fedgazette

Incubating economic development

Fast becoming a popular tool for local economic development, incubators' long-term impact less obvious

Jane Brissett - Contributing Writer

Published November 1, 2001  |  November 2001 issue

Brookings, S.D., probably isn't on the "A" list of many entrepreneurs starting technology-based companies, but Alex Kahler liked what he saw in 1988 as he was about to start his business, Biogenetic Services Inc.

South Dakota had—and continues to have—no state corporate tax or personal income tax. South Dakota State University offered the promise of workers with the educational background needed by the company, which does genetic testing of plants.

And perhaps the icing on the cake was the city's new business incubator, a building that once housed an automobile dealership. It had space for the two 2,000-square-foot laboratories Kahler needed and the price was right. Rent on the building, bought with federal and city tax dollars, was $3 per square foot in the incubator. The space he'd considered at Iowa State University was $18 per square foot.

"You can be very competitive in that kind of environment," said Kahler, a plant geneticist.

Definitions vary, but according to the National Business Incubation Association, true business incubators are more than buildings. They offer shared office services, access to equipment, flexible leases and expandable space. They also help start-up firms survive and grow by providing access to financing, management assistance and business or technical support services. "The goal is to develop strong companies and get them up to speed faster," said NBIA Executive Director Dinah Adkins. Often, however, incubators need and receive public assistance to get started or with ongoing operations.

Kahler's businesses, which now also include Identity Genetics, a human genetic testing company started in 1992, stayed in the Ron Reed Economic Development Center incubator for 10 years. That's far longer than the usual three- to five-year time frame most incubators allow. Kahler said he'd have built his own building, but he didn't know how to go out and get the money he needed.

It turned out that being in the incubator allowed the firms to survive some tough times. In 1993 Kahler sold controlling interest in Biogenetic and Identity Genetics and in 1995 bought it back after the new owner had financial problems. That's when having the low overhead really helped, he said, because he needed every penny in order to refocus the company. Today the companies rent space at market rate in a city-built building. They have about 65 highly educated employees recruited from all over the nation.

Kahler's story sets up economic arguments both for and against publicly subsidized business incubators, which are becoming a popular local tool for economic development. Advocates can point to the fact that Kahler's companies were given an opportunity to grow and stabilize in the incubator, rewarding the community with strong companies that provide good-paying jobs—a home run in the world of economic development.

But economists would argue that incubators shelter a chosen few from the economic reality of market competition, creating an unfair playing field and providing competitive advantages to a few lucky entrepreneurs. The question then becomes: Why give that edge to some and not others? And if it can't be given to all, should it be given to any?

Incubating growth

The nation and Ninth District have seen strong growth in incubators over the last two decades. Most are nonprofit or quasi-public and typically receive some government assistance along the way. In 1980, the NBIA counted only 12 incubators in the nation; today there are more than 900. In the district, Wisconsin claims 30 incubators; Minnesota, 28; Montana, about 10; North Dakota, 6; and South Dakota, 4.

The justification for such growth is rooted in the fact that most new businesses don't survive, and communities are looking for ways to improve the success rate of local businesses. The Small Business Administration (SBA) has put the failure rate for all new small businesses in their first five years at 80 percent, although some experts believe that is too high. Nevertheless, starting a new business is undisputedly a huge gamble.

The NBIA reports that incubated businesses do much better than nonincubated firms. In a 1997 survey of members, a compilation of responses showed 73 percent of all companies graduated from an incubator were still in business. But the higher success rate might be due in part to the screening process most incubators have to admit companies—businesses that don't appear to have a fair chance of success can simply be passed over. The NBIA also doesn't track the number of companies that fail while in incubators, which would be a better comparison of success rates between incubated and nonincubated start-ups.

Technology focus growing

Like the majority of business incubators in the Ninth District, the Ron Reed Economic Development Center is rural and not for profit. The city owns the building, but the incubator is an independent nonprofit entity that pays the city $12,000 a year generated by fees and rentals. Supporters say the incubator complements business recruitment and workforce development efforts by other agencies in the area.

"The incubator is a very small part of the Brookings economic development world," said Executive Director Richard Smith.

A growing number of business incubators focus on nurturing technology businesses similar to Kahler's, the NBIA says. In North America, 40 percent are technology-oriented, 30 percent are geared toward other uses such as manufacturing or retail and 30 percent are mixed use.

Compared with other economic development programs, incubators appear to be an inexpensive way to create jobs. Very little research exists on incubators; one study of Michigan incubators from 1985 to 1995 by University of Michigan business professor Larry Molnar concluded that the average cost per job created in an incubator was about $1,100. That's compared to about $10,000 per job created via other public support mechanisms. The NBIA also argues that incubators benefit their communities by helping to diversify economies, commercialize technologies, create jobs and build wealth.

But exactly how much impact incubators have is an open debate. NBIA figures show that in the past 21 years North American incubators have helped 19,000 companies that are still in business and those firms have created 245,000 jobs.

In the context of this nation's business growth, however, those numbers are fairly meager. In 1999 alone, 151,000 businesses started up in the United States, according to the Statistical Abstract of the United States. Labor Department figures show employment grew by 1.7 million jobs that year. Assuming a 20 percent success rate (per the SBA estimate), 30,000 of the companies created that year will survive—or better than 50 percent more than were nurtured in incubators over 21 years on the whole continent.

Incubators also proliferated during the 1990s against a background of flourishing entrepreneurship. From 1992 to 1998, according to Census Bureau reports, the number of firms increased in each of the Ninth District's states—from a low of 4.8 percent growth in North Dakota to a high of 18 percent in Montana.

Wisconsin snapshot

Public resources are often involved in incubator programs as well. The U.S. Economic Development Administration has given out about $11.5 million for 13 incubator projects in the Ninth District since 1990, with local agencies contributing another $9.2 million to those projects. State and local governments have contributed additional millions to incubators as grants, loans and occasionally equity investments.

A 1999 survey of 25 of the Wisconsin Business Incubation Association's 30 members showed the average start-up cost of an incubation program was $967,710. Fifty-eight percent of the incubator buildings were retrofitted rather than built new. The most frequently cited funding sources were local government, the EDA, private banks, state programs and other federal programs.

Two of the respondents, or 8 percent, were for-profit incubators. The others were controlled by some form of not-for-profit entity, 88 percent of which did not take equity positions in their tenant companies. More than half of the programs said they broke even, while 38 percent reported receiving an annual operating subsidy from sponsors or owners of cash or in-kind services—but the report did not say how much. Twenty-two incubators said that since inception they had graduated 374 businesses.

During the past few years, for-profit incubators were the hot new trend, especially on the East and West coasts. Many were formed by "new economy" investors. The idea was to get companies up and running in a matter of months rather than years. As that craze cooled, a significant number of incubators folded, both nationally and regionally.

"Huge numbers of people—people with money—decided they were going to start up incubators and take an equity stake in these small companies," said Adkins of the NBIA. "It was a gold rush." In December 2000 the NBIA estimated 350 for-profit incubators were in existence; today that estimate has shrunk to fewer than 200.

Profit-making incubators are nothing new, though. Control Data Corp. formed a for-profit incubator in St. Paul in 1979. The idea of nurturing young companies for profit is usually to sell them, exploit a new technology developed by an entrepreneur or develop real estate.

Incubators that seek to make profits, however, are typically real estate deals and don't do much for the young businesses, said Michael Luger, director of the Office of Economic Development at Kenan Flagler Business School, University of North Carolina at Chapel Hill.

That's precisely why John Risdall, CEO of Risdall Linnihan Advertising of New Brighton, Minn., said his firm's venture capital fund established a for-profit incubator without a building and the services normally touted as necessary for success. "I guess we're not interested in helping [entrepreneurs] sharpen their pencils," he said. "We're interested in, 'Can we move the needle on the revenue stream?'" The fund has done early-stage investing in about two dozen companies since 1972, 10 of which are up and running, Risdall said.

The concept is this: By providing general operating intelligence to high-tech, environmental technology and medical technology companies, or by enlisting assistance, Risdall Linnihan cultivates the businesses. It earns profits when it sells its equity stake or the business goes public. Many don't survive but those that do make up for the losers, at least in theory.

For-profit incubators in the Ninth District have clustered in the Twin Cities area. In a report last February, the Minnesota Department of Trade and Economic Development found that the state's 28 business incubators were evenly split between for-profit and not-for-profit. Of the state's 14 for-profit incubators, 11 were located in the metro area, while only five of the 14 nonprofit incubators surveyed were in the Minneapolis-St. Paul area.

Not-for-profits

Economic developers tend to see not-for-profit incubators as a way to give businesses a leg up and to do some social good, especially in economically distressed areas. Most of them—whether run by independent nonprofits, government, universities, colleges or public-private collaborations—operate on a shoestring.

"We operate very guerilla style," said Bruce Davis, president and CEO of the Northwest Enterprise Center Network in Spooner, Wis., which has created a handful of incubators in northwest Wisconsin since 1994. "We operate just enough just-in-time technical assistance."

The organization has invested $7 million in real estate, 60 percent of which was public money. It has a $5 million loan fund available to incubator businesses and others, as well as a $2 million for-profit venture fund. "In relative terms, we have invested very little money," Davis said.

The Network doesn't track graduates, but Davis asserted that without that investment, the 10 counties of northwest Wisconsin would have seen fewer businesses born, fewer expansions take place and slower growth of the companies that did survive. Davis said 80 young firms are being incubated by the Northwest Enterprise Center Network, 30 of them in the network's incubator buildings.

Cruel markets

But businesses that grow in publicly subsidized incubators are coddled and that's unproductive, said Doug Johnson, director of the New Business Development Enterprise at the University of Minnesota's Carlson School of Management. "The capital markets are cruel," he said. "Incubators are designed to address market failures. In my opinion, all they do is prolong the agony for those [businesses] that should not exist."

Attractive businesses will be funded by private sector investors, he said, while "government agencies don't like to see anybody fail so they throw good money after bad."

Luger agreed. He is co-author of Technology in the Garden: Research Parks and Regional Economic Development, a 1991 book that argued the only economically viable business incubators are associated with colleges and universities. In university research parks, he said, top-notch brainpower is available and the costs of developing technologies can be somewhat muted.

He still holds that view, although he added that incubators striving for nonmonetary long-term goals—such as creating an entrepreneurial culture within a neighborhood or region—might be worth spending public money on if that's what taxpayers want.

How helpful?

It's unclear how well rural, not-for-profit incubators are prepared to help fast-growing, innovative companies outside metropolitan financial centers. Johnson joins a chorus of private investors who say government and nonprofit incubator employees don't have the background and experience to advise businesses, especially those on the cutting edge of technology.

A case in point may be Meridian Environmental Technology Inc., which has grown up in the University of North Dakota's Rural Technology Incubator in Grand Forks, the very kind of incubator Luger found most efficacious. Meridian's revenue is close to $2 million a year and payroll is more than $1 million. But recently the company has had difficulty finding space and money.

The customized weather forecasting company with 30 employees has outgrown the incubator and needs a new home. The business was formed in 1998 to commercialize research activity at the university. Based on the new technologies, Meridian's services include route-specific weather forecasts and road conditions for highway departments, businesses and travelers.

Proximity to the university and flexible space without a long-term lease were some of the advantages owner Leon Osborne saw in the incubator. He is a professor of atmospheric sciences at UND.

Late last summer he was looking for new facilities wired for technology with a reliable power supply, appropriate networking that can accommodate custom-designed work stations and room for future growth. Osborne said that kind of space is difficult to find in the small community.

The 5-year-old incubator is working hard to stimulate an entrepreneurship culture, Osborne said. But his association with it and the university didn't help him find financing, he said. Local lenders apparently didn't see the business as able to compete despite a head start in the incubator.

If his wife hadn't worked for a bank for 18 years, Osborne didn't think he could have found any money at all in Grand Forks. He was successful, finally, and Meridian is financed entirely by debt, Osborne said.

Now that he's looking for equity investors to throw in "seven to eight figures" for a major expansion, the situation is even bleaker. North Dakota investors are almost nonexistent and the big city-types aren't interested. "The words technology and North Dakota in the same sentence turns people off," Osborne said.

Meridian is just one company, but the paradox is that creativity and innovation are exactly what incubators hope to encourage, and providing access to financing is generally considered part of the mission.

While he's quick to point out that the incubator has been a good place for his company, Osborne said he wonders if incubators are up to the challenge of helping cutting-edge companies. "We present a very unique challenge to incubators and I don't think they know how to deal with us," he said.

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