Posted 04 Feb 2011
Great news — your startup just got accepted to an incubator! But before your startup signs up and cashes that $[XX,000] check, your startup’s co-founders should sit down and evaluate the incubator’s offer. The following are some issues to consider and actions to take before accepting an incubator’s offer:
(1) Calculate Valuation and Determine Value.
Pre-money valuations startups receive from incubators are typically low…really low. If an incubator offers your startup $25,000 in exchange for 6% equity, the pre-money valuation is a whopping $391,667.
As you can see, I don’t think any startup has joined an incubator based solely on the pre-money valuation. Thus your startup needs to determine the intangible value offered by the incubator (and yes, a $150,000 convertible note with no cap and no conversion discount qualifies as an intangible).
Rather than assign a monetary value to the intangibles, a startup should instead assign an equity percentage value to intangibles like mentorship. As equity in the company tends to be the currency of early stage startups, the startup should have a good foundation for assigning value in terms of equity.
This advice holds true for even if the incubator’s program provides tangible items free and such items have an assigned monetary value. For example, if your startup get $2,000 worth of massages during the program, don’t add the $2,000 in free services to the $25,000 investment amount. Determine how much of your startup’s equity you’d actually give up for those services if they weren’t provided free — it may be worth $2,000 retail but it can also be worth 0% of your startup.
Thus, if your startup is willing to give a couple points to a few advisory board members, determine how much the incubator’s mentorship (and introductions) equates to an advisory board and assign a percentage. Now subtract that amount (and any additional equity amounts you have assigned to other intangibles at the incubator) from the total equity the incubator is requesting.
Using the previous example, if your startup believes the mentorship is worth 2%, then re-calculate the incubator’s offer of $25,000 for 6% to $25,000 for 4%. The “revised for the cash investment only” pre-money valuation is $600,000.
(2) Scrutinize the Investment Structure.
Incubators aren’t non-profits, therefore in addition to asking for a low pre-money valuation, they may structure their investment in a way that helps to ensure a higher return across their portfolio. Most incubators take common stock and sit “side-by-side” with the founders, but some may want some (weak) preferred stock and/or dilution protection.
Other incubators may want to set up an option pool. If so, the startup’s founders need to know this option pool lowers your pre-money valuation. Using the previous example, if an incubator wants your startup to set up a 15% option pool as part of the $25,000 for 6% of the company, the pre-money valuation gets effectively reduced to $329,167.
Like any issuance of stock or investment, one of the main things a startup should be concerned with is: Is this going to fuck up a future financing? (Technically, your startup should be asking this question for any contemplated transaction.)
If the terms won’t hinder a future financing, then your startup is good to go. If the terms will, then the question becomes: is the incubator going to waive these terms when a VC makes the request — without asking for anything in return for the waiver?
(3) Research the Mentors.
I wrote in a previous post, startups value mentorship over money when it comes to incubators. Research the mentors so you can accurately assign the amount of intangible value (in equity percentage terms as discussed in point 1 above) and justify the shitty pre-money valuation.
Analyze the mentors not just in what those mentors currently do or did when you were in middle school — but also how they fit with your team and your startup’s product. Do they know your space? Will you get to select your mentor or mentor group? How often will mentors drop in or otherwise be available?
(4) Inspect the Office Space.
Some incubators offer free office space. If so, check out the lay of the land to determine if your startup can be productive in the office space. Does your startup get a private office or will it share space coworking-style? How is the conference room and how hard is it to schedule time in the conference room? Can you break away for a confidential call from your girlfriend or potential VC investor? Do the chairs make your butt hurt after sitting in them for more than one hour? How is the technology?
(5) Figure Out Your Incubator’s Class End Date.
When does the mentorship and other benefits end? Can you continue to work out of the incubator’s office after your class ends? While most incubators’ class end dates fall around the respective incubator’s demo day, what type of support will you receive post-demo day from the incubator and/or the mentors? The best incubators are going to have no true “end date” and will be a forever-resource with respect to mentorship…although the incubator can likely only offer office space until the next class of companies move in.
(6) Search For the Incubator’s PR and Marketing Efforts.
If the incubator doesn’t take its class “stealth,” take a look at what the incubator does to market itself and its incubated startups. Take a look at pictures and videos from previous demo days, if any, and see if they’ll help get your startup’s name out there. It’s not really a demo day if only friends and family show up. Of course, joining some incubators give startups an instant “I’m Awesome, Fund Me Now” virtual-badge. Nonetheless, if an incubator can’t promote itself, how is it going to help promote your startup or the crucial demo day event?
(7) Reach Out To Prior Incubated Companies.
If you contact a startup that was part of an incubator’s past class know that you are accepted to and contemplating the same incubator, you should not have a difficult time getting a few minutes from one or more of that startup’s co-founders. Ask them about points 1-6 above but go further — ask them which mentors they perceived as being the most helpful or even which office to snag if you move in to the incubator’s office space. If a startup doesn’t get back to you, then that may tell you something, but don’t automatically assume that startup had a bad experience with the incubator.
(8) Determine the Opportunity Costs.
A startup that is accepted by an incubator may have an alternative funding offer from an angel investor. This can add complexity to a startup’s decision, because maybe the angel doesn’t want your startup to join the incubator. If the angel investor is offering an investment amount (greater than the incubator) that would “guarantee” your startup will reach a certain goal, it may difficult to accept the incubator’s offer. Regardless if your startup has an angel investor lined up, your startup will need to have a tangible goal in accepting the incubator’s offer that can be realized by completion of the program (or shortly thereafter). If not, the incubator is just a bridge financing to potentially nowhere for your startup.
Getting into an incubator is an exciting experience for any startup, but before signing up take a look at the incubator and how (much) it will help your startup. With the explosion of startup incubators, I hope the list above is helpful in determining whether your startup should accept such an offer. The more intangible value you can assign to the incubator, the more appealing the incubator’s offer will appear.