The Organic Incubator

Since the recession hit (and yes we are now climbing out) there was a flurry of articles on how the VC model is broken. I believe it’s true. 

For entrepreneurs, the road to equity investment is challenging at best, and at times, less and less desirable as much is given away in return for immediate cash. The concept of smaller early exits, debt financing, and organic growth are becoming increasingly popular with entrepreneurs.  Why? I see a few good reasons.

First of all IT based businesses are not as capital intensive as they used to be. The cloud is a cost effective way to deal with most infrastructure needs and let’s you scale when you perform.

Secondly, the recession has made entrepreneurs more Darwinian. I believe that tough times force us to become better partners and better planners. As better planners, we craft our exit strategy BEFORE determining our funding needs [READ BASIL PETERS: EARLY EXITS]. Part of that process is identifying the most optimal moments to fund your company. Perhaps your business model does not call for any funding whatsoever. Like many things in life, sometimes it’s just better to wait.

There has also been much talk of incubators and their role in our economic ecosystem.  After all, they are credited with providing the first critical services and some capital to get a business going.  Like VCs, the incubator model is one to be considered.

The classic approach is to raise capital through government, institutions or private investors and then use that capital to setup infrastructure, such as office space, provide business mentorship, and make smaller investments. Local incubators Bootup Labs and Wavefront are two examples.

The goal is to help nascent businesses develop to a stage where they are eligible for their first angel round (or not). Some challenges with this model are that it takes a very long time to realize any returns for the investors.  Furthermore, unless the approach is to continue to participate in equity rounds the ownership level for an incubator decreases sharply as blossoming companies go on to additional rounds of fundraising.

The point of this article is not to poke holes at traditional forms of financing, be it VC or incubator. We all know of many successful examples – and as a local Vancouver entrepreneur, I look forward to the results that Bootup Labs and Wavefront will bring.  However, if the incubator model was to organically grow, prove business models before they need cash, well, then one could expect that the risk for investors is somewhat mitigated. What we are looking at is the Organic Incubator.

The Organic Incubator shares the same objectives as a traditional incubator, however it operates more as a startup, than as an investment house. The goal is to develop products or solutions that eventually get spun out into businesses. Given that sales are the only means to fund development, products are developed, proven quickly, or ditched. This model forces ALL stakeholders to be extremely nimble and critical of their efforts. All market tests are done live, with real feedback from real customers from the day the product hits the market. That is the only form of due diligence required. Of course, once a product reaches a certain level of maturity, the Organic Incubator can spin out the asset and build a company around it. At this time, perhaps different management and staff are needed or the case can be made for capital – depending on the exit strategy of course. Either way, the decision to add and grow is based on real-time market information and real customers.

Now the Organic Incubator is by no means new. There are likely many companies that operate this way without getting any recognition for their role in our economic system. Two that come to mind are 37 Signals (Chicago) and Invoke (Vancouver).

37 Signals began as a web development services business. They saw a need for better collaboration and planning tools and created a suite of highly successful tools such as Basecamp, Campfire and more recently Highrise.  The 37 Signals team literally wrote the book (Getting Real) on how to create lean startups, geographically dispersed team development, and minimal feature products. Through a blend of product and services revenue, 37 Signals managed to incubate their complete stable of products without outsider investment until 2008.

Invoke is known as an interactive agency, but I believe, it’s an incubator in disguise. Like 37 Signals, Invoke is the epitome of the Organic Incubator. Invoke began creating products where they saw gaps in the markets they were serving. Some of  the products never made it to market; some came and went because they lacked the necessary proof points to warrant more focus. And of course, some have become extremely successful, providing support to the organic model.  Of note is the globally recognized Twitter client, Hootsuite.com. Hootsuite has over 150,000 users and is ranked in the top 5 of Twitter clients (Twitter is ranked #1).

Another of Invoke’s products is Memelabs, a video-contesting platform that is used by an enviable list of the world’s largest brands. The platform is performing well, generating over a million dollars per year. Plus, Invoke is bringing more products (or mini businesses rather) to market, such as Vidrollr, an unreleased video conversation tool that won funding from IRAP for the 2010 Showcase BC initiative.

For all those entrepreneurs out there trying to tackle the challenge of raising capital, the Organic Incubator model teaches us some good lessons (and yes 37 Signals and Invoke are not the only ones). Selling equity early on for capital may not always be the best route for your business. If you can (and this advice has been given to me), try and take your business as far as you can without raising money. Innovate and change direction as much as you need to until you can garner sufficient proof points from your market to justify the need for capital. Plan everything against your exit strategy and don’t be afraid of change. Your business model will likely change many times before you lock down the right one. Recent market times have forced entrepreneurs to become Darwinian and out that new businesses AND new investment models have emerged. I wonder what new models are emerging from our counterparts, the Darwinian VCs?