In Pursuit of Financial Sustainability: Startup Incubators as Capital Investors

One of the main challenges in managing equity stakes is determining the right percentage to take. Photo: Getty Images

ANDndia has quickly become one of the most vibrant startup ecosystems in the world, fueled by a young population, a growing economy, and a thriving technology sector. This environment has fostered a surge in entrepreneurial activity across industries. At the heart of this ecosystem are more than 1,000 startup incubators supported by government, academic institutions, and private corporations.

The traditional incubation model, which focused primarily on providing mentoring and workspace, has evolved significantly. Today, incubators are increasingly adopting equity-based models, reflecting a shift toward deeper engagement with startups and aligning their success with the startup’s future achievements. This article explores strategies that incubators can use to manage equity, their challenges, and how they can effectively navigate this changing landscape to ensure sustainable growth.

Evolution of the incubation model

Traditionally, incubators have focused on providing resources such as office space, mentoring, and access to networks. While these elements remain important, the shift toward including equity-based support reflects a deeper commitment to the long-term success of the startups they support. This shift is partly driven by the need for financial stability. Many incubators, particularly in India, initially rely on government grants to get their start-ups off the ground. However, because these grants are temporary, incubators need to develop alternative sources of income to ensure long-term viability. Equity offers a compelling solution, allowing incubators to generate income when their incubatees succeed.

Mr. Sivasubramanian Ramann, chairman of Small Industries Development Bank of India (SIDBI), recently stressed the importance of moving from a “free money” mentality to embracing equity investments driven by seed funding. He noted that equity investments bring greater discipline and accountability, encouraging incubators to more closely align their interests with those of their startups.

Understanding the role of equity participation

Equity refers to the percentage of ownership that an incubator acquires in a startup in exchange for the resources, funding, and support it provides. This model allows startups to reduce their initial cash costs by offering equity instead of service fees. Incubators can receive equity in exchange for two offerings: incubation capital for incubation services and investment capital if they also provide seed funding. The purpose, management, and financial instruments used for these two types of capital tend to differ.

Managing equity requires an investor mindset. For incubators, the potential to generate revenue through equity stakes is realized when they exit their investment, typically by selling their stake in subsequent rounds of funding. However, this process can take several years, as successful exits typically occur after a startup has attracted additional rounds of funding from angel investors or venture capitalists. This long gestation period means that incubators must carefully manage their equity portfolios, balancing the potential for high returns with the inherent risk of startup failure.

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The Challenges of Managing Equity Shares

One of the main challenges in managing equity stakes is determining the appropriate percentage to take. Early-stage startups often have limited resources, so taking on a large equity stake can be counterproductive for founders because it dilutes their stake too early in the company’s life cycle. Typically, equity stakes for early-stage startups range from 3 to 5 percent, depending on the level of support provided and the startup’s specific circumstances. An incubator may also consider taking on additional investment capital if it provides seed funding.

Incubators need to negotiate fair and mutually beneficial equity deals. If an incubator takes on too much equity without providing adequate value, it can discourage high-potential startups from joining the program. On the other hand, taking on too little equity can limit the incubator’s potential profits, especially if the startup is successful.

In addition, equity stakes must be managed strategically to align with future investment rounds. For example, investment capital is typically held in convertibles—where valuation is deferred to future rounds—and can help prevent founders from becoming overly diluted and ensure valuations remain realistic. This approach is especially important when considering the dynamics of follow-on investments by venture capitalists, who typically invest only in startups with significant growth potential.

Building capacity in equity management

Effective equity management requires incubators to develop solid skills and processes. This includes negotiating valuations, writing term sheets and managing shareholder agreements. Incubator managers must also regularly monitor the progress of their investee companies, make strategic interventions as needed and manage equity dilution as startups attract additional investors.

Monetization of equity stakes is another critical aspect of equity management. As startups progress through various rounds of funding, incubators may decide to make partial exits to recoup initial costs and grants while retaining enough equity to benefit from future growth. An equity exit strategy should balance immediate financial recovery with long-term valuation maximization.

The importance of strategic exits cannot be overstated. The decision to sell equity in a particular round of financing depends on several factors, including the startup’s valuation, the needs of new investors, and the financial situation of the incubator itself. Careful planning and a deep understanding of market dynamics are essential to maximizing returns. The recent IPO of companies like IdeaForge illustrates the importance of strategic equity management for incubators.

The broader impact of equity participation

Equity stakes not only provide incubators with a potential revenue stream, but also contribute to the broader success of the startup ecosystem. By taking equity stakes, incubators align their interests with those of their startups, creating a symbiotic relationship in which both parties benefit from each other’s success. This alignment encourages incubators to offer more tailored and effective support, knowing that their financial returns depend on the startups’ performance.

It’s important to recognize, however, that an equity model isn’t right for all types of startups. For example, companies with limited growth potential or in sectors with a long development period, such as biotech or space technology, may not offer the quick returns that equity investors typically seek. In these cases, incubators need to carefully consider their equity strategies and may need to supplement them with other revenue models, such as incubation fees or revenue-sharing agreements.

Application

The shift to equity-based models represents a significant evolution in the role of startup incubators. By taking equity stakes in the startups they support, incubators can align their success with that of their incubatees, creating a more sustainable and impactful model for nurturing innovation. However, managing equity requires incubators to develop new skills and strategies, from negotiating fair equity allocations to strategic exits.

As the startup ecosystem grows and evolves, incubators must adapt to these changes by adopting equity management as a core competency. This enables them to ensure not only their own financial stability, but also the long-term success of the startups they support. This symbiotic relationship, if effectively managed, has the potential to drive significant growth and innovation across the ecosystem.

Rohan Chinchwadkar is an assistant professor of finance and entrepreneurship at IIT Bombay.
Poyni Bhatt is the former CEO of SINE, a technology business incubator at IIT Bombay.
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(This article was reprinted with permission from Indian Institute of Technology Bombay, Mumbai)