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Can Business Incubators Justify Their Existence?
They've brought hosts of startups into the world, but at what price? No one really knows

It's hard to justify public subsidies for entrepreneurs these days. After all, taxpayers now expect welfare mothers to tough it out, so why not young businesses? Congress has even taken an ax to the Small Business Administration budget.

Oddly, one kind of aid to small businesses hasn't gone out of fashion -- the incubator. Born in the 1980s after the industrial mainstays of many regions left or slashed jobs, the concept was to create tax-exempt organizations that coddle select startups with bargain rents, equipped offices (often renovated with public funds), management assistance, and connections to funding. The baby companies, which typically spend about three years in incubators, eventually "pay back" the public through taxes on their earnings and jobs.

It was a noble effort. "[Entrepreneurs] were a dynamic part of the economy that kept us alive, and incubators were thought to be part of that," says Candace Campbell, principle of CDC Associates, a Minneapolis consultancy, and former chairman of the National Business Incubation Assn., an Athens (Ohio) trade group. Laudatory press fostered that image. By 1990, 400 incubators were operating, vs. 8 in 1980.

UNTALLIED TOTAL. Today -- after a nine-year U.S. economic expansion that has spawned millions of unsubsidized small businesses -- publicly supported incubators are still going strong. The NBIA counts 627, mostly in urban areas and predominantly tax-supported, harboring 20 companies each on average. The number of incubators has grown by an average 10% annually in the last three years. The full value of public subsidies to incubators is unknown, but last year, the Commerce Dept.'s Economic Development Administration (EDA), the primary federal funding source for incubators, allocated nearly $20 million for them, nearly 45% more than in 1997.

No question that incubators give entrepreneurs a terrific deal. Who wouldn't love a break on rent and office equipment? But no one knows whether incubators are a good investment for the communities that support them. No study in over a decade has tracked incubated businesses and compared them with companies that managed on their own, say researchers who've worked in the field. The arguments for incubators are mostly anecdotal.

Why did Commerce increase incubator funding? "It was based on the opinion of the EDA that [incubators] are successful," says Renee Holmes, a Commerce spokeswoman. Incubators did come under limited scrutiny in the early 1990s, when Commerce investigated alleged misuse of funds at a leading Chicago facility. Yet, the incident never produced a comprehensive look at incubators, and their numbers have grown with little further examination.

UNIMPRESSIVE. In fairness, trying to measure incubators' success is very difficult. CDC's Campbell made a serious attempt to do so in 1987. For 18 months, she studied companies from 60 incubators to determine sales growth and job creation after "graduation," when the companies leave the incubator. A mind-boggling number of variables had to be controlled for, she says. She tracked down 75% of the businesses, which had been independent for five years on average. The results weren't impressive. "These were not high-growth firms," she says. Their revenues were $1 million or less, and median number of employees nine.

Incubator proponents have tried to quantify their benefits with limited success. In 1997, the NBIA produced a much-publicized study claiming that for every $1 in subsidy, incubators generate nearly $5 in tax revenues and a host of other public benefits. The study, which looked at 50 incubators, was produced with the University of Michigan, Ohio University, the Southern Technology Council, and the EDA. Yet, for all its heavyweight contributors, the public summary sheds little light on how the researchers reached their conclusions -- mainly because the data presented are so incomplete. The NBIA tried but failed to establish a control group of nonincubated companies.

Its main claims -- besides the $5-for-$1 return on public investment -- were that the vast majority (87%) of all incubated companies surveyed were still operating, and 85% were in the same communities in 1996. However, the report doesn't say how long the companies had been out of the incubators on average -- making it difficult to evaluate survival rates or companies' commitment to their towns. Moreover, the researchers mixed graduates with companies that were still in incubators.

Keeping small businesses alive for a few years isn't an exceptional feat, contends Paul Reynolds professor of entrepreneurial studies at Babson College in Wellesley, Mass. Ninety percent of new businesses survive their first year. The remainder close for a variety of reasons -- not necessarily because they failed.

SELF-EVIDENT? The study's claim that incubators produce $5 in taxes for every dollar of public subsidy is also puzzling. The ratio is based on estimated tax revenues generated by 23 companies -- not actual taxes paid by companies in the 50 incubators. Even so, few small businesses are profitable in their first few years, so they don't pay much tax. Nor do incubators, because they're mostly nonprofit entities, points out Peter Bearse, president of Development Strategies Corp., a Gloucester (Mass.) consultancy that specializes in entrepreneurial development projects. Bearse wrote a scathing critique of the NBIA report, citing it for sloppy data collection and analysis.

Dinah Adkins, the NBIA's executive director, says it's not necessary to do comparative studies to see the benefits of incubators. "I think that we can see that on the ground even without the research," she insists, citing such examples the Enterprise Center in West Philadelphia and the Franklin Business Center in Minneapolis, which attracted private investment to once-desolate inner-city areas. As for the tax revenue-to-subsidy ratio, she says most incubators have some profitable clients, and the employees of incubated businesses pay taxes.

Critics of incubators say the basic flaw of most is that they need regular injections of public cash. But some incubator directors have tried different models. Della Clark, president of the Enterprise Center in West Philadelphia, raises money for operating expenses from the private sector. This year, only 10% of her $1 million budget comes from public subsidies. Bela Musits, director of the Rensselaer Polytechnic Institute Incubator Program in Troy, N.Y., tries hard to connect its businesses to angel and venture-capital investors.

PEAPOD'S STORY. There's another nagging question about incubators. If they dramatically improve a small business' chances for success, it would seem likely that in the last 20 years, at least one would have produced a large, profitable company. The big success story incubator proponents point to is Peapod, the online grocery store. Peapod operated at the Technology Incubation Center in Evanston, Ill., which is affiliated with Northwestern University, from 1989 to 1996, more than twice the time most businesses stay in incubators. It went public in June, 1997, and had $60 million in revenues in 1998. It has yet to post an annual profit. Peapod employs about 1,200 people nationally and 400 in the Chicago area. It didn't stay in the town that fostered it, though. Faced with doubling rent, Peapod left Evanston for cheaper Skokie as soon as it graduated.

Andrew Parkinson, president and chief executive of Peapod says the chief benefit of the incubator was "office space at very cheap rent" and the moral support from other startups. Access to Northwestern University's mainframe computers was also a plus. "It was a nice way to tap [university] brain power," says Parkinson. TIC's prestige also gave Peapod credibility when it approached Jewel Foods, its first supplier and now an investor. TIC "enhanced our ability to get through the startup phase," Parkinson says.

Perhaps the current incubator model needs some updating. Development Strategies' Bearse says incubators can ultimately become self-sustaining enterprises if they are planned as real-estate development projects that get an initial public subsidy for building renovation. After that, they'd be on their own. Under this scheme, incubated startups would pay something, say discounted fees, for services that are now free, for example. But until incubators can prove that they do give back to taxpayers more than they take, questions surrounding their ultimate effectiveness will persist.

By Jeremy Quittner in New York



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