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Incubating Innovation

December 23rd, 2007 by Jacob Ukelson

I read an Forbes article this weekend on incubating innovation which is something I have had the opportunity to do as part of an extra large organization, a medium size company, a small startup, and now as an investor.

The thought process of setting up an incubator in a large company is pretty simple – management sees the outsize returns that VCs produce, know they have wealth of worthwhile internal projects that will never make it to market – put one and one together – and come up with some sort of incubation process. They also hope that it will help them break into new markets. According to the Forbes article  “Arthur D. Little found that only 47% of companies believe their new ventures satisfy strategic objectives. Worse, only 24% meet financial objectives.” I am guessing that these numbers were mentioned since they show that incubation doesn’t work well – on the other hand, IMHO, a 24% across the board success ratio for new ventures isn’t too bad (not great, but not bad).

So I thought I try to do a back of the envelope comparison of the success requirements of internal incubation versus VCs. This is of course comparing apples to oranges since VCs look at the market value of the new venture upon exit, while existing companies look at the revenue and profit generated by a new venture. In any case, I thought it would be fun to try and somehow generate a comparison.

Let’s start by looking at early stage VC returns. Fred Wilson’s success ratio is that 35% of his companies do really well – over 5x investment , 45% do OK – 1x to 5x investment, and 20% tank.

A simple way to try and compare the two is to look at much revenue $1 investment would achieve if invested in existing products at the company– that of course depends on lots of things (including the industry), but I think a ROI of 2 would be considered a success. So to beat out a comparable investment in an existing product – a new venture needs to return at least $2 in recurring revenue for every dollar invested. Using another simplified (and conservative) measure, that $1 in revenue generates $5 in company value in the new venture which is equal to a VC obtaining (1×2x5) 10x on their investment. Now I know this is over simplifying things but a 24% success rate under these assumptions would be really, really good.

Another possible model is to assume that a company needs to return its investment in the new venture (via new revenue) within 3 years (so the new venture needs to return 1/3 of its investment each year). So let’s say the new venture generates $5M of revenue a year on average and with a really high growth rate (what the market and companies reward). The market value of a new venture like that would around $50M-$80M – which means that to get a good return – a VC can invest $10M-$14M and get a pretty good return (3x-8x). In this case the company and VCs are equivalent – the company can invest up to $15M in the new venture and also get a pretty good return by their standards (a 3 year ROI through revenue). Even here a 24% success rate isn’t bad…

Now these are just playing with numbers, there are a lot of qualitative differences between incubating new ventures in a company versus starting new ventures using VCs, but I’ll get to those in another post. These are also the kinds of considerations that companies ake into account when trying to decide between organic, and non-organic growth.

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