Medical Device Link.

Originally Published MX July/August 2001

Business Planning & Technology Development

Business incubators can provide medtech start-ups with strategic services essential to their growth.

S. Ramesh and Jenny Sakhrani

Medical technology companies are at the forefront of developing innovative products and services that improve not just the quality of healthcare, but of people's lives. But starting a medtech company based solely around a new idea isn't feasible—no matter how great the idea. Entrepreneurial scientists and researchers with bold visions shaped by breakthrough discoveries or technical wizardry often wind up as heads of failing medtech companies because they don't realize that the business development process can offer many difficult challenges.

One challenge specific to medtech companies is the high level of difficult clinical testing required for regulatory approvals. Another major challenge is industry's slow adoption rate. To succeed, medtech entrepreneurs must convince healthcare professionals to adopt a new product or process, which can require a tremendous amount of marketing know-how. These obstacles, of course, are only part of the larger picture of growing a business. Since medtech start-ups lack the resources to compete with large, established companies, they must be able to anticipate market opportunities before their competitors. To keep their business afloat, medtech entrepreneurs therefore need hands-on management assistance, marketing expertise, and financial planning services.

One way that medtech entrepreneurs are obtaining such critical support is by turning to business incubators. Incubators nurture start-up companies, helping them grow in the early stages of development during which they are most vulnerable. According to the National Business Incubation Association (NBIA; Athens, OH), 87% of early-stage companies that work with incubators are still in business after five years. NBIA also reports that such companies experience significant growth, with sales increasing by an average of more than 400% following the period of incubation.

Even with such statistics, however, medtech entrepreneurs in the market for a business incubator should scrutinize prospects carefully. But before signing with an incubator, companies should be sure that they understand the various types available and know what to look for in an incubator. Moreover, they should learn about and study carefully the business models used by successful incubators with experience in their field.

This article will address several of these topics, with emphasis on the issue of identifying the type of incubator most suited for a particular medtech company. But first, a few words about what an incubator is—and what it isn't—and what incubators can and can't do for the leaders of fledgling medtech companies.

The Incubator Model

An incubator is an organization that provides an environment to help early-stage companies grow. As such, the role of the incubator is to add value to its member companies by providing investment capital, management contacts, and support services whose costs might otherwise be prohibitively expensive for those companies to obtain. The range of such services is very broad, including everything from financial management and legal representation to secretarial assistance. As discussed below, however, not every incubator offers the same types of services. Medtech entrepreneurs must therefore be informed and selective when seeking to partner with an incubator.

In the past few years, the number of incubators has proliferated tremendously. To a large extent, this growth has been a result of the struggle of industry to keep pace with technological advances in such fields as telecommunications and computers—including, of course, the Internet. Incubator companies often represent the entrepreneurial cutting edge of technological advance, a phenomenon with which manufacturers in the medical technology industry are well acquainted. Unlike large corporations, incubators are typically able to offer a focused, favorable, and supportive environment for the development of new technologies and products. If not for the (perhaps temporary) halt in the growth of Internet-sector incubators, in fact, the current decade might well mark the beginning of a "golden age" of incubators.

As the number of incubators has increased, so also has the variety of different business models they represent. By definition, incubators are designed to assist company leaders in meeting the challenges typically faced by start-up companies. The types of assistance that most incubators provide generally fall into the following categories.

Management. Getting good business advice isn't easy. However, some incubators provide access to seasoned businesspeople who are available on an occasional basis to provide advice. To entrepreneurs with a background in technology and a great product idea—but no background in growing or running a business—such contacts can be an important asset.

Investment Support. Although most incubators primarily provide services in lieu of cash, many also have partnerships with angel investors and early-stage venture capital (VC) funds. Through the relationships of the incubator with VCs, start-ups can find it easier to move along through the stages of funding. However, not all such claims of VC connections have equal merit. If access to funding is an important need, company leaders should arrange to check out the interests of the incubator's investment connections before signing on. By partnering with an incubator whose investment connections have a strong interest in and track record for supporting medtech companies, company leaders will have better assurance that their next request for funding will reach receptive ears.

Financial Services. Many incubators have partnerships with individuals at leading professional service firms, including bankers, accountants, and payroll service providers. Since the needs of start-up companies in such areas are often small, it would usually be cost-prohibitive to hire a large, well-known firm to perform them. By going through an incubator's partners, however, companies can often gain top-flight expertise at greatly reduced cost.

Legal Representation. For start-ups, dealing with the need for legal representation can be daunting. Companies need access to legal expertise simply to draw up contracts with employees and other organizations, but they may also require more-specialized services such as those provided by intellectual property and regulatory affairs attorneys. Here again, many incubators have partnerships with leading firms through which start-ups can gain access to high-powered services at reasonable cost.

Technology Vendors. Incubators commonly have ready access to suppliers of specialized components for medical products. Such contacts with hardware vendors, software consultants, and other suppliers can save start-ups a lot of time hunting down basic items they need.

Infrastructure. In some cases, access to a physical environment appropriate for experimentation and product development is the major service that an incubator provides. For start-up companies, cost savings can often be realized by sharing reception and administrative space and services with other members of the incubator.

Finally, all incubators promise great networking opportunities with other companies within the incubator, and with all of their partners. While perhaps not the first thing that leaders of a new company might think of, the value of such networking shouldn't be minimized.

Gaining the Most Mileage

Most incubators have a venture aspect to their business in that they invest cash and services into a start-up in return for equity. Since incubators are investors, they have a natural place in the investment life cycle of a start-up company (see Figure 1). Incubators are best equipped to help start-ups in two different phases of their life cycle.

Late Concept Stage. At this stage, the start-up typically consists of its founders, with other interested parties in either advisory or consultant roles. As such, the management team is usually incomplete, the business plan may not be finished, and there is no proof of concept. The company may be growing, but at this point it is still too early for most angels to invest. Incubators, however, will typically invest at this time, and will provide the missing elements in the management team and help the company execute and complete a proof of concept.

Late Seed Stage. At this stage, the start-up has typically completed a thorough business plan, has its initial management team in place, and may have developed a demo or proof of concept. In addition, the company has usually had an infusion of angel funding. This stage is an awkward one for most companies; their valuations are typically too high to get more angel funding, but they don't yet have revenues or a beta product, which are the first steps toward early VC funding. Incubators may invest at this stage to help the company achieve its major goals of completing product development and generating revenues.

Companies in these stages of development stand to gain the most from partnering with business incubators. Incubators are willing to work with very-early-stage companies, assuming risk when other investors are reluctant to invest—that is, before a company has demonstrated its ability to execute and succeed in delivering to the market. They are the most hands-on type of investor, ready to roll up their sleeves along with the entrepreneurs and help the start-up grow.

Business Milestones

Funding Sources
Figure 1. The typical investment life cycle of a start-up company.

Types of Incubators

There are many different types of incubator business models. Each model provides a different set of services to help start-up companies succeed. The challenge for the leader of a medtech start-up is to identify the incubator that will make the greatest contribution to the success of that company, and then to convince the incubator that the company will be a moon shot with its help. The following sections describe various types of incubators, with notes on their potential for adding value to early-stage medtech companies.

Profit-Oriented Early-Stage Incubators. This type of incubator has one special characteristic: medtech executives are unlikely to ever encounter any other business whose interests are so completely aligned with their own. These are businesses that are willing to get their hands dirty and work with start-ups, providing ancillary services as well as detailed technology development expertise. Since they only make money when their client companies succeed, those companies literally hold the success or failure of the incubator in their hands. This is especially true when the incubator takes a long-term approach to capital return; the longer the time to return, the greater the risk for the incubator.

Infrastructure-Oriented Incubators. Many of the incubators that started out during the dot-com bubble are infrastructure oriented. These incubators primarily provide office and lab space, equipment, and other types of infrastructure in return for a considerable equity position in the start-up company.

Infrastructure-oriented incubators follow a few different revenue models. Some provide a cash investment up front, but require the company to rent space and equipment in their facility—usually for about the same amount of money that they invested. Others simply take an equity percentage for incubation, with defined graduation criteria. Still others charge a reduced rate for the infrastructure they provide, in return for the equity they take in the company. Some argue that this last model isn't really incubation at all, but merely a leasing arrangement in which the lessor is willing to take a partial payment in equity.

The promise of infrastructure-oriented incubators is that member companies receive huge intangible benefits through the networking opportunities existing within the incubator. Companies in the incubator are encouraged to use one another's services, contacts, and talents, in the hope that they will all succeed together. Unfortunately, such intangible benefits rarely turn out to be as valuable as they seem. Companies select vendors based on their needs and the vendor's reputation, service, and price. Being in the same building as a potential client or vendor doesn't create an automatic relationship.

A major problem with infrastructure-oriented incubators is that they focus on providing services that rarely make the difference between a company's success or failure. Very few start-ups fail because they can't find office space, lawyers, accountants, or technology suppliers. On the contrary, vendors actively looking for medtech companies are on the rise, and they usually don't need a lot of convincing to do business with those companies. Vendors may use incubators to locate new clients, but on their own many such providers of professional or specialized services do a good job of providing networking and relationship opportunities for their clients.

Of all the models for business incubation, the infrastructure-oriented approach is the most problematic. If incubation is about adding value—with both partners succeeding most when the incubator adds the maximum value to the start-up—then it is essential that an incubator add value in the areas that are most critical to the start-up's success. All too often, infrastructure-oriented incubators fail to do this. Not surprisingly, many of the recent high-profile incubator failures have been infrastructure-oriented incubators. These failures suggest that incubators of this type may be even worse for their own investors than they are for their incubated companies.

The best reason to join an infrastructure-oriented incubator is that the entrepreneurs or businesspeople involved are excited about the start-up's business, have expertise directly relevant to that business, and are willing to guarantee a certain minimum amount of their time to helping that business. But even if all these conditions are satisfied, medtech leaders should still make sure that any equity they surrender returns a fairly equivalent value of infrastructure assistance.

Funding-Oriented Incubators. Funding-oriented incubators are like mini-VCs. They invest dollars in the company in return for an equity stake. Since they are investing at such an early stage, they are usually also quite active in company operations.

Like infrastructure-oriented incubators, funding-oriented ones may provide office space and other infrastructure. The difference is that funding-oriented incubators invest much more money than they will ever take in fees.

Cash is the lifeblood of a start-up—especially in the medtech industry, where long product-development cycles and high burn rates are commonplace. For this reason alone, medtech entrepreneurs should always look seriously at accepting incubation from a funding-oriented incubator. Most funding-oriented incubators have good relationships with angel organizations and VCs, and these contacts can prove useful for a company's future rounds of financing.

Because the start-up phase of a company's development is very risky, there are not many funding-oriented early-stage incubators. In fact, the main problem for this type of incubator is that investors are becoming involved even before they know whether the start-up can execute its business plan. The main protection that such investors have in this situation is to roll up their sleeves and help the start-up execute. Investors who are not willing or able to do so will inevitably carry a greater risk of failure—a lose-lose result for both the investor and the start-up.

In terms of equity, funding at such a very early stage is always expensive. Company leaders should expect to throw away their own valuation of the company and accept something close to what the investors suggest. Such low valuations at this round help to balance the level of risk for investors. This may not be as bad as it sounds, however, as the company will then likely end up with a higher valuation at later rounds. Moreover, the founding members generally end up with about the same percentage of the company by the time it gets to an IPO or acquisition event.

Company executives should seriously consider whether such a funding-oriented incubator will be able to deliver the added value that all VCs promise. Leaders should especially look for senior people who are excited about the company's business, have expertise in that business, and are able to help with strategies and connections.

Angels and angel groups also provide cash and strategic advice to companies at this stage, and they can usually help company leaders with the challenges of executing their plan. Funding-oriented incubators, angels, and angel groups are ideal funding sources for start-up companies that are not yet ready for VCs.

Execution-Oriented Incubators. Execution-oriented incubators focus on the hard job of helping start-ups execute according to their business plans, even before the company has raised all its funds or completed its management team.

There are two main types of execution-oriented incubators. Commercialization incubators specialize in commercializing technical advances. They are often allied with universities or government R&D centers, and work with start-ups that are founded by technologists. They help to provide the business and marketing underpinnings that can help bring the start-up to success. Expert-services incubators provide top-quality technical and business support. These incubators include experts from business and technology who can make a huge contribution to the success of a start-up, but they only incubate companies in fields where the founders are domain experts. They can usually provide interim management assistance to give a start-up credibility and help it execute, but they expect that the company will itself have sufficient domain knowledge to bring it to success.

The key issue with execution-oriented incubators is determining whether the start-up and the incubator are a good fit for one another. Both sides need to determine that their contribution will be critical to success, and that together they can help the company reach new heights. If the company is a good fit and the incubator successfully fills the gaps in the management team, this can be the relationship that makes the greatest difference in a start-up's ability to succeed.

Strategic Incubators. Strategic incubators are those that have a strategic reason for wanting to incubate a start-up. For instance, they may have an interest in exploring technologies that they might later want to purchase or license, they may be seeking potential extensions to existing product lines, or they may be looking for a technology that would give them a competitive edge in the marketplace. Depending on their long-term interests, strategic incubators may or may not take an equity stake in their member companies.

The goals of strategic incubators are usually not tightly aligned with those of their member start-ups. How effective such incubators are at fostering a particular company is partly a function of how involved its management is and how effective the involvement of the team proves to be. When looking into strategic incubators, medtech entrepreneurs should keep in mind that such organizations may have a definition of success that is very different from their own.

Nonprofit Incubators. Government agencies, universities, and other nonprofit organizations run nonprofit incubators. The type and level of help they make available depends on the organization that supports the incubator.

A major advantage of nonprofit incubators is that they generally do not ask for very much in the way of equity. A disadvantage is that they are not motivated by profit, but commonly have another agenda that they are trying to accomplish. As in the case of strategic incubators, this means that nonprofit incubators can define success very differently from the companies they serve. Nonprofit incubators also tend to focus on infrastructure support and networking, which are usually not the most essential services that medtech start-ups need to succeed.

Nonprofit incubators can offer some advantages that other types of incubators do not. For instance, university-sponsored incubators may provide access to professors and students who can be a great source of advisors and employees. Incubators that focus on the development of disadvantaged areas may also be able to provide government grants or loans. As a general rule, nonprofit incubators can give companies some help without demanding too much in return.

Corporate Incubators. Corporate incubators may have many different goals that determine how useful the incubation will be for a start-up business. Some corporate incubators act as R&D resources for the corporation, while others act as an extension of the sales team.

Incubators whose goals include finding strategic technology investments for the corporation can be very valuable. Such investments often come with access to knowledgeable individuals in the corporation, sales agreements, and a possible acquisition if the start-up continues to execute or develops valuable technology or products.

Incubator programs whose goals are linked to increasing sales of the corporate parent's products are usually less valuable. They may offer discounted versions of the products and deferred payment terms, along with opportunities to network or gain press exposure. The effort to get into this type of incubation-sales program is usually much less than to get into more-complete incubation programs. For companies that would be buying the corporation's products anyway, a corporate incubator may offer an opportunity to reduce or defer costs and get additional networking and PR opportunities without excessive effort.

Finding the Right Match

"Incubators are like any product or service on the market," says Dinah Adkins, executive director of NBIA. "They come in a wide range of shapes and sizes." With so many different types of incubators available, it's hard to know which is best suited for any particular company. Although some services provided by incubators are similar regardless of type, others relate directly to an incubator's mission and goals. Incubation is highly adaptable; a successful partnership between a start-up and an incubator depends on whether the incubator can sufficiently meet the start-up's needs and foster growth.

Just as incubators screen prospective clients, so too should entrepreneurs screen prospective incubators. Medtech entrepreneurs especially need to do proper due diligence to ensure that they are entering into a partnership that will bring the benefits they need and expect. For example, many medtech start-ups, because they are faced with high development costs and relatively slow returns, depend on incubators to provide them with enough working capital to cover these costs. Some medtech entrepreneurs are so focused on developing their technology that they don't give any consideration to achieving profitability, and rely on incubators for all their marketing needs. In addition, many medtech companies partner with incubators to better their chances of getting funded by angels and VCs.

For medtech entrepreneurs, then, finding the right incubator involves being able to assess objectively their company's strengths and weaknesses. The next step is to identify incubators whose strengths make up for their company's weaknesses. When assessing their company's weaknesses, medtech entrepreneurs should look for the critical ones that can make or break their company. Most early-stage companies need legal representation, accountants, office space, and so on, but these weaknesses aren't hard to remedy. A company's real deficiencies lie in not having senior people in technology, marketing, sales, and other positions that are critical to its success.

To choose an incubator best suited to a company's needs, NBIA suggests researching the following aspects of prospective incubators.

• Services provided.
• Space available.
• Access to specific markets.
• Industry knowledge.
• Business contacts.
• Success rates.
• Policies and procedures.
• Management.

As for incubator types, medtech entrepreneurs should look for profit-oriented incubators whose strengths cancel their company's weaknesses, or strategic incubators whose goals are closest to the company's own. They should, of course, also look for incubators that have expertise in their company's field—no matter what their type.

Conclusion

Since the valuation of incubators is dependent on the success of the companies that they help develop, it is in their best interest to truly act as value-added investors. A study conducted by Dun & Bradstreet (Murray Hill, NJ) indicates that incubators well matched to their clients increase a start-up's chances of success by an average of 80–93%, compared with 20% in the general economy—a considerable enticement for a start-up endeavor. For medtech entrepreneurs looking to partner with business incubators, here are some quick tips to consider when approaching them.

• Don't exaggerate about where the company is in executing its business plan. Incubators hear a lot of hyped-up pitches, and they consider integrity and enthusiasm among the most important qualities in an entrepreneur.
• Less is more. Medtech entrepreneurs need to be able to tell their stories succinctly, and should have a short executive summary of their business plan available.

Incubators are on the cutting edge of developing new and strategic tools for early-stage success, and can afford medtech start-ups an opportunity to address specific concerns germane to their economic reality. While partnering with business incubators doesn't ensure market success, early-stage companies that find the right one are provided with the basic support that helps bring companies to life.

S. Ramesh is president and Jenny Sakhrani is CFO of Philosopher's Stone (Redondo Beach, CA), a business incubator specializing in the development of high-tech companies.

Copyright ©2001 MX