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All systems go: From day one, incubator managers fuel clients for takeoff after graduation

by Ellen Gerl

February 2002

The Maverick Corp., a recent graduate of the Hamilton County Business Center in Cincinnati, Ohio, began thinking about its move almost two years before it left the incubator. The maker of high-temperature polymer materials had expanded its market niche and needed more space to add equipment and people. "I knew from the get-go that the goal was to spend five years – plus or minus some – and to launch out of here," says founder and CEO Eric Collins. Incubator staff maintained gentle pressure, from working with the firm to set realistic goals to helping the firm access reduced-rate financing to buy a 12,000-square-foot building. "The incubator forces you to plan for success," Collins says.

Incubator managers who've watched dozens of young companies come – and go – admit they don't have a month-by-month wedding-planner strategy for getting clients to the graduation altar. But they do know that business assistance needs evolve as clients move from defining goals to financing growth and finally shopping for new space. Here's how the conversation changes as the graduation date nears.

Very early

Is it appropriate to bring up graduation even before the firm is a client? Definitely, a number of managers say. Start the discussion when you are reviewing a prospective firm's business plan and determining if the applicant's goals match your program's mission.

Bruce Gjovig, director of the University of North Dakota Center for Innovation and its Rural Technology Incubator in Grand Forks, sets the climate for long-range thinking during the screening process. "We ask potential clients what their five-year plans are and have them focus on beyond the incubator stay," he explains. "We emphasize that graduation is a milestone toward profitability and growth." (See Exit sign)

At the Hamilton County Business Center, which has graduated 64 companies, Director Patrick Longo says he asks applicants – from manufacturing to high-tech firms – where they want to be in three to five years. "Or we might ask: 'In your wildest dreams, how do you see this company and your role?' We help them set up long-term goals, then what is to be done in the next six to 12 months."

Establishing goals makes new entrepreneurs think ahead. But managers need to help them maintain enthusiasm. Longo has discovered one effective strategy: the center's annual celebration recognizing firms that graduated from the program in the previous 12 months. The event features as keynote speaker a graduate "who's done very, very well." The invite list includes the last three years' graduates, prospective clients and current clients. When clients see other young firms graduate, they're motivated to earn the same badge of honor, Longo says.

At for-profit incubators, the where-am-I-headed discussions require an additional question: Do my goals fit investors' needs? Directors of for-profit incubation programs seek companies whose growth strategies involve an initial public offering (IPO) or acquisition by a publicly held company – or what are known as "liquidity events." The for-profit program's mission typically centers on providing its investors a return on investment in a specified period of time. (See Exiting with investors in mind)

"We don't use the word graduation," says Rob Carruthers, managing partner of STARTech Early Ventures in Richardson, Texas, a technology-focused, for-profit program that provides seed funding and business assistance to Texas-based start-ups. "We take companies through the five- to six-year process of getting them to go public or the three- to four-year process of getting them sold to a publicly held company," he explains. To qualify for STARTech seed funding, companies must "meet the bar for venture capital. They must have an exit strategy for the investors."

Harlan Jacobs, president of Genesis Business Centers in Columbia Heights, Minn., explains that the for-profit program negotiates an equity position in each company, and its mission "is to eventually realize capital gains from a company that we bring in." Therefore, applicants whose personal goals or company business plans envision a family business as the end point wouldn't be invited into Genesis' incubator programs. While there's nothing wrong with these goals, Jacobs stresses, "That's not what we're interested in investing in."

An example of a company that attracted his program's interest is Cymbet Corp., which is developing a manufacturing process to produce thin, long-lasting rechargeable batteries. The firm grew out of the incubator program in 18 months, and in April 2001 moved into its own 10,000-square-foot headquarters in Elk River, Minn.

The firm's graduation occurred, in part, due to calculated moves on the part of incubator staff. "I had the technical idea and [Jacobs] had all the business concepts," says Cymbet founder and president Mark Jenson, a 20-year veteran of Honeywell's solid-state electronics group. Jacobs helped him define his goals in an indirect way, by connecting him with people who understood high-growth firms' needs. "He brought in people as directors and employees – in name only as we didn't pay anyone to start with – who were experienced in market strategies and every aspect of putting together the business, from preparing incorporation documents to term sheets for funders," Jenson says.

Ongoing

Helping companies finance growth is critical to preparing companies for graduation, according to incubator managers. Your assistance may involve helping a firm find new markets or, as with Cymbet, introducing principals to major investors.

For instance, with Jacobs' help Jenson secured $4.5 million from Israeli and Finnish venture capitalists. To cinch the deals, the two traveled overseas for 10 days to meet with investors who – unlike Midwestern venture capitalists – were willing to assume more risk, according to Jacobs. "Genesis is 100 percent responsible for all of our funding to date – through acquaintances or relationships," Jenson notes.

Gjovig agrees that the biggest issues in helping companies graduate are financing growth and building a good customer base to ensure adequate cash flow. "It is no favor," he says, to have firms graduate before they are ready to tackle the financial obligation of signing a commercial lease for several years. On the other hand, he says it's "corporate welfare" to handhold a venture too long. "We need to strike a balance." (See When nudge comes to shove)

Sometimes incubator clients will know when they've reached the financial milestones that indicate they should consider exiting the incubator. Particularly savvy clients will know exactly how to time the move. Take, for example, John Williams, founder and president of Group 8760, a recent graduate of the Entrepreneurial Center in Birmingham, Ala. Williams, who had founded and grown another business before this one, knew when Group 8760 became profitable in 1999 that his firm could afford space outside the incubator. "But when the '99 crash occurred, we delayed the move," says Williams, whose software firm specializes in "hooking up computers with one business to computers at another business." In October 2001, the company moved to commercial space that a downsizing business had vacated in a Birmingham suburb.

Other clients will need help determining when the time is right for graduation. For instance, a company's receiving a large cash infusion is not reason enough to exit, according to Entrepreneurial Center President Susan Matlock. She describes a client that had been in her program almost three years when it received a significant investment, but that was not the best time for the physical transition. "They needed to ramp up the people issue first, which was why they needed the money. It's difficult to do all those things at once," she adds. It was another nine months before the firm graduated.

Like many of her colleagues, Matlock uses a rent structure that escalates annually. "By the time someone graduates they should be able to get cheaper per-square-foot space outside of the incubator facility. If you have someone who hasn't achieved the above-market rent rate, they aren't ready."

Most managers say they don't wait for specific events to prompt a discussion of graduation. They broach the subject at regular client meetings – whether during informal monthly meetings, a quarterly review of financial statements or when the firm's lease comes up. "We talk about exit strategy when our firms' 12-month lease is up," Longo says. "Something the client may not recognize as an exit event, we might." This might include a strategic alliance or potential buyer or a technology taking off and bumping up the company's staffing to 12 or 15 people.

Near graduation

As the graduation date nears, it's time for a "reality check," says David McNamara, director of the BioSCIENCE Enterprise Centre in Halifax, Nova Scotia, Canada. He reminds entrepreneurs that they will assume the overhead for support services the incubator has been providing – everything from the PowerPoint presentation that clerical staff "prettied up" to the preparation of a conference room to an industrial bay the incubator let them use for two weeks to put together a prototype. "Until they have to rent a room, call a caterer and rent a flip chart, they don't realize what we've been doing for them," McNamara adds.

The discussion may result in cold feet for some small firms, says Laurie Katana, manager of the Bonner Business Center in Sandpoint, Idaho. "They might decide to postpone graduation until they have more capital saved up to pay for costs we've absorbed." She's found that clients have little idea of the real world costs of things like janitorial services, snow removal in the winter – important in Idaho's climate – and attorney fees.

Managers say the exit discussions turn increasingly real estate oriented when the firm is 12 months out from graduation. "Start the discussion no later than nine months," McNamara stresses. "At six months they should be just about ready to review the lease and accept it."

Both he and Katana begin with introducing clients to different commercial real estate options from renting or purchasing an existing building to building a new facility. Gjovig encourages clients to think strategically when they consider a new location. "Does this location make sense based on employee talent, resources, customers, vendors and transportation?" he asks.

McNamara agrees. Paying $110 per month to park at a downtown location would be a hardship for entry-level staff in companies where they are not highly paid. Other considerations, he says, are expandability and portability within the leasehold. "And they'll find it's not nearly as easy to expand as it is in an incubator."

It's important to help clients plan how much space they will need and to economize. "We tell them, 'You don't need a grandiose reception area. You are paying by yourself for spaces that you shared in the incubator,'" McNamara says. He shares tips such as to store computer boxes in rental lockers that cost $1 per square foot – not in space that costs $20 per square foot. The program's leasing manager helps clients through their first lease, "like kids that graduate university and buy their first home. We try not to get clients boxed in for too many years."

Indeed, real estate lingo can befuddle clients, according to Kathy Osborne, COO of Meridian Environmental Technologies, a client that is planning to graduate in the next year from the Rural Technology Incubator in Grand Forks, N.D. Besides needing more space with highly technical capabilities, the firm is ready for its own corporate identity, Osborne explains. She suggests managers educate clients about commercial real estate terminology such as triple- and single-net leases and other building terms.

Managers take two tacks when helping clients relocate: sharing their own knowledge of the commercial real estate scene and introducing clients to economic development officials and real estate professionals well versed in the issue.

Matlock says she recently talked with a client who is about nine months out from graduation about current commercial market rates, and she identified three buildings the entrepreneur might want to look at. "I also have some IT companies that would like to be in the downtown area and would like to buy their own buildings. I'm watching for [building prospects for] them," she adds.

Once a year McNamara brings into the incubator commercial realtors as a group: "They can go in and recruit companies all they want." McNamara also lets clients know that industrial properties owned by the province or municipalities offer many advantages. "They're extremely rural, but that's not bad. There's free parking, a smaller tax structure and, in rural Nova Scotia, your neighbor will help you."

Pointing clients to funders is a big part of preparing clients for the move, according to Katana, who's accompanied clients to talk to bankers and lending institutions. McNamara went with a group of three clients to a bank to seek a building loan. "I told the bank that they'd never missed a rent payment and that they showed expansion capabilities." The clients got their money.

Once they have made a building choice and know their move date, Matlock reminds clients of the many small things, such as ordering a T-1 line or telephone service, which they need to do well in advance. "They're naive about how long it takes to get something done," she says. "They honestly think they can call one week, and utilities will be installed the next."

Clients may move out, but they're still family. Longo proactively calls on the new graduate during its first month out, and less-recent grads "get mad at me when I don't visit often enough." Katana puts the new graduate in touch with previous graduates to give them an additional support network. And affiliates programs ease the transition by letting clients access business support services at the incubator.

McNamara says some clients "do cut the cord on their own" but other graduates pay premium rates for continued use of incubator services as affiliates. "One graduate brings its invoices to us in a brown bag and we organize them," he says. Ah, kids.

Exit sign

Pointing the way to graduation, a sign in the Center for Innovation Rural Technology Incubator in Grand Forks, N.D., reads:

A venture is ready to graduate once it achieves two of the following:

  • Reaches annual sales of $1 million
  • Is acquired by a larger company
  • Makes a successful public or private stock offering of more than $500,000
  • Exceeds the capacity of the tech incubator
  • Is a client for four years
  • No longer has a university "tie" to be in a university tech incubator

Exiting with investors in mind

Investors' needs determine the exit path for a client of a for-profit program. The investors might include the incubation program itself, a seed fund that the program manages, or independent angel and venture capitalists. The investors negotiate an equity position in each company, and they want to see their risk pay off.

NBIA Review asked Harlan Jacobs, director of the Columbia Heights, Minn.-based Genesis Business Centers, and Rob Carruthers, managing partner of STARTech Early Ventures in Richardson, Texas, what exit means in the for-profit incubation setting.

NBIA Review: What do you look for in applicants?

Jacobs: We look for five factors of success before we invite firms into the incubator program: 1) Does the firm have proprietary technology that can be protected by patents or trade secrets – basically some advantage? 2) When the company makes the product or offers the service, can it earn a 60 percent gross margin? 3) Can the company sell a sufficiently large volume; for instance, can it do $20 million in revenues in three to five years? 4) Is there a good faith commitment in the business plan and all documents that says they are going to try to grow the business and provide an exit for investors? 5) Most compelling is whether the people involved conduct themselves with integrity. Are they resourceful and dependable?

Carruthers: We want companies that can qualify for venture capital funding. And what venture capitalists want is a company whose growth strategy involves acquisition by a publicly held company or an initial public offering. Companies likely to have terminal values below $20 million are not ones venture capitalists are interested in.

NBIA Review: Does the investors' timeframe for return on investment affect the length of time a client spends in your programs?

Jacobs: We don't expect a liquidity event for five to seven years. For example, the first company we incubated came into the program in 1993 and just went public this summer. However, as for a specific exit time from incubation programs, we tell firms, "You're in this program one or two years. This is your dorm room. We'll help you find partners, surround you with mentors. You raise money, move out and pay for your own apartment."

Carruthers: Venture funds are 10-year limited partnerships. The money in our seed fund comes from 35 investors, mostly venture capitalists but also some corporate investors like Texas Instruments. Typically they want to see liquidity in investments in a period of three to six years.

NBIA Review: What are the most important services you provide your clients?

Jacobs: We provide acting CFO services, helping with significant transactions very early on. We'll facilitate meetings with potential customers or investors and ask the questions they don't know how to ask.

Carruthers: We help with executive staffing of these companies through our mentor network and corporate sponsors' contacts. "Who's running this company?" is one of the venture capitalist's hot buttons. The top CEOs can do wonders in good times but also do well in bad times. "B" players falter in difficult situations. Every STARTech portfolio company has a mentor from our network of 60 individuals in Dallas and Austin, all of whom are former CEOs or vice presidents of a publicly held company. And STARTech mentors serve as CEOs for 10 of our companies.

Another high-value service is finding for our portfolio companies strategic investors from corporate America who can be channel partners. They have the resources to sell the product in a vertical market, an important part of a tiered sales and marketing plan.

NBIA Review: What percentage of your companies can you really expect to go public?

Jacobs: Our exit path is to have one of 10 of our firms go public. When they go public you are likely to realize a 30 to 50 percent – maybe 100 percent – return. The other nine don't necessarily fail; they could become lifestyle businesses. These firms create jobs and enhance the tax base, and the communities win more readily than the equity investors do.

Carruthers: Only 50 percent are likely to go public in a good economy. In a bad economy, that drops to zero to 20 percent. Right now it's as close to zero as it can be. Thus selling out is the only choice. But potential acquisition by a large corporation is seen as a good growth strategy. Also, the company that's not achieving milestones – not moving toward a public event – might have technologies of value to other companies. The firm's latest round of investors, who become the majority owners and sit on the company's board of directors, might guide the firm through the process of selling that technology.—EG

When nudge comes to shove

"Nudging is part and parcel of this business," says David McNamara, director of the BioSCIENCE Enterprise Centre in Halifax, Nova Scotia, Canada.

But there may be instances when you need to push harder. Perhaps it's the entrepreneur whose business is booming but who's grown too comfortable with your program's support system. Or it may be a firm that's not meeting its benchmarks, and just as important, not making use of your services. These are times that call for blunt discussions about alternatives outside the incubator.

You may have to "take them by the hand and introduce them to commercial space," McNamara explains.

Susan Matlock, director of the Entrepreneurial Center in Birmingham, Ala., says she had to tell one client last year: "You have taken advantage of everything here and participated in the incubation process. It's time to make an alternative decision." Despite extensive coaching in areas of need, the company just didn't seem to learn or build from its experiences, Matlock says. "If we had allowed it, they would still be here in 10 years."

Giving clients a timeframe for the move lets them know you're serious. Patrick Longo of Cincinnati's Hamilton County Business Center says he might tell a client who wasn't using the incubator resources or meeting agreed-upon goals to plan an exit strategy for sometime in the next three to six months. He'll let them out of their lease, if necessary, he adds.

Laurie Katana, manager of the Bonner Business Center in Sandpoint, Idaho, gave a client – the only one she's had to nudge out – a timeframe and scheduled mandatory meetings for the client to talk with lending institutions "to plan cash flow to survive outside the incubator."

Besides helping the outgoing client to strategize finances and assess available commercial space, you might have to carry file boxes to the client's car. That says it clearly: The incubator is not a permanent home.—EG

Keywords: benchmarking clients, exit policy, graduation policy, relocation assistance

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