the scalability of this,

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since we have our doubts as to what number of jobs can possibly be created relative to
the total workforce.

However, a government also has another real option to decide on: what industry to
decide to promote, by investing a little upfront to have an option in its further success.

On this topic, literature and practical experience seem to be pretty clear. As Aziz GIlani,
Kauffman Foundation Fellow and DFJ Mercury VC firm employee, says to Business
Week (2012), winning industries to be supported do not get picked.
They arise based on local business conditions, for example the presence of a great
department at a university in combination with a cluster of firms already operating in that
sector. More specifically, he says “Houston won’t become a consumer Internet hub, but
an energy-company accelerator would be a slam dunk.” Therefore we would add that
governments should look at these conditions and create the momentum for further
growth in sectors that are looking stronger than others in the local context.

We have also seen that the initial successful spurt of entrepreneurial activity in specific
sectors attracts further VC presence and investment in Bray and Lee (2000). Burke et
al. (2009) also shows clearly how the growth in entrepreneurial activity, evidenced by
firm creation and later on success, are key determinants in boosting initially the supply
of informal investors and later on more institutionalized VC firms.

Wadhwa (2010), another vocal thinker in this field, also recommends that central policy
focus on the industries that arise as winners, in consistency with Porter’s (1998) cluster
creation ideas. In reality, though, he sees more of the opposite - wishful thinking on
what ‘might’ prove successful based on imitation.
Elements of Wadhwa’s position cover the benefits provided to the whole ecosystem:
- focus on formulation of strong social networks for information sharing. This is clearly
evident in Silicon Valley where the eagerness to share and help is high.

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- acceptance of risk taking and removal of the stigma of failure. This is not as intangible
as it might sound. Two successful countries in tech entrepreneurship, USA and Israel,
have introduced extremely liberal bankruptcy law which makes it very easy to start over
even if a previous business effort has failed.
- practical teaching of entrepreneurship to all, including students. it is far more effective
to actually do what you’re learning than just listening about it.
- reward academics based on startup generation, instead of research papers production
or fees for technology transfer. This leads to the optimization of focus allocation and
incentivizes marketable research actually hitting the market en masse.

For corporations, the real option would be to do nothing in incubation and focus on
purely internal R&D strategy (or not, this is a suboption). The second option would be to
invest in incubators and expect results that will affect the company’s course.
As displayed by Ford, Garnsey and Probert (2009) in their Philips study, incubators
bring things to the company that could otherwise not be achieved:
- market oriented teams instead of technology oriented. This cannot be developed in an
R&D lab.
- business development of products that would otherwise not be accepted if ‘owned’ by
an existing sales channel.
Additional benefits include other economies of scale, such as access to R&D resources
very similar to what a university can offer via its incubator, but also product
diversification leading to reduced portfolio risk for the firm.
The incubated companies, on the other hand, benefit also from the abundance of capital
reserves within a corporation (taken that it is made available to them) and also the cooperation with an investor type that is much more long-term oriented than a closed-end
venture fund.

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It is hard to refute the success in elevating the survival rate of firms that have been
incubated.
Moraru and Rusei (2012) compile data to display that, regardless of geography, survival
rates are much higher than the average survival rate in the economy:

In the UK it seems the success/survival rate while in incubation is a whopping 98%
(Lord Young, 2012) compared to 30% that is the national average.

From the entrepreneur’s point of view, incubators must provide value addition to
companies in their efforts. Therefore the real option for the entrepreneur would be to
give up some control over his firm (or idea at this point) in exchange for something that
would add firm value within an incubator.

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Marmer et al. (2012a) collects data from Internet entrepreneur responses to show what
challenges they face, based on their stage of development:

Clearly companies face predominantly IP and technological challenges moving into an
incubator (as part of their discovery process) while in the validation stage, a significant
advantage comes from being able to attract partners in their efforts, be it established
corporations, big clients etc.

Here, an entrepreneur must ask himself if an incubator can provide substantial
assistance mainly in these categories.

Naval Ravikant, technology investor and entrepreneur, says that the venture industry is
finally seeing some innovation through the creation of incubator/accelerator spaces. He
also talks about the value-add of incubators for the entrepreneur and sums it down to
these questions that must be answered (Devaney and Stei, 2012):
- Who are the mentors at the incubator space?
- What investors are affiliated with it?

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- What are the graduates doing afterwards, did they receive follow-up funding?

These questions lead to a real option in the mind of the potential entrepreneur, which
must consider the value-added compared to the percentage of his company that he will
give up to the incubator.

NESTA (2011) summarizes the things founders should be looking to get from an
incubation/acceleration environment to the following:
- initial funding
- business and product advice
- connections to follow-up investment
- validation of product. This can be seen in conjunction with the Marmer et al. (2012a)
stages.
- a peer support group. Alumni networks are invaluable outside university boundaries
too!
- pressure and discipline. This has to do with the psychology of the entrepreneur, which
feels highly committed to push forward once he has officially set on a journey and
informed other about it.

Christiansen (2009) did a MBA thesis on tech accelerator programs and followed up
with a ranking for what is important to founders that join them:

1. Connections to future capital: 8.51
2. Brand/Alumni connections: 7.83
3. Business support: 7.42
4. Product support: 7.13
5. Pre-money valuation: 5.25
6. Level of funding: 4.14

(point system on a scale from 1 to 10)

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Furthermore, Bar and Feldman (2012) seek to promote the Israeli incubation/
acceleration scene and attract entrepreneurs by providing:
- access to mentors and service providers
- encourage self-discipline and focus.
- freedom to form the future of their own company. The purpose of the
incubator/accelerator is simply to provide guidance, not tell how things should be done.

Additionally, they admit there is a slight market failure persisting, one that we have
previously identified as important, and it has to do with the access to follow-up funding.
However much Israeli policy-making has focused on the final stages of funding through
Yozma, and the initial stages through the technology incubator program, there seems to
still be a gap in between in the eyes of the participants in the local tech scene.

To sum up, it appears that incubators have significant positive effects on company
creation and survival. It is also the perception of the entrepreneurs that a successful
incubator can add value through connections to follow-up funding, networking with other
entrepreneurs and mentoring the team, as the three most important contributions.
Universities, corporations, governments and of course the entrepreneurs stand to
benefit in various ways from their involvement in an incubator environment.

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Venture capital definition
Progressing from the stage of incubation, a company will require follow-up funding to
keep pursuing its business goals. While these might already come from existing
customers, taken that most companies are surviving after the incubation phase, in some
industries the needs for investment in order to scale are high (capital-intensive). A
sector that provides follow-up funding and has attracted a lot of research is the venture
capital industry. Here we must add that for the purposes of this research, angel
investors (people who invest their own money) and VC firms (companies that manage
investments with other people’s money) are treated in a similar manner, since we are
focusing solely on the practices of these investors and not the investment size or origin
of the capital.

Avnimelech, Schwartz and Bar-El (2006) use the following compiled description to
define the contribution of the venture capital industry:
VCs are financial intermediaries that strive to respond to the needs of startups. The
unique VC structure, contracts, practices, and expertise enable them to deal with
asymmetric information problems and to add value to their portfolio companies. VCs are
not merely suppliers of capital for the new ventures, they also add operational value and
provide specific expertise and
assets.
Their expertise is in their ability to select firms with growth potential and to improve their
quality by providing them with the resources they generally lack and by increasing their
accessibility to external resources.

We believe this view is very useful to show the close connections among the VC
mindset for investment and the way incubator managers and policymakers should be
viewing their investments too. We will use it as a working definition and come back to

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the continuum among incubation and venture funding, right after we look into what
venture capital provides to an economy.

Venture capital performance and economic effectiveness
The venture capital industry is facing its own challenges at this point of time. Average
performance seems to be disappointing, even in the US:

Kedrosky (2009) discusses the challenges facing the industry which include the fact that
the ICT and other sectors it has served so well, are facing macroeconomic changes that
severely limit the amount of capital needed to build a company these days. He goes on
to argue that the industry must undoubtedly change and shrink in size.

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While we observe that the average returns for the VC industry are lagging, we’d like to
add that this does not give a fair estimate of the returns at the top quartile of the firms
included. As an example a VC fund called Sequoia Capital displays its returns relative to
the S&P500 (Sequoia Fund, 2012):

Evidence suggests that, while the industry as a whole is underperforming, the top firms
can perform regardless of average numbers. Thus the downsizing argument, combined
with the macroeconomics of the sectors VC firms are exposed to, might be easy to
support.

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Additional evidence for this might be a Sante Ventures (2011) research outcome that
shows the returns generated by VC firms broken down by fund size:

It is obvious that most returns of at least 2x the fund size, which implies around a 16%
IRR, come from smaller-sized funds of under 300 million USD under management,
clearly showing how smaller size relates to better financial performance.

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The Israeli technology ecosystem experience
An important study in understanding the similarities and possible overlappings at the
intersection of incubator development policies and early stage venture investments, is
one conducted by Avnimelech, Schwartz and Bar-El (2006) in Israel. Israel ran two
parallel government-run programs focusing on incubators development and venture
capital industry stimulation, called Yozma, separately. The success has been
documented here and it provides a nice view on how these programs can work in
collaboration.
During the 1990s they facilitated the successful transition of the Israeli economy from a
medium-tech driven to a high-tech, core innovation driven one, while the development
of the VC industry is thought as a critical turning point in this transition. The phase
before the 1990s can be viewed as the R&D driven period, while the 1990s symbolize a
movement to thought that is governed by Porter’s theory of cluster development, where
the local co-presence of research institutions, financial capital, industry and
entrepreneurs can create virtuous circles of economic development (Porter, 1998).

These state-run programs address specific market failures in entrepreneurship, namely
the early stage equity gap and the lack of complementary assets in start-up firms.
The equity gap refers to the thin markets prevalent in most countries for early stage
startups, which are not yet in the stage where they can be valued on cash flow
generation, but rely on the ability to find investors that will buy the expectation of future
growth and return on that initial cash influx they provide.

Gompers and Lerner (2000) show how dominant VC industries might not provide all that
a technology ecosystem needs to flourish, mainly because of their short term orientation
and abstaining from investment in technologies that have long development cycles.
Additionally, Avnimelech, Schwartz and Bar-El (2006) show how this has affected the
development of the high tech cluster in Israel. They demonstrate how investments

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incentivized by the Yozma program got concentrated in specific geographic locations
and the diversification effect of investment in different technologies was decreased. VCs
tend to locate in specific geographies with a technological advantage, like next to a
renowned university.

This, however, is not necessarily negative. Israeli policymakers mitigate this through the
parallel investment in the development of regional incubators, which lead to the
attraction of qualified personnel to other areas of the country too. In summary, they see
incubators benefiting the economy in the following ways:
- diagnosis of business needs
- early monitoring and selection of companies
- access to business networks
- access to financial capital
- development of credibility for the tenant companies
- shortening of learning curves
- local enhancement of the entrepreneurial spirit
- attraction of highly skilled individuals
The incubator program’s main goal was to reduce unemployment during its conception,
however the benefits as listed above were manifold.

While the government began and funded these programs initially, it did not seek an
active role in management of the VC or incubator industry. Furthermore, the
participations of the state have now progressed to be privatized, once the critical mass
seemed to have been reached in financial capital terms, as well as number of firm
participants.

An interesting development of these two government programs is that during
privatization, the most successful incubators were the ones that had developed stronger

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ties with the VC industry, an unplanned development of the programs but one that
makes absolute evolutionary sense, since natural selection will drive a VC to look into
opportunities for follow-up investment in an incubator that has pre-selected firms based
on their potential for success. VCs also took equity positions in incubators during the
phase of privatization, possibly indicating that there are more complementarities than
we can identify at first sight.

In numerical terms, the impact of these programs can be seen in the following table
(Avnimelech, Schwartz and Bar-El, 2006):

The numerical growth of sales in the past 30 years is obvious from the table, in which
numbers of 15 billion USD are achieved at the end of 2004 from nothing at the very
beginning. There is a connection between the government-run incentives and the output
of the Israeli high-tech sector.

An additional important success metric of the program is the access to follow-up
financing. Around 87% survival rate coming out of the program is a great result, which is
enhanced by the 78% rate for companies that received follow-up funding (Frenkel et
al.,2006).

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Finally, let’s take a look at the reasons that entrepreneurs chose the incubator for
(Frenkel et al., 2006), broken down also by its ownership structure (public or private):

What Frenkel et al. (2006) observe on their Israeli dataset is that there is a clear ranking
on the priorities for entrepreneurs choosing for an incubator, which does not change
substantially based on its ownership structure.
Financial support is the most important for both, while other tacit qualifications like
access to financial sources or networking with strategic partners follow closely. This is
consistent with our view on what the value addition from incubators should be. It does

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not come down to things like office access or cheap rent, it involves things like the
above.

Meseri and Maital (2001) in their study clearly show that university incubators apply VClike criteria to their selection for admission in Israel. These focus highly on the
experience and motivation of the founding team and, combined with the success of this
program, might suggest that the application of these criteria early on in the process can
breed better results.

A European Investment Fund paper by Kelly (2011) provides some analysis to look into
regarding differences between Europe and the US, as regards to the maturity of the VC
industry. Combined with the Israeli experience described, we draw some learning
points:

- The EU invests far less % of GDP in VC than the US. Taking into account that Israeli
investment is also far more than the EU average, it seems Europe has not yet reached
critical mass, which will allow for a self-sustaining industry.
- VC mobility in the EU is smaller, due to national legislation barriers and varying tax
schemes. This has clear policy implications for Europe.
- European VC funding is spread too thinly across too many companies. Again tackling
the critical mass argument, it seems that EU firms have not found the ideal funding
round size in order to allow for company survival, rather they focus on diversification.
- US venture capitalists tend to be far more specialized in their backgrounds and include
a lot less personnel from a financial background. This is seen as a critical factor by us in
the performance gap of the industry, as people with operational backgrounds closely
attached to what their portfolio companies are doing have a much better understanding
of the business. As confirmed by a Vlerick Leuven study (Knockaert et al., 2005),
specialization of the venture capitalists is highly associated with more involvement in
value-added activities, like strategic decision making. An entrepreneurial background in

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a related sector is an important value-adding element to good VC decisions. Another
reason for this not being common in Europe might be that public funding of venture
capital, still prevalent in most European countries, leads to underpaying the
management companies which cannot attract highly skilled and specialized fund
managers, as mentioned in the study.
- US venture capital is far more active in the more early stages of investment. This
exposes the funds to higher volatility. However, this is not as important in the downside
situations since most funds do not exist to deliver absolute returns, rather exist to
deliver a high upside return. By investing more in the early stage, American VC can take
advantage of the higher upside potential.
- fragmented EU capital markets for exit don’t seem to be a big constraining problem.

In a recent comparison, Hege, Palomino and Schwienbacher (2008) come up with some
interesting facts about the performance of the venture capital industry, also based on
geographic segmentation.
Among the findings we see elements of a different approach to venture investing among
the US and EU firms. It seems that the higher value creation in the USA by the venture
capital industry there has its roots in the locally prevalent contracting behavior (such as
staging frequency and syndication) which is much more inclusive and leads to an
ecosystem with higher information sharing capabilities.

Staging frequency refers to a higher amount of financing being contingent on the
completion of specific steps, or milestones for the company. The initial risk a new
venture faces might be technical, while later on it turns into market-driven. Successfully
completing each step is a contingent for additional financing in the US much more than
the EU, something that reduces the entrepreneur’s opportunity for “window-dressing”
(Cornelli and Yosha, 2003) and tends to focus him on creating real value.

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Syndication refers to opportunities for risk pooling as proposed by Hege, Palomino and
Schwienbacher (2008) as well as the possibility to attain improved screening by having
a second opinion in the due diligence process (Casamatta and Haritchabalet, 2007).
Riyanto and Schwienbacher (2006) stress how corporate investors can improve access
to distribution networks, thus alleviating one of the bigger pains of small companies, the
initial customer acquisition.

US venture capitalists invest higher amounts of capital in their firms, which gives
companies ample opportunity to ‘breathe’ and grow faster during this stage.
These firms are much more specialized in the investments they target, while they also
tend to involve corporate venture capital at a much higher rate than their European
counterparts.
Also, a large part of their investment is contingent on the completion of the first round of
investment.

Another finding in this paper is the fact that economic value creation in the venture
portfolio is independent of tax and legal treatment per country. Differences between EU
Civil and Common Law countries, for example, show no significant returns disparity.
This, of course, has to do with economic value creation in the firm, not the final after tax
results for the venture capital fund.
Additionally, we see in their paper that American- originated venture investment in the
EU does not yield significantly higher results relative to European investment firms
putting their money in the local economy.
Hege, Palomino and Schwienbacher (2008) show how European IPO exits yield returns
on the same level of US companies, while the trade sale exit underperforms by a small
amount. This would lead us to believe that the main problem is the choice of
investments, rather than issues related to exit possibilities.

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VC as an asset class has disproportionate economic effects in an economy. The BVCA
and NESTA (2009) report mentions how the investments of this asset class are only
suited for specific sectors with short development cycles and high growth potential. The
VC investments even in the US amount to less than 2% of the total investment in
startups, while the significant returns for investors come only from those firms in the
upper quartile of performance. The average rate of return for the asset class is rather
disappointing, evidence of the high risk associated with these investments.

However, these relatively small investments happen in companies that in 2003
accounted for around 9,4% of the US private labour market workforce (around 10 million
people), brought in around 1,8 trillion dollars in sales and accounted for around 20% of
all publicly traded companies (BVCA and NESTA, 2009), a performance which is
nevertheless admirable.

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The convergence among incubator and venture capital investment
practices and decisions

After examining the definitions, analyzing the industries and examining their economic
effectiveness, we synthesize and look at the incubator and venture capital industries as
a continuum in facilitating company growth.

Todorovic and Suntornpithug (2008) discuss the different stages of a company starting
with the proprietary-driven stage, leading into the capital intensity stage and argue that
the incubation contribution is higher at the first one. Aernoudt (2002) also confirms that
the initial stage is where an incubator is more likely to contribute to the firm.
Ford, Garnsey and Probert (2009) show how even in corporate incubators, the
decisions to further finance a venture follow specific milestone patterns based on
achievements so far.
These models can be seen as akin to what leading thinkers in the Internet startup
sphere are now trying to make science out of, like Steve Blank and Eric Ries (Blank and
Ries, 2009).

In the Startup Genome Report (Marmer et al., 2012a) data input from 650 web startups
shows the following development stages for an internet company:
- discovery: the team is trying to figure if they are actually on to a real life problem, by
asking around, collecting feedback, gathering the first team members and possibly
joining an incubator/accelerator
- validation: the company is putting product out quickly to see if there are initial users
willing to use it, while constantly refining some of its features
- efficiency: once the first customers have been acquired, the company seeks ways to
grow the customer base profitably, thus without losing money on every acquisition from
different channels

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- scale: after the company had identified ways to grow its customer base profitably, it
can go out and look for additional financing in order to pursue aggressive growth (this
financing can be referred to as the A round and usually comes in large quantity from a
venture capital firm)

After this, there are two more steps called profit maximization and scale, which fall out
of the scope of an early stage company and are thus not covered.

This milestone based approach to growing a company can be used to explain other
sectors too. In the pharmaceutical sector, for example, every company chooses if it will
continue investing or not after every test phase has been completed.

We believe there is vast potential for cooperation in scaling among incubators, which
see the company in its very first steps, and venture capital firms which are the next
financier for the companies that will successfully reach the later stages of development.

This view is also supported by the macroeconomics that are driving company expansion
today. NESTA (2011) summarizes them as follows:
- shrinking costs to begin a company
- easier to reach customer channels today
- easier to begin earning revenues
- more openness in the venture investment market
The above trends suggest that it is now becoming easier for investors to pursue lowercost opportunities in the long term, thus allowing to look at earlier stages of investment
to increase returns. Additionally, they suggest that entrepreneurs require less capital to
begin and would rather appreciate good mentoring coming from experienced
professionals in the field. Thus, the distance of both participants to the incubation stage
is decreasing.

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Zwilling (2012) writes about Dave McClure’s talk on the early stage financing options
available for companies today. McClure is a successful technology entrepreneur that
has moved into a venture investment role and he argues that most VC new activity is
now focusing on an earlier stage of investment.
This occurs either through micro-VC firms that invest at the stage where the company
does not yet have a proven revenue stream or through super angels, people with
enough money of their own in combination with others’, to fund an initial round of
business expansion for the company.
Funding rounds discussed by Dave can occur right after incubation, thus the timing and
access to the incubator by investors of this type is again seen as crucial.

Another few elements that can be useful for the incubator ecosystem to consider, arise
from the Working Group on Director Accountability and Board Effectiveness (2007) for
the venture industry. These include:
- good corporate governance should be pursued, mainly through competence of the
CEO and his Board. This has implications for the selection of companies even at the
incubator level.
- exit plans, investment timing, syndication with other investors should be openly
discussed in meetings. This could lead to the development of a roadmap early on while
in incubation, in order to have certain milestones in place that will lead to follow-up
investment.
- internal controls should be in place. To encourage the openness of data and access by
all parties involved, incubators can develop a framework to measure the companies’
performance on a regular basis, making it easier for follow-up investment to monitor
progress.

A significant element here is the focus on tracking progress in a consistent manner.
While this seems intuitively correct, its impact is not clear yet. To this point, Marmer et

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al. (2012a) break down their responses by companies that consistently track metrics
and those who don’t:

It is clear that, from the very beginning all the way to the point where a company might
be ready for its A round of venture financing (in the scale stage), companies that track
their progress grow a lot faster in their customer base. Data-driven decisions are crucial
for growth in this environment of uncertainty during the early stage.

Finally, a key element of venture capital firms is the LP-GP structure (Ramsinghani,
2011).
The LP (Limited partner) is the official name for the organizations that provide the funds
to the venture capital firm, while the GP (General partner) is the name for the actual
management company of the VC fund. This is the firm that picks the companies the
fund will invest the given money in.
While this structure provides clear advantages for the alignment of incentives and is
prevalently used in the most advanced countries in the field, it can be seen in

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comparison to more unofficial ways of funding that might be prevalent in the incubator
sphere (ad-hoc fund-raising, money installments based on upcoming needs).

A LP-GP structured fund will always know what its monetary capabilities are, since the
money has been committed to the fund upfront. However, its limited timeframe of
existence and the high requirements for financial performance might deem this structure
unsuitable for some sectors of companies that seek incubation/acceleration, namely
ones with long development cycles or not-so-high growth potential.

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Conclusions and recommendations
We now attempt to synthesize our findings and take a holistic view on the ecosystem
that allows technologically-driven companies to flourish.
Firstly, we have seen that technology adoption is accelerating. Countries and cities
compete today to attract the knowledge workers that will drive new economic
development.
It appears that countries that have chosen to support local business ecosystems have
done better in the building of critical mass for startup entrepreneurship in specialized
industries.
We also saw that startups are the companies that have the highest effect in net job
creation compared to existing firms.
The incubator environments set up by either university, corporate or private sponsors
play a substantial role in the creation, survival and value-add of new technology
companies. The effectiveness of investing in incubators is manifold, ranging from the
government which can promote job creation, to the training of entrepreneurship at a
university, to the creation of new business opportunities for a corporate and also to
financial returns for a private incubator, once critical mass is reached.
Additionally, we looked at the economic impact of venture investing and it appears to be
disproportionate to its size; while only a small number of firms qualify for this form of
funding, these firms are the ones that deliver significant economic results. Venture
capital firms that have access to these investment opportunities tend to return
significantly better than other asset classes.
Furthermore, it appears that taking equity stakes in companies being developed is the
best way to align incentives in the ecosystem, instead of charging fees for services. This
is of course understood in venture capital, whereas much more of this must be seen in
universities and incubators. This seems to be underway by the recent moves of
traditional venture capital firms into the creation of their own incubation spaces or the
partnership with existing ones for follow-up investment.

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We now provide our conclusions per research question we set out to answer.

- What is the economic significance of newly created technology companies for an
economy?
It has become obvious during our research, that technology startups deliver significant
economic results to an economy. Seen either in the creation of new net jobs or through
the value addition of companies that are venture-funded, with companies being
incubated now reaching critical mass to deliver economic results as well, the
significance to an economy in promoting their success cannot be understated.

- What does the business incubator offer to a new technology company and what
subset of that creates the highest value?
Incubators/accelerators offer a variety of services. However, there are some that are
ranked as more important than others, based on research among entrepreneurs. These
are specifically:
● Access to follow-up capital investments
● Relevant mentors with prior entrepreneurial experience
● Access to an alumni network of graduates from the incubator

Another point we tackle is the lack of a good definition that encompasses these valueadding aspects in it. We therefore go forward and propose a definition that does not
change the essence of what we are discussing (an incubator space) by focuses on the
main things incubators should be looking at.

Our proposed definition of an incubator space, formulated by the aspects that
entrepreneurs see as most important in this co-operation and driven by the optimal
model of incentives alignment, the equity participation of the incubator in the company,
is as follows:

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Incubators can be defined as environments that aim to support entrepreneurship via the
creation of new technology-driven companies. Their contribution to the company
includes intensive mentoring of the founders to help the team develop additional skills,
in order to overcome the early stage from business idea to discovery of an initially
verified business model. In exchange, the incubator management company receives a
percentage of the newly created company. Furthermore, incubators provide access to
additional venture capital, enabling the companies that qualify from the incubation
process successfully to obtain the necessary funds for scaling their initial business
model into a profitable business offering.

- How should follow-up investment in a venture be formulated and what are the stages
of financing needed?
We identify differences in resources needed to support technology companies at the
earlier incubation stage. Therefore, the split between the first financing round, which will
allow for cultivation of the venture and metrics-based tracking of its progress, and the
follow-up rounds pending on milestones tracked by the aforementioned implemented
metrics seem to be explained as a funding continuum among the early stage, where
incubators are active and the further rounds for which incubators connect companies
with venture capital firms.
There is also a clear milestone discovered that, once hit, would make sense to lead to a
next financing round. This is the discovery and potentially the validation, already, of a
company proposition, namely the fact that there are initial users willing to pay money for
the product. After this is verified, the company can focus on scaling up its customer
base efficiently by taking an additional financing round from venture investors.

- What are the key learning points for fostering entrepreneurial technology ecosystems
that are relevant to each participant?

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The recent developments in the technology ventures arena and our refined view on the
incubation space lead us to recommend the following, beginning with recommendations
targeted at policymakers:
- Incubator environments have a significant impact on the survival rate of young firms,
while they are the cheapest use of public money for job creation. Policies that focus on
this goal must take them seriously into consideration.
- Building critical mass in the incubator and venture investor industry is important for
their sustainability. Once instigated, a virtuous circle can begin and eventually, create a
significant economic impact that can be taken up and furthered by private sector
involvement.
- The industries chosen to support via incubator policies or by guaranteeing venture
investments towards potential losses, are the ones that have naturally arisen so far in
the local context. They should not be chosen based on the will to imitate someone else
or by wishful thinking.
- A culture of risk-taking and the de-stigmatization of failure is critical for a technology
ecosystem to flourish.
- The support of the full ecosystem along a startup lifecycle must be taken up, from
incubation to later venture investment stages. Otherwise, there is always something
missing, leading to funding gaps that impede all efforts.

For managers of universities we would recommend the following:
- Incubating new companies and taking equity participation yields better results than
mere technology transfer. Therefore, investment in developing incubators should be
preferred.
- The benefits of teaching entrepreneurship in a practical manner, by involving students
in the creation of new companies, is a better way compared to learning theories. An
entrepreneurial culture in the university fosters better results in this too.
- Academic reward incentivizing should be targeted toward promotion of company
creation based on technology developed, instead of mere research paper publications.

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- Even if technology or intellectual property are not developed internally, there are a lot
of business development and market access aspects that a university-affiliated
incubator can offer its resident entrepreneurs.
- The focus in value addition must be directed to the mentoring process for development
of the required skills missing in the team, instead of promoting the view of resident
companies as clients to take fees from.

For anyone seeking to set up an incubation/acceleration environment:
- Good human capital is the most important ingredient for providing value. It’s not about
the building or the good location, it’s about who advises the companies and who runs
the show by carefully selecting the participant companies. The backgrounds of these
individuals are important and people who are veteran entrepreneurs are highly valued.
- Another important element to focus on is the access to follow-up investment.
Companies are going to need further funding rounds once at a certain level after
incubation and provision of these connections can be critical to success. Incubators
must see themselves as platforms that prepare companies for this type of follow-up
investment that venture investors can source deals from.
- Accelerator models, with cohorts of companies admitted and a set timeframe to build
product, lead to higher standardization and specialization in focus. The latter seems to
have a big impact on venture capital investment success.
- Mentoring the founding team is much more important than the initial funding provided.
The company’s goals might change along the way, thus a strong focus on the team’s
capabilities is necessary to select the best and nurture them.

For corporations that want to be active in this sphere:
- Incubation environments support open innovation much better than typical R&D
spending, by instigating a commercial orientation to research.
- Based on existing practices in this field, corporates must allow incubator managers to
devote more time to mentoring and far less on administrative tasks.

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- It is important to ensure the continuation of these investments into the future, since
success comes in the long term. Thus, board level support must be present from the
very beginning.
- Corporations do not only provide financial support and other company resources, but
can also provide tacit benefits like access to networks or supply chains, knowledge of
consumer behavior and social proof, which refers to the perception of the incubated
compan being higher because of the association with the host corporation.

For venture investors (angels or VC firms) we would recommend the following:
- Venture investing might be underperforming on average, but the best firms continue to
yield significantly higher returns than other asset classes. Therefore the opportunity
always remains but downsizing the industry might be necessary.
- Capital needs are getting smaller in traditional industries that venture investors pursue.
The investors must try to bring other things to the table too, like industry expertise or
specialized knowledge, while they can also focus on earlier investment stages. This is
important since the higher returns come from investments that have been made earlier
on in the company’s lifecycle.
- Follow-up investments in companies, after the incubation stage, should be based on
the achievement of specific milestones set. This way the investment strategy can be
optimized and is contingent on achievements by the underlying company, leading to
better incentive alignment.
- Syndication in the investments is a good way of bringing additional expertise onboard.
This can include working with investors that focus on later stages, different markets, or
even with corporations that view the underlying company as a strategic asset for their
portfolio.
- Specialized knowledge is a key determinant to successful investing. Prior
entrepreneurial experience in the field is probably far better than a financial or other
background.

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- LP-GP structures allow the fund manager to always know how much capital is
available for further investment, compared to investors that will seek to raise funds on
an opportunistic basis. However, investors must be aware that LP-GP structures have a
finite lifetime that must be matched with the expected company building lifecycle in the
industries chosen (eg. developing new drug treatments takes longer than focusing on
internet technology).
- Big fund sizes deliver worse results than smaller funds raised. Combined with
macroeconomic trends that allow for smaller capital requirements to start a company
today in traditional VC-funded industries, investors must optimize fund size compared to
the exit size opportunities in their respective industry to deliver economic value.
Focusing on an earlier investment stage, such as the incubation stage, can also allow
for higher future returns by investing at a smaller valuation.

Finally, we will recommend what potential entrepreneurs, the main drivers of value in
this whole process, should be focusing on:
- The decision to join an incubator should be tackled by looking at the answers to the
following questions:
- Who are the mentors that add value in the incubation environment under
discussion? What is the product and business expertise that the mentors can
add to our efforts?
- What is the incubator/accelerator connection to further providers of capital?
- Is there an established alumni network from this environment that could be
helpful?
These must be answered satisfactorily in order to assess the value from giving a
percentage of the company to the incubator in exchange for these growth-critical
resources.
- The implementation of business-critical metrics tracking should be pursued from the
very beginning. By measuring the company’s activities it will be a lot easier to get a

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sense of direction, while also being able to show progress to the providers of capital at
every stage, instead of simply doing guesswork.

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