Incubation in Entrepreneurial Ecosystems

3. Why does policy support incubation?

Abstract

Governments are important funders of business incubation. Indeed, many incubators are either run by public entities or rely upon public funding as a primary source of funding for their operations. This chapter explores the rationale behind public support for business incubation by setting out the mechanisms through which incubators stimulate startup and scaleup activity, the available evaluation evidence on their effectiveness, as well as the different market failures that result in a sub-optimal supply of incubation supports in the absence of policy intervention.

How incubators facilitate startup and scaleup development – transmission channels

It is well-documented in the academic literature that newly created ventures suffer from a so-called “liability of newness”, which refers to the acute challenges that startups face in obtaining the external resources, information, and connections needed to develop and grow (Stinchcombe, 1965[1]). The result is that most new business ventures fail and exit the market (Aldrich and Martinez, 2003[2]).

Business incubators provide a range of supports and services to young companies, in effect acting as “sponsors” for these organisations. Incubators aid the development of startup companies via two key channels (Amezcua et al., 2013[3]):

• Buffering: In order to develop a nascent business, particularly at the pre-revenue stage, founders require the financial capital to fund their businesses’ operations as well as the knowledge and entrepreneurship skills needed to plan and execute them effectively. For example, entrepreneurs need to have a good understanding of relevant markets and regulations (Vincent and Zakkariya, 2021[4]), as well as an ability to seize market opportunities (Bingham, Eisenhardt and Furr, 2007[5]), build a strong reputation and credibility (Zott and Huy, 2007[6]), and develop and maintain networks (Stegbauer, 2019[7]). Few startups are endowed with these resources internally from their inception, which means they have to be acquired externally – something that many early-stage ventures are not yet capable of doing. As a result, a lack of financial capital, entrepreneurship skills, and knowledge constrain the development of startups and scaleups and cause many to close down.

  By providing subsidised access to physical facilities, training, support services and peer learning opportunities (Gonzalez-Uribe and Leatherbee, 2018[8]), incubators reduce startups’ early dependence on external resources and enable them to develop their internal knowledge and skills. This serves the function of “buffering” young companies from dependencies on external resources that they are not capable of acquiring independently (Amezcua et al., 2013[3]).

• Bridging: Incubators act as a “bridge” between new ventures and the wider entrepreneurial ecosystem, providing access to external resources, social capital, and legitimacy by connecting their clients with actors such as investors, research institutions and large corporates (Woolley and MacGregor, 2022[9]). This “bridging” role is performed by organising events and through active introductions and matchmaking, among other things (van Rijnsoever, 2020[10]).

In this way, incubators simultaneously work to reduce their clients’ initial dependence on external resources while also building their capacity to eventually acquire them.

Evaluation evidence on incubator impacts

The previous section presents the theoretical transmission channels through which business incubators can support the development of startups and scaleups. This section turns to the available evaluation evidence on the impacts of incubation to explore whether the theoretical benefits of incubation are borne out in practice. This is particularly important to ascertain given the significant sums of public money that go into funding incubation (Part 3 of this publication delves more deeply into this topic) and the consequent need to demonstrate value for public money (OECD, 2023[11]).

Despite the growth of incubation as a model for supporting young companies, the evidence base on the impact and efficiency of these programmes is still somewhat underdeveloped. This is partly a reflection of the relatively recent emergence of some incubation models (Cohen and Hochberg, 2014[12]) and partly a reflection of the numerous challenges associated with conducting reliable evaluations on incubators’ impacts (OECD, 2023[13]; Pompa, 2013[14]). These include difficulties monitoring the performance of firms once they leave the incubators, identifying suitable control groups of comparable firms outside of the incubation programme, and a lack of clearly defined programme objectives, which complicates the identification of success metrics. The highly specific nature of incubation programmes and contexts also mean that evaluation studies can have limited external validity.

With that being said, the literature is expanding, and there are a growing number of reliable evaluation studies that have sought to determine the impacts of business incubators, both at the firm-level and the ecosystem-level. Most show that participation in incubation programmes improves startups’ growth performance with respect to employment and revenues (Lasrado et al., 2016[15]; Bone et al., 2019[16])), though these growth increases are often found to fade in the longer-term (Amezcua, 2010[17]; ISED, 2024[18]).

Other studies explore how participating in incubation programmes can help with bridging startups’ financial capital constraints. For example, a study focusing on nanotechnology firms in the United States finds that participation in private incubators improved the likelihood of companies obtaining a government grant or venture capital funding (Woolley and MacGregor, 2022[9]). By comparing firms participating in acceleration programmes with similar firms that were close to being accepted in the same programmes, (Hallen, Cohen and Bingham, 2020[19]) find that companies in accelerators experience better long-term outcomes with respect to funding, as well as other metrics such as employment growth and web traffic. (Hoffman and Radojevich-Kelley, 2012[20]) also find that mentorship-driven acceleration programmes increase startup success rates by providing access to angel investors and venture capital.

The evaluation evidence paints a mixed picture on the impact of incubators on the survival rates of their clients. Some studies find that incubator participation reduces the chances of firms’ closing (Woolley and MacGregor, 2022[9]), while the finding of (Barrows, 2018[21]) that receipt of a competition prize increases the probability of startups’ survival by 64% sheds light on the potential effects of the direct funding provided by some incubators. However, other studies conclude that firms in incubators have lower survival rates or exit earlier than non-incubated companies (Amezcua, 2010[17]; Schwartz, 2013[22]; Yua, 2020[23]). A likely reason for why firms in incubators might exit more quickly than other startups is that, through the access to the mentors, investors, and testing facilities that incubators provide, founders more quickly obtain the information necessary to determine whether to continue with or step away from a business venture (Yua, 2020[23]; Amezcua, 2010[17]).

Evaluation evidence underscores the importance of incubation programme design and delivery choices in determining impacts. In a study of 117 accelerators, (Chan, Patel and Phan, 2020[24]) find that between 11% and 14% of the variation in startup performance can be attributed to differences between programmes. Interestingly, differences between countries or industries had only a minor effect on startup outcomes, highlighting the primary importance of programme design. The existing evaluation evidence base provides some useful insights on types of programme approaches that can deliver the greatest benefits. (Gonzalez-Uribe and Leatherbee, 2018[8]) find a positive effect of support programmes only when they include an entrepreneurship training component. They estimate that participating in a programme that includes entrepreneurship schooling increases the probability of securing additional financing by 21%. This effect does not hold in programmes that only provide cash or coworking space without any other support. These results can be interpreted as evidence that incubators are effective when they contribute to building founders’ managerial capital through entrepreneurship training. Similarly, (Hallen, Cohen and Bingham, 2020[19]) conclude that learning is the key mechanism through which incubators can stimulate improved firm outcomes. The research highlights the importance of broad and intensive consultation with third parties, which prevents entrepreneurs from exploring opportunities with a low likelihood of bearing fruit. (Hallen, Cohen and Bingham, 2020[19]) also find some evidence of a “Hawthorne effect” whereby founders work harder when they are on accelerator programmes, with an increased share of founders within accelerators working full-time on their enterprise.

The measured impacts of incubation programmes also could be attributable in part to signalling effects that reduce uncertainty surrounding new ventures, rather than solely the effects of the concrete supports and services provided by the incubators. Admission onto prestigious incubator programmes can be interpreted as a badge of a quality for the startup, facilitating greater engagement from other potential partners, including investors (Kim and Wagman, 2012[25]). However, the evidence on the strength of signalling effects is mixed and there is not a consensus on this issue. (Howell, 2020[26]) finds that winning a new venture competition increases the chances of a startup receiving external financing by approximately 35%, which provides an indication of how positive signalling can address the information asymmetries that so often constrain startups’ access to financial capital. However, (Hallen, Cohen and Bingham, 2020[19]) find that the level of knowledge on the history of entrepreneurs participating in acceleration programmes does not have an attenuating effect on the accelerators’ impact.

Beyond delivering direct benefits to their client firms, incubators also contribute to the broader entrepreneurial ecosystem. As noted, incubators play an important role in reducing information asymmetries on new startups and providing a form of quality assurance for other actors in the entrepreneurial ecosystem. (Goswami, Mitchell and Bhagavatula, 2018[27]) also find that incubators strengthen ecosystem actors’ commitment to the regional ecosystem and in accelerating the failure of low potential ventures. Meanwhile, (Fehder and Hochberg, 2014[28]) show that the presence of accelerators in a region increases the supply of venture capital both for firms inside and outside of the accelerators. A mechanism for this could be that increased investment activity around accelerators may also increase the exposure to investors for non-accelerated companies in the area.

To summarise, evaluating the impact of incubation programmes remains a complex task, complicated by the variability in programme objectives, methodologies, and contexts. The evidence suggests that the success of incubation programmes is heavily influenced by factors such as programme design, the quality of mentorship, and the characteristics of the participating firms. There is also some evidence of positive spillovers from programmes on the ecosystem as a whole, meaning that impacts spread beyond the individual firms supported. Further evaluation will be crucial in developing a clearer understanding of the impact of incubation programmes and the mechanisms behind this.

Market failures affecting the supply of incubation

There is a strong rationale for public support to incubation programmes to fill gaps where the private sector is not active. Public policy can help address barriers to startup and scaleup development by intervening where there is an insufficient offer of incubation and acceleration services and by upgrading its own publicly supported services in line with recent trends. While private entities can and do deliver effective incubation programmes to certain types of startups and scaleups, public support is often needed to help “weak but promising ventures” (Tavoletti, 2013[29]; OECD, 2022[30]). Public support is essential especially for incubation outside the main global innovation hubs, where the private sector is less likely to operate.

The rationale for policy support for business incubators is underpinned by a number of market failures, which, in the absence of policy intervention, could result in an undersupply of incubation supports and services. These are outlined below:

• Underinvestment in innovation. Business incubators support the development and commercialisation of innovative new technologies, products and services. These types of innovation activities often create positive spillovers for other entities beyond than those making the initial investment (Martin and Scott, 2000[31]), resulting in underinvestment by the private sector due to the difficulties associated with fully internalising the returns. Public support for incubation systems is one way of helping to drive up levels of investment in innovation towards socially optimal levels.

• Underinvestment in new companies. Startup companies based on the development and deployment of novel technologies often pass through an extended pre-revenue stage where they face high capital requirements (McAdam and Marlow, 2011[32]). Information asymmetries between investors and investees surrounding the strength of an investment opportunity result in funding gaps, both in debt and equity markets, whereby the amounts of risk capital invested are below the levels that would exist in a context of competitive markets and no information asymmetries (Lerner, 2002[33]; Wilson, Wright and Kacer, 2018[34]).1 These funding gaps are particularly acute for innovative, young companies without an established track record, limited collateral, and for whom the potential returns on investment are highly uncertain given the relatively unproven nature of their products, services or business models. Even venture capital investors that specialise in funding early-stage companies suffer from significant information gaps (Howell, 2020[26]). Recently this issue has become more serious as technology has lowered barriers for entrepreneurial entry, increasing the level of uncertainty about startup and scaleup quality (Ewens, Nanda and Rhodes-Kropf, 2018[35]). In innovative entrepreneurship, the founders themselves often do not know the intrinsic quality of their venture, how the market is going to react to the marketed innovation, and the expected revenue flow. Information about the probability of success of a startup therefore has economic value for both founders and investors (Arora and Fosfuri, 2005[36]).

  Incubators address the information gaps that result in underinvestment in new companies by testing a business idea rapidly and informing founders and investors about its feasibility and probability of success (Yua, 2020[37]). Business incubators can also alleviate financing gaps for early-stage ventures directly through the provision of grants, loans or equity investment, as well as through supports to build the investment readiness of their clients (see Chapter 7).

• Underinvestment in business support services. Startups and scaleups face imperfect information surrounding the potential benefits of business support services, resulting in some not seeking assistance even where the benefits outweigh the costs (OECD, 2022[30]). Business support services are a core feature of incubators’ value offering, and by subsidising incubation, governments can address the imperfect information-induced market failure that results in a less-than-ideal number of startups and scaleups accessing vital supports. Incubators can also help their clients to become more aware of their knowledge and skills gaps and connect them with experts who can address these.

• Ecosystem spillovers. As well as supporting their clients’ development, the actions of incubators also generate positive spillovers for other actors in the entrepreneurial ecosystem, creating a rationale for public intervention. For example, incubators play a role in extracting information about the quality of ventures (Barrows, 2018[21]), in accelerating the failure of low potential ventures (Goswami, Mitchell and Bhagavatula, 2018[27]), and in attracting private investors to the ecosystem (Fehder and Hochberg, 2014[38]). Incubators also serve a critical networking function within entrepreneurial ecosystems. Deep and well-functioning networks of investors, research institutions, talent, corporations and startups have been integral to the emergence of some of the world’s leading entrepreneurial ecosystems, the most famous example being Silicon Valley in the United States. While a confluence of serendipitous factors can trigger the organic development of such networks in some contexts, network failures in other contexts can result in the non-appearance of what would be profitable and productive networks (Schrank and Whitford, 2011[39]). Incubators’ role as ecosystem bridges and connectors can therefore help to overcome network failures and thus boost the overall functioning of the entrepreneurial ecosystems in which they are situated.

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Note

← 1.  The venture capital business model seeks to overcome these informational asymmetries through close monitoring and careful selection. However, venture capital markets in many countries remain relatively underdeveloped. Even where venture capital markets are more sophisticated, they can still fail to finance investment-worthy businesses due to a variety of factors such as rational herding or the relatively higher transaction costs associated with smaller scale investments in early stage ventures (Devenow and Welch, 1996[40]; Jaki and Molnar, 2021[41]; Harding and Cowling, 2006[42]).