In pursuit of financial sustainability: Startup incubators as equity investors

One of the primary challenges in managing equity stakes is determining the appropriate percentage to take. Image: Getty Images

India has rapidly become one of the world’s most dynamic startup ecosystems, driven by a young population, a growing economy and a thriving tech sector. This environment has fostered a surge in entrepreneurial activity across diverse industries. At the heart of this ecosystem are over 1,000 startup incubators supported by the government, academic institutions and private corporations. 

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

The Evolution of the Incubation Model

Traditionally, incubators focused on providing resources like office space, mentorship and access to networks. While these elements remain important, the shift towards incorporating equity-based support reflects a more profound commitment to the long-term success of the startups they support. 

This shift is partly driven by the need for financial sustainability. Many incubators, particularly in India, initially rely on government grants to kickstart their operations. However, as these grants are temporary, incubators must develop alternative revenue streams to ensure long-term viability. Equity stakes offer a compelling solution, allowing incubators to generate revenue when their incubatees succeed. 

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

Understanding the Role of Equity Stakes

An equity stake refers to the percentage of ownership an incubator acquires in a startup in exchange for the resources, funding and support it provides. This model allows startups to reduce upfront cash costs by offering equity in lieu of fees for services. Incubators can take equity in return for two offerings: incubation equity for incubation services and investment equity if they also provide seed funding. The objective, management and financial instruments used in these two types of equity tend to vary.

Managing equity requires an investor’s mindset. For incubators, the potential for revenue generation through equity stakes is realised when they exit their investment, typically by selling their shares during subsequent funding rounds. However, this process can take several years, as successful exits usually 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 risks of startup failure.

Also read: Powering sustainability through partnerships

The Challenges of Managing Equity Stakes

One of the primary challenges in managing equity stakes is determining the appropriate percentage to take. Early-stage startups often have limited resources, so taking a significant equity stake can disadvantage founders by diluting their ownership too early in the company’s lifecycle. Generally, incubation equity stakes for early-stage startups range from 3 percent to 5 percent, depending on the level of support provided and the specific circumstances of the startup. The incubator can also consider taking additional investment equity if it provides seed funding.

Incubators must negotiate fair and mutually beneficial equity arrangements. If an incubator takes too large a stake without providing corresponding value, it may deter high-potential startups from joining the program. Conversely, taking too small a stake may limit the incubator’s potential returns, especially if the startup becomes successful.

Moreover, equity stakes must be managed strategically to align with future investment rounds. For instance, investment equity is usually held in the form of convertible instruments – where the valuation is deferred to future rounds – and can help prevent excessive dilution of the founders’ ownership and ensure that 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 Capability in Equity Management

Successfully managing equity stakes requires incubators to develop robust skills and processes. This includes negotiating valuations, drafting term sheets and managing shareholder agreements. Incubator managers must also regularly monitor the progress of their investee companies, make strategic interventions when necessary and manage equity dilution as startups attract additional investors.

Monetising equity stakes is another critical aspect of equity management. As startups progress through various funding rounds, incubators may choose to take partial exits to recover their initial costs and subsidies while retaining enough equity to benefit from future growth. The strategy for exiting equity should balance immediate financial recovery with long-term valuation maximisation.

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

The Broader Impact of Equity Stakes

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, incubators align their interests with those of their startups, creating a symbiotic relationship where both parties benefit from mutual success. This alignment encourages incubators to offer more tailored and effective support, knowing that their financial returns depend on the startups’ performance.

However, it is important to recognise that the equity model is not suitable for all types of startups. For instance, businesses with limited growth potential or those operating in sectors with long gestation periods, such as biotechnology or space technology, may not provide the quick returns that equity investors typically seek. In such cases, incubators must carefully consider their equity strategies and may need to complement them with other revenue models, such as incubation fees or revenue-sharing arrangements.

Conclusion

The move towards 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 splits to strategically exiting investments.

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

Rohan Chinchwadkar is an assistant professor of finance and entrepreneurship at IIT Bombay.
Poyni Bhatt is the former CEO of SINE, IIT Bombay’s technology business incubator.

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[This article has been reproduced with permission from Indian Institute of Technology Bombay, Mumbai]