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Right-sizing an incubator facility

by Corinne Colbert and Kathleen C. Boyd

June 2006

Almost immediately after opening the doors of a new facility in the summer of 2003, the Southwest Michigan Innovation Center in Kalamazoo began filling up much more quickly than the incubator’s management team had anticipated. After projecting 29 percent occupancy for year one and 58 percent for year three, the 58,000-square-foot incubator actually achieved 71 percent occupancy by the end of year one and 90 percent by the end of year two. Now approaching its third anniversary, the incubator is already at full capacity. “This has placed tremendous strain upon the facility in terms of capital requirements,” says Sandra Cochrane, SMIC chief operating officer. “We anticipated having several years to ramp up occupancy and to slowly complete the various build-outs and upgrades we knew the building would need.”

Why were its projections so far off? Pharmaceutical giant Pfizer’s acquisition of Pharmacia resulted in a massive downsizing in Kalamazoo just as the incubator’s doors were opening; the incubator’s efforts to retain local scientific talent by helping them form companies yielded 12 new firms. “This situation has been both a blessing and a curse,” Cochrane says. “We love having clients to serve, but it has been hard to accommodate so many new companies with such high levels of needs. We also worry about our future pipeline. We are near 100 percent capacity now, but as this bubble of companies started by ex-Pfizer scientists graduates from the incubator, will we continue to have elevated occupancy levels, or will we drop back to original projections?”

As the folks at SMIC are discovering, predicting lease-up is no easy task. Therefore, it’s not surprising that one of the biggest questions when developing an incubation program is, “How large should the facility be?” During the process of researching and writing your incubator’s business plan, you must “size” the program based on market demands.

Ultimately, the size of your incubator facility will relate not only to the number of clients your program will serve but also to its financial sustainability. An incubator that’s too big can take so long to fill that you’ll deplete your cash reserves to keep the program running in the meantime. A too-small incubator can be just as bad; you’ll never have enough rent revenues to cover the program’s costs.

So what’s the “right” size for an incubator? Ultimately, you must make the decision based on your own unique circumstances. “You have to look at your community and the building to decide what really makes sense for your project,” says Jim Greenwood, president of Greenwood Consulting Group in Sanibel, Fla. Following are some of the factors you’ll need to consider when determining facility size.

Square footage

In the 2002 State of the Business Incubation Industry survey, NBIA found that incubator sizes ranged from 500 square feet to 770,000 square feet; the average size was 47,157 square feet and the median was 25,908 square feet. Many incubation professionals consider 20,000 to 30,000 square feet the minimum for achieving financial sustainability. Any less than that and you will have difficulty covering operating costs through rent and service fees alone. Furthermore, if you start off with a small building and high operating costs, you likely will be unable to create a financially sustainable program unless you have guaranteed revenue streams to cover the shortfall.

“In the case of a technology incubator in a 10,000-square-foot building and an operating budget that could reach $300,000 to $400,000 per year, the shortfall may be significant, so you have to have some other plan for covering operating expenses,” says Chuck Wolfe, principal of consulting firm Claggett Wolfe Associates in Auburn, Calif. Your financial model must clearly define your reliance on each revenue stream – such as rental income, fees for services, contracts and annual fundraising.

Be sure to leave some room to expand; if you’re successful in growing your client companies, they’ll need space to move into as they progress. “The last thing you want to do is lease up your space to 100 percent and then force your clients to seek space outside the incubator as they grow,” Wolfe says. He usually recommends setting aside 5 percent to 10 percent of the facility to allow for client growth, depending on the size of the building, the type of industry and anticipated frequency of client turnover.

Use of space

Square footage isn’t the only factor in sizing a facility; you also have to consider how the building will be used. Analyze the building’s spatial efficiency: How much square footage is eaten up by hallways, elevators, stairwells and other areas that can’t be rented (and thus don’t generate revenue)?

“If you look at the floor plan of some buildings, some are 80 percent rentable, others are 50 percent rentable,” says Jim Robbins, a principal of Business Cluster Development in Menlo Park, Calif., and executive director of the Software Business Cluster, a technology incubator in San Jose, Calif. A 30,000-square-foot building that is 80 percent efficient yields 24,000 square feet of leasable area. If it’s 50 percent efficient, you have only 15,000 square feet available to clients.

If you are constructing a new facility, you can direct the architect to make the building as efficient as possible. But if you’re working with an existing structure, look carefully at its efficiency to see if you can fit enough clients into it to generate the revenue you need.

Another factor to consider is how you will divide the space, which depends on the type of incubator you’re planning. If most of your clients will be service companies, you’ll need a variety of office layouts to accommodate companies of different sizes and at different stages of growth. A mixed-use incubator will need varied office spaces plus larger, open bays for light manufacturing or warehousing.

Don’t try to figure a floor plan yourself. “You might need someone with more expertise than you have,” Robbins says. Bring in a general contractor, an architect or a space planner to help you decide what range and number of office sizes you need, as well as draw sample layouts to maximize the space.

While you will need professional help in dividing the space, your input (or that of an experienced incubation professional) is crucial to a successful plan. “You have to have somebody involved who understands incubators,” says Carol Kraus Lauffer, also a principal of Business Cluster Development. That’s because an incubator’s aim is to maximize client interaction and to foster a sense of community, where a commercial office building is set up to maximize rental space and the landlord’s return on investment.

Estimated revenues

Once you know what size building you need and how to lay it out, you can begin running budget estimates. As with sizing the facility, you need accurate market estimates and a strong sense of realism. “If you assume 95 to 100 percent occupancy in the budget, that’s a huge mistake,” Robbins says. “You’ve got to be able to keep running when you’re not full.”

Many experts advise aiming for 80 percent as your break-even point, giving you a financial cushion for client turnover. It’s also a good target for synergy, Greenwood says; while you might be able to generate enough rental revenues to stay afloat at 50 percent occupancy, there’s more than money at stake. “A building that’s half empty isn’t giving a lot of optimism to clients,” he says. “You have to be 75 or 80 percent full to [convince people you] have a project they want to be a part of.”

But bear in mind that you probably won’t reach that level for a while. “Be realistic about how long it’s going to take for you to fill that space,” Lauffer says. In a robust economic setting, you can probably achieve target occupancy within 18 months. In a rural or economically depressed setting, though, it may take as long as five years to reach target occupancy.

If your feasibility study indicated that it could take a long time to fill the incubator, you’ll need to plan carefully, Wolfe says. “If it takes that long to fill, how can you be sure there is a continual backflow of prospective clients to sustain it?” he says. That doesn’t necessarily mean your project isn’t feasible; it may, however, require a broader market area (regional vs. local) or a business model that assumes a higher-than-usual proportion of anchor tenants.

Anchor tenants – established companies that take up long-term residence in the incubator and pay market rental rates – were strongly suggested in the business plan for the Indiana University Emerging Technologies Center, a technology incubator in Indianapolis. The plan recommended that in addition to providing stable cash flow, anchor tenants could give IUETC a built-in reservoir of business mentors and examples for its start-up clients, as well as a home-grown pool of potential clients as the anchor tenants spun off new technologies and opportunities. In return, IUETC could leverage its connections to Indiana University to recruit faculty to serve as advisory board members and consultants to the anchors.

Now in its third year of operation, IUETC has one anchor tenant, a spinout company from Eli Lilly and Company. “[Having this anchor tenant] helps us significantly in all areas, including supplying services to other tenants, providing business and technical mentors, and assisting with cash flow,” says Mark Long, the incubator’s president and CEO. “It is indeed a good strategy.”

No matter how long it takes you to fill the incubator, you will need to budget for the gap in revenues while the incubator is mostly empty. “In your ramp-up [period], you will have higher expenses and lower revenues,” Robbins says. “You’re not full from the day you open your doors, but all the other operating expenses are there.”

To make an accurate estimate of initial rental revenues, decide how long you expect to need to reach target occupancy. “Halfway through that period, you will be half full,” Robbins says. “So if you say it’s going to take you a year to reach full occupancy, your average occupancy is 50 percent” – and thus your expected revenues will be half of those you would receive if the incubator were full all year.

While that average will give you an idea of the total revenues to expect in your first year, be careful about applying that figure to monthly cash flow. Because monthly revenues are directly related to monthly occupancy, it’s important to break your growth projections down to a monthly basis to adequately understand cash flow during the incubator’s early stages of development.

Owning vs. leasing

Although expert opinions vary on the issue, Wolfe believes it’s important to have a building free and clear from the start. “[Servicing debt] becomes this noose,” he says. “You start worrying about paying a debt obligation rather than delivering services.”

But how can you start off debt free? Some incubation programs lease their buildings, often from a city, county or university entity that leases the building for a token amount (such as $1 per year). Others form partnerships with organizations that can help pay expenses in return for services provided to the community. For example, the Software Business Cluster in San Jose, Calif., forged a formal partnership with San Jose State University and the city of San Jose in 1996. The university, through its nonprofit San Jose State Foundation, oversees the incubator’s finances. The city pays SBC’s rent, which represents approximately half of its operating costs.

Another way to start off debt free is to raise all of the money needed to pay for a building before breaking ground or beginning a renovation project. Or, like SBC, you might be able to make an arrangement with the city or another stakeholder to pay the rent or mortgage on your facility, even if it is for only the first year or two. However, there is an inherent risk in this latter arrangement; if the stakeholder suddenly decides it no longer wants to cover your rent or mortgage, you’ll have to scramble to find ways to cover that significant expense. Thus, it is necessary for the incubator to demonstrate its value to the stakeholder paying the rent.

For example, in the SBC partnership with the city of San Jose, the incubator completes a written return on investment analysis when the facility lease is due for renewal. The analysis shows that in sales taxes paid by incubator clients alone, “the SBC returns approximately 1.5 times the city’s investment each year,” Robbins says. That’s in addition to direct and indirect job creation and other economic development benefits, such as attracting companies to San Jose. According to Robbins, during SBC’s 10th anniversary celebration in 2005, the mayor of San Jose highlighted the annual rent contribution and stated that he had never had a single city council member or city employee question the value of the city’s investment.

Although it is better to avoid debt, carrying a mortgage or leasing space might be the right choice for some programs. “Typically, leased space is used for incubators when either buildings and sites are not readily available, the cost to purchase space is too high, or there is not a source of funding that would support the purchase of a building,” Lauffer says. However, if an incubator leases its facility at market rates, the program must bring in sufficient revenue via multiple funding sources (e.g. grants, service contracts, sponsorships, etc.) to cover expenses, including common areas and staff to provide business assistance services. Lauffer says most clients cannot afford to pay above-market rental rates, so other sources of revenue must be realized.

In the end, incubator development teams go about selecting facilities in many different ways. Their goal, however, should remain the same: to lay the foundation for a self-sustaining business incubation program.

For more information on incubator development

This story features excerpts from NBIA’s newest book, Developing an Incubation Program, Insights and Advice for Communities.

Theory into practice

How do you put all of this sizing advice into practice? Consider the Indiana University Emerging Technologies Center, a 62,500-square-foot incubator in downtown Indianapolis. The actual rentable area is 43,750 square feet, set up as a mix of wet labs, dry labs, light manufacturing spaces and offices. The offices range in size from 150 square feet to 220 square feet, with most at the lower end of the size scale.

The incubator needs about 25 clients to reach its 80 percent occupancy goal; Mark Long, the incubator’s president and CEO, keeps some of the facility open as “float space” to allow for client growth. Rent includes utilities, maintenance, light housekeeping and Internet access with one phone line. Rates depend on the type of space used.

“The wet labs pay the freight at $35 to $45 per square foot,” Long says, subsidizing the lower-cost office spaces. “You have to have inexpensive office space for support companies. For instance, we have one company that provides services to companies for FDA filings. They are a huge help to the laboratory-type companies in the building, so it helps to have them as a [client], even though their rent structure is much less. You have to have flexible space to accommodate any type of good company that might come along.”—CC

We need more space!

Solid market estimates are crucial to sizing an incubator accurately – if you underestimate demand, you could wind up in a situation like the one Jim Greenwood faced when he started a New Mexico incubator in 1985 with 15,000 square feet. “We filled it so rapidly that we were forced to look around,” says Greenwood, president of Greenwood Consulting Group in Sanibel, Fla. With no room to expand in the existing facility, the incubator opened a second facility in a nearby industrial park. “Even though they were only two and a half miles apart, it was a logistical nightmare,” he says.

Jean-Jacques Ledoux, manager of the National Research Council’s Industry Partnership Facility in Ottawa, Ontario, Canada, experienced a similar challenge. It started with a 35,000-square-foot facility in 1998, but demand later warranted a 10,000-square-foot expansion. Continued demand prompted Ledoux to utilize an additional 7,500 square feet of space in another NRC building across the road from the incubator. However, as it turns out, proximity to researchers and related equipment was a major factor in filling up the main facility. Although there is demand for space, the satellite facility “is not adjacent to the original facility, and tenants are reluctant to locate there because researchers are not just down the hall,” Ledoux says.

Even if you start out with what seems like plenty of space, the time could come when you simply have outgrown it. When the Akron Industrial Incubator opened in 1983 in a 30,000-square-foot former warehouse in Akron, Ohio, no one could have predicted that the program would eventually grow into one of the largest incubator facilities in the United States.

The incubator’s original focus was to create jobs to help mitigate the job losses resulting from rubber companies moving out of the city. Within about a year, the incubator was full. “We stayed there until 1990,” says Mike LeHere, incubator director. “But during that period of time, we realized we didn’t have a facility of sufficient size to meet the needs of the community.”

With demand greater than expected, the incubator expanded in 1990, relocating to a 65,000-square-foot former workshop area of a major department store. LeHere knew this would be an interim move, because the space wasn’t exactly what he wanted. LeHere says the area didn’t provide for the efficient movement of materials in and out of client spaces and had only one small truck dock. “Further, some floors were made of wood, greatly restricting the weight of materials and equipment that it could hold,” he says. “These are all important considerations to manufacturing and distribution companies.”

But the move bought him some time to identify the right space, which turned out to be a former rubber company facility. The city of Akron, a strong driver of the incubation program, purchased a former BF Goodrich building and leased it to the Akron Development Corp., the entity that oversees the incubation program.

After renovations, the incubator moved into this third location in 1995. It currently features 129,000 square feet of manufacturing, assembly and distribution space and is home to about 25 client companies. Although a behemoth by most incubator standards, it wasn’t quite enough for the Akron Industrial Incubator. “We’ve learned since 1995 that there’s a huge market we’re not addressing properly – the technology company that needs labs and upscale facilities to operate from and bring potential customers and investors into,” LeHere says.

To help meet that market, the incubator is expanding again by renovating an additional 70,000 to 80,000 square feet of its facility. With the help of a $1.75 million grant from the U.S. Department of Commerce’s Economic Development Administration, it’s creating upscale, modular offices; labs; conference rooms; and conferencing facilities, which will enable the incubator to address a market that it essentially has had to turn away. The expansion is scheduled to come online in July.—KCB

Measure for measure

When discussing an incubator’s square footage, it’s important to distinguish between different areas of the building. Following are some commonly used terms.

Construction area: The total square footage of a building

Nonrentable space: Hallways, elevators, stairwells, bathrooms and other spaces that are necessary but won’t generate revenue

Rentable area: Office space plus common areas such as conference rooms, reception areas and kitchens that add value to the clients’ occupancy

Usable area: Space clients can occupy and use, i.e., offices

Keywords: entrepreneurial pool, facility management, facility selection/construction/renovation, market research -- incubator, self-sustainability

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