After the Fall

By Kristi Lamont Ellis

(Catalyst Magazine, March 2001)

Remember when for-profit incubators burst onto the Atlanta technology scene with a vengeance, capitalizing on the unrealized potential of one sizzling startup after another, thriving on the buzz, riding it hard?

Remember how all of the golden boys and girls with their red-hot hatcheries and green launchpad machines believed, yes truly believed, that they had the Midas touch - that they could take one brilliant dot-com success and parlay it and some below-market cost real estate into an equity trade for multiple minions? Remember the sexy office space, the de rigueur celebratory beer at the desk for every little milestone reached? The way magazines like ours bought it - hook, line and sinker?

Ahem.

With apologies to Waylon and Willie and the boys, perhaps it's time we got back to the basics of business life. and what better place to start than with a look at what was right and what was wrong with those for-profit incubators?

First, the wrong. in retrospect, it seems screamingly obvious: private or public, the for-profit incubators that took the biggest financial hits were those that took their compensation in equity only - businesses that were, as a result, essentially market-dependent when it came to cash flow. In a raging bull market, it was safe to count your internet pure-play chickens before they hatched, to depend on that next round of VC funding to pay the light bills and the salaries of newly hired sales forces. Substantial revenues and actual profits were metrics to be achieved a quarter or two down the road, maybe even after the holy grail of an IPO.

Just one such positive liquidity event would mean a big enough return on investment to keep your other incubatees afloat until they, too, could cash out (or even make money). In a bear market whose dormancy seems even more frustrating when compared to its recently gored bull brother, you can forget all that. Example: eHatchery.

The full-service incubator was founded and funded in June 1999 by Jeff Levy and quickly carved out its niche as Atlanta's dot-com mentor extraordinaire thanks to the buzz surrounding its initial incubating companies - Figleaves.com, SimplyCollectibles.com, TradeUps.com and VetExchange.com (the latter was a subject of a day-in-the-life profile by none other than this Catalyst reporter in May 2000).

eHatchery's pitch: "Our approach breathes life into the process of evolving from concept phase to business reality at Internet speed." Its take: A variable percentage of equity in the nascent companies. Its success rate: SimplyCollectibles and Figleaves were gone by the third quarter of 2000. By the end of the fourth quarter, VetExchange had been acquired by VetMedCenter and laid off part of its workforce, leaving out any form of severance. It's now shut down operations and is trying to unload its assets. But Levy & Co. didn't get successful - and rich - by ignoring the handwriting on the wall; by the end of fourth quarter, they were changing eHatchery's business model.

"We are transforming ourselves into an operating entity that is in fact cash-flow neutral," Levy says. So while eHatchery will continue to retain equity in its current stable of companies as well as charge them a rent and facilities usage fee, the incubator will also create a hybrid fee structure for new companies that come into the fold.

"That will include the desk charge to be in our space and a monthly cash payment for services, as well as a much smaller equity piece," Levy says. "We're early, early-stage venture capital.

"The principals here have all been CEOs of companies they have built from virtually nothing," he says, adding that eHatchery is also changing its focus to technology companies, as opposed to technology-enabled (read: Internet b-to-c and b-to-b) companies. "We are experienced operators in both the Internet space and traditional business space. We are not consultants who think you should do this; we are helping with every aspect of the business."

With its rent and fee charges, Levy's new model sounds like one that's been in use for years at Intelligent Systems Incubator, which is sponsored by publicly traded Intelligent Systems Corp. But to compare the two directly would be a case of apples vs. oranges. (We're not even going to get into not-for-profit entities such as Georgia Tech's ATDC - that would take us all the way to kumquats.)

First of all, the Intelligent Systems Incubator is backed by the long-standing and fairly stable infrastructure of its parent company; eHatchery had to create its own infrastructure at the outset, thereby immediately incurring some heavy expenses. Second, says Intelligent Systems Corp.'s Vice President and CFO Bonnie Herron, her company's incubator doesn't always put equity into - or take an equity piece out of - the companies it houses; investments are done outside of the rent charge and fee structure associated with the incubator. Third, and perhaps most important, are the incubators' strikingly different missions. Intelligent Systems isn't in the incubator business strictly to make a profit, which, one can suppose, eHatchery still wants desperately to do.

"To us, the incubator is a tool to help with our company's overall strategy and business, which is finding good opportunities to invest in and work with early-stage companies, wherever they may be located," says Herron, who is also a member of the National Business Incubation Association board of directors. "Having an incubator improves the quality and number of opportunities we see ... and gives us a solid reputation for the value we can bring to entrepreneurs.

"Incubators have traditionally never been viewed as vehicles for creating a lot of independent value," she adds. "If your whole strategy is that your incubator has to be an independent entity with a lot of value as opposed to providing services to make other companies valuable, that's fairly risky."

Another morphed model on the Atlanta incubator scene is one that has never used the i word to describe itself: the Red Hot Technology Accelerator, co-founded by partners of the Red Hot Law Group of Ashley LLC (which has also seen a lot of this magazine's ink) and Alan McKeon, who is billed in Red Hot's promotional materials as "chief firestarter." Similar to Intelligent Systems, the Red Hot Accelerator is housed in the law firm and supported by existing infrastructure. There's a cash and equity payment mix, a la eHatchery's new old-fashioned approach. The twists? First, Red Hot Accelerator has been set up that way from the get-go. Second, the Accelerator works with any company regardless of its legal representation, but houses only clients of the Red Hot Law Group. Third, the companies it works with don't have to be physically housed on site.

While it does invest in its portfolio companies, the Red Hot Accelerator believes money is a commodity; companies today are only going to give up equity when there's a strong value-add to go with it. "It's angel investing on steroids," says McKeon. "We provide tactical business and consulting services, competitive analysis and an equity-raising plan. We understand how the raise is done."

OK, if you're counting, so far this is what we've got:

eHatchery, a pure for-profit, stand-alone incubator that both invests equity capital and takes equity pieces in portfolio companies it physically houses while helping to operate them and to support their technology (a combo VC-founder approach), but that is also about to add in a fee structure;
Intelligent Systems Incubator, set up to help foster the parent company's overall mission, that physically houses its incubatees, invests capital sometimes and takes equity sometimes but not always, and that doesn't get into the down and dirty of running its incubating companies (less a VC-more a pure incubator); and
Red Hot Technology Accelerator, an incubator that both always invests capital and takes equity, fosters the parent company's mission, doesn't always house its portfolio companies on site, helps them with only certain aspects of their business, and doesn't call itself an incubator at all (the melded VC-pure incubator model).

For-profit incubators in Atlanta can best be likened to designer blue jeans. For the sake of this little analogy, let's assume that the Intelligent Systems Incubator is a pair of good ol' Levi 501s. It's basic, not very sexy, just gets the job done. eHatchery came along next as a pair of Guess denims; you paid a lot - at first - for the panache that went with that little label, and now you can find a pair occasionally at T.J. Maxx. Red Hot Accelerator equals Calvin Klein - another name with some sex appeal, but always a little more affordable than Guess. The next thing you know, everybody and their brother realizes that there's at least some money to be made in the denim market, so they're out there pushing what makes their pair of jeans different - boy-cut, button-fly, boot-leg, comfort-fit - you name it, there's something for everybody, seemingly endless variations on the theme.

Do any of these models rise to the top as something that can be termed Incubator 2001, Atlanta Edition? Yup, Red Hot. And here's why. The city's tech and finance players have realized that partly virtual for-profit incu-accela-whateverabators that have a parent infrastructure and derive a solid chunk of their compensation in cash also have a higher financial risk tolerance. They need it: Morten T. Hansen, assistant professor of business administration at Harvard Business School, has said the median first round of financing for a startup at an incubator is $690,000, which doesn't take into account additional money burned when a company has to stay under incubation longer than planned.

Red Hot isn't alone; others in Atlanta with somewhat similar models include Duffey Communications' Golden Egg; Morris, Manning & Martin's eFacilitator; McKinsey & Company's accelerator@mckinsey; and CyberStarts. At one point Cyberstarts touted its strategic relationship with iXL Enterprises, but now that iXL is getting out of the venture business, the incubator leaves it off a list of strategic investors and relationships that includes Wachovia and Marsh & McLennan.

To think that in Atlanta "similar" means "exactly the same" would be just as silly as to assume we would be content with only three streets named Peachtree. Golden Egg, for example, takes equity but doesn't invest any capital - no angel/VC element there. Accelerator@mckinsey doesn't really do business with that many startups in the pure sense of the phrase; instead, it focuses mainly on brick-and-mortar behemoths that want to spin off ecommerce divisions. And, again, there's no real investing going on - it's more taking part of the compensation as equity in lieu of fees. Same with Morris, Manning & Martin's eFacilitator. (Law firm Kilpatrick Stockton offers help with services, such as marketing, sales development and IT outsourcing, and takes equity, but Attorney and Technology Chair Martin Tilson says the firm is not developing an incubator.)

CyberStarts touts its difference as being a "category killer" in the financial services sector - it invests, takes equity pieces, helps manage - but in a very limited space, thus giving it enough expertise to maybe morph into an operating company somewhere down the road if need be. Being physically housed with some of these players is not necessarily a requirement for a company to avail itself of their services.

Even if a particular incu-accele-bator model is working, that's no guarantee the fledgling companies it hatches or otherwise graduates will make it on their own in the long run. Case in point: yuSave.com Inc., which was a Red Hot Accelerator portfolio company from February to August 1999, physically housed on the Red Hot Accelerator premises for part of that time. The firm created a middleman-type Web entity that enabled manufacturers to sell directly to consumers through the yuSave site. When it graduated from the Accelerator, says McKeon, yuSave had about $2 million in funding, 12 employees, and a business plan full of objectives to achieve and deadlines to meet, mostly centered around the holiday sales season of December 1999. Let's just say the meeting and achieving didn't quite go as planned, and, as happened with so many of its ilk, the nascent concern got sucked into the April 2000 market vortex. Results? yuSave filed for Chapter 11 protection on November 17, 2000.

By that time, the company had been out of the Red Hot Accelerator nest for well more than a year, and the Accelerator no longer had a presence on yuSave's board of advisers; McKeon vacated that role in late '99/early 2000, he says to devote more time to current Accelerator clients. That the time period just happened to be right about when yuSave was missing launch and other operating deadlines willy-nilly in retrospect seems a bit, shall we say convenient? McKeon is quick to nix that sort of talk, pointing to the equity stake (less than 5 percent) in yuSave, and noting that Red Hot Accelerator's purpose was never to actually run the company. "We're not really similar to eHatchery in that they put a large number of people to work [on a company]," McKeon says. "Our goal is to provide strategy, direction, to help them grow and to raise capital. We launch companies, and if they change course and crash back to earth, well, we still launched them in the right direction. Entrepreneurship inherently has failure in it. There will be companies that fail."

McKeon does say, however, that -hindsight being 20-20 - it might have been a good idea to have kept yuSave housed at Red Hot Accelerator a bit longer, thereby allowing it to focus on the business of its business during late third quarter and early fourth quarter 1999, rather than the minutiae of moving.

It doesn't take a crystal ball to look toward the future and predict that by year-end 2001, there will be a lot more changes in strategy - and a lot fewer players - on this city's for-profit incubator scene. And if some folks have their way, the changes and exits will be made a lot more quietly than the entrances were. Don't look for press releases trumpeting closings or reduced investments. But don't think, either, that it's just the death-of-the-stock-market-as-we-knew-it-in-2000 that brought all this on: Hyperexpansion is naturally followed by hyperconsolidation.

Fads, be they blue jean or financial, they come - and they go.

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