Incubation in Entrepreneurial Ecosystems

7. Financing

Abstract

Access to finance is one of the main development bottlenecks for innovative startups and scaleups. This chapter examines how incubators support their clients in overcoming financing gaps. This is achieved both through the direct provision of funding and subsidised services and facilities, as well as through helping their clients to tap into external financing opportunities by building investment readiness. The chapter concludes with recommendations for governments on how to enhance the role of incubators in alleviating startups and scaleups’ financing gaps.

The startup and scaleup finance gap

Creating a new business, particularly one based on the development and deployment of novel technologies, is generally a capital-intensive endeavour. Innovative startups must often pass through a protracted pre-revenue stage where they face high capital requirements to develop new products, services or technologies that cannot be met internally (McAdam and Marlow, 2011[1]). As a result, they quickly reach a point where they need external financing in order to continue to develop and grow (Oranburg, 2020[2]).

Across the OECD, one of the major development bottlenecks for highly innovative and impactful new companies is a limited access to external finance. This stems from market failures inherent to the nature of innovative startups and financial markets. There are informational asymmetries in the relationship between an entrepreneur and investor, with the former possessing much more detailed knowledge on their business than the latter (Akerlof, 1970[3]). It can be challenging for investors to accurately assess the risk and potential returns of investing in new companies, particularly where these companies are based on innovative or disruptive technologies and lack an established track record. In addition, innovative startups generate positive externalities by producing knowledge and technologies that can eventually be utilised throughout the economy (Martin and Scott, 2000[4]). This leads to a mismatch between the private and social returns of investment. There is also the challenge that some countries and regions do not have investors large enough to provide the substantial sums of scaling finance often required by more advanced startups and scaleups. Investors specialised in particular technology areas or sectors are also absent in many countries, depriving innovative companies of the supplementary benefits that come from working with such investors such as specialised expertise and contacts. The consequence of these factors is that startups and scaleups – particularly those that are innovative and based on new technologies – commonly experience acute financing gaps.

How incubators bridge financing gaps

In recent decades, there has been a growth in the number of high-tech, knowledge-intensive startups for whom access to finance is a critical development need (Grimaldi and Grandi, 2005[5]). Incubators have adapted to this need by funding their clients directly and by intensifying support to help their clients access external sources of finance. This financing assistance is a core part of incubators’ value offer and is potentially an area where incubators could do even more – in a survey of business incubator clients in the United States, “funds, capital and investment” was identified as the most inadequate aspect of the programmes’ supports (Lange and Johnston, 2020[6]).

Direct funding by incubators to startups

Many incubators provide direct funding to their clients. This funding can take many different forms. For some business incubators, making investments into client enterprises represents the core of their business model, and as such these organisations serve jointly as investors and business support providers. (Allen and Mccluskey, 1991[7]) denote these incubators as “for-profit seed capital” incubators within their typology of different incubator types, which originate from fund managers’ desire to co-locate their portfolio firms in a single location to increase visibility. Incubators’ equity investment deals can be structured in different ways, as described in Table 7.1 below.

Table 7.1. Equity investment models for incubators

Name	Description
Fixed cash to equity ratio	Incubators provide a fixed sum of cash to incubated startups in exchange for a fixed equity participation. For example, Startup Bootcamp, invests USD 15 000 to each startup that it admits in return for a fixed 6% equity participation, while the European Seedcamp invests EUR 200 000 for a 7% equity stake.
Simple Agreements for Future Equity (SAFE)	SAFEs are convertible equity instruments that give investors the right to purchase shares in the company at a future funding round, typically at an agreed discount. An example of this approach can be found in Y-Combinator, which invests USD 500 000 in each admitted startup. USD 125 000 of this investment is in return for a fixed 7% equity participation and USD 375 000 is in the form of a “Most Favoured Nation” (MFN) Simple Agreement for Future Equity (SAFE). The MFN clause gives Y-Combinator the right to participate on the same terms as future SAFE investors in the event that the later investors obtain a more favourable agreement.
Convertible notes	Convertible notes are similar to SAFEs in the sense that finance is provided in exchange for participation in a future funding round. However, they differ in the sense that convertible notes have an interest rate (payable in equity at the future funding round) and a maturity date at which point the investor can extend the note or request repayment. Techstars’ accelerators, for example, invest USD 120 000 in each of its startups, out of which USD 20 000 of investment is in return for the right to 6% in common shares and USD 100 000 is in the form of a convertible note.
Discretionary or ad-hoc investments	There are business incubators who make equity investments into their client startups on a more discretionary basis, either during or after their participation in the incubation programme. For example, the Plug and Play Tech Center does not require startups to cede equity as a condition for participating in its accelerator programme but it does have a venture team that invests into the programme’s startups.

Business models based on providing equity to clients are typically associated with private incubators. With that being said, public incubators may still provide direct financial assistance to their clients, though this is more likely to be in the form of smaller grants and loans rather than equity investments. Examples include the EUR 15 000 tax free allowance awarded to participants of Enterprise Ireland’s New Frontiers programme, the grant support directed to startups via incubators supported through Israel’s Technological Incubators Programme, and the EUR 20 000 grants offered by the Bravo Innovation Hub in Italy. University-based incubators can also provide grant support to their startups, often leveraging the universities’ financial resources.

Building investment readiness

In very mature and well-developed entrepreneurial ecosystems with a strong pipeline of investible startups, it is more viable for business incubators to make equity investing a core element of their business model. However, a core function of an incubator is to support “weak but promising ventures” that may not yet make for a viable investment. Furthermore, incubators often operate in areas or sectors with less advanced entrepreneurial ecosystems and therefore a weaker pipeline of investible companies. In addition, many incubators operate with public funding support, which may be relatively limited and have tight controls in terms of the types of expenditure permitted. In these contexts, it might not be viable for incubators to channel large amounts of direct funding support to their clients. This does not, however, mean that the incubators cannot still support their companies in bridging financing gaps.

Though an important source of assistance for firms at the early-stage, direct funding from incubators can only go so far in supporting startup companies as they develop and grow. Alongside finding customers, securing external finance is a defining challenge for innovative young companies. Incubators can be seen in a sense as “startup clearing houses” for venture capital and institutional investors, since these entities are often the exit partners of their graduate companies (Carayannis and Von Zedtwitz, 2005[8]). A central task for business incubators is therefore to give their clients the knowledge, characteristics, competencies and connections necessary for them to be “investment ready”, defined by (Douglas and Shepherd, 2002[9]) as “the ability to attract significant external investor funding from business angels and/or venture capital funds”. Incubators’ strategies tend to focus on equity investors rather than external debt providers such as traditional banks. Although the cost of external debt is generally lower than external equity, equity investors provide an array of additional benefits that make them a preferred option for startups, including networking opportunities, mentorship, and marketing, managerial or technical advice (Vaznyte and Andries, 2019[10]; Oranburg, 2020[2]).

Investment readiness is a multifaceted concept that captures the broad set of criteria that investors consider when making investment decisions. This includes factors relating to the startup’s product and business model, such as the technological readiness level, product-market fit and sales track record (Douglas and Shepherd, 2002[9]; Westerik, 2014[11]). However, while the nature of the product is of primary importance for investors, difficulties in assessing the commercial potential of often complex technologies means that investors may turn to more easily-interpretable signals such as the characteristics, experience and management competencies of the entrepreneurs and leadership teams behind the startups (McAdam and Marlow, 2011[1]; Westerik, 2014[11]; Douglas and Shepherd, 2002[9]). Attracting investment requires startups to have a clear understanding of investors’ investment criteria and how they stack up against these (Douglas and Shepherd, 2002[9]; Queen, 2002[12]). (Mason and Kwok, 2010[13]) extend the concept of investment readiness to take into account not only the underlying attributes of the entrepreneurs and their companies but also the entrepreneurs’ awareness and perceptions of different financing options and their ability to communicate information effectively to investors. On the former point, reluctance to surrender control of a business or a lack of investor connections are common obstacles for companies in securing equity investment. There can also be situations where entrepreneurs fail to secure financing even when their underlying business proposition is viable due to a poorly constructed or presented business plan (Mason and Kwok, 2010[13]; Clark, 2008[14]; Queen, 2002[12]). Investors can interpret such presentational failings as a signal of a broader gap in sales or communication skills (Clark, 2008[14]). It is also important for funding applications to be submitted in the correct format given the high volume of applications received by investors, with concise executive summaries being a crucial element (McAdam and Marlow, 2011[1]).

Building firms’ investment readiness involves several components (Mason and Kwok, 2010[13]; Mason and Harrison, 2001[15]):

• Initiatives to raise awareness of equity financing opportunities and their benefits.

• Diagnostic assessments of startups’ investment readiness in order to identify current issues or weaknesses.

• Programmes to build investment readiness and address issues identified through diagnostic assessments. These should include support in developing robust business plans with credible information (Zana and Barnard, 2019[16]). Other important topics include market validation, financial planning and future product development. Incubators should also support their clients in understanding the criteria that investors consider when making investment decisions and how to meet these. Furthermore, incubators can direct their clients to other forms of business support as a means of bolstering investment readiness, such as innovation grants.

• Support in preparing investment pitches and presentations that effectively convey the competences of both the entrepreneur and the company. Coaches can assist businesses in understanding what investors are looking for and the concerns they might have. A key challenge to be addressed at this stage is how to package complex, technology-based information into a format digestible to outside investors (McAdam and Marlow, 2011[1]).

• Networking to connect startups to potential investors. In their review of critical factors and performance measurement for business incubators, (Pattanasak et al., 2022[17]) recommend that incubators focus on facilitating relationships with external parties as a means of helping startups to access resources and attract investment. Here the ecosystem embeddedness of the incubator is key in ensuring that it can provide its clients with relevant investor connections. Incubators should also be proactive in the organisation of demo days and other matchmaking events, taking care to facilitate curated connections between specific startups and investors where the investment opportunity matches the investors’ expertise and interest.

Table 7.2 summarises the main ways in which incubators support startups in accessing external finance by building their investment readiness.

Table 7.2. Incubators’ strategies for building clients’ investment readiness

Support type	Description
Coaching	The provision of individualised advice, delivered through coaches or mentors, is a core component of many incubation programmes (see Chapter 5). These advisors often work with entrepreneurs to support them in developing credible business plans and funding applications that are appealing to investors (McAdam and Marlow, 2011[1]). In this way, the advisors act as “sense makers” between equity investors and entrepreneurs, helping entrepreneurs to communicate their business proposition to investors in a convincing way by drawing on their knowledge of investors’ requirements and preferences (McAdam and Marlow, 2011[1]). Facilitating external financing is often seen as a core objective of coaching within business incubators, and startups’ funding metrics and milestones are commonly used to gauge the progress of the startups and the effectiveness of coaching approaches.
Investor linkages	Incubators play a crucial role in connecting startups to other actors and resources in the entrepreneurial ecosystem, including private and public investors. Incubators facilitate these connections through networking and matchmaking events that bring together major investors and promising startups. Often, these events take the form of high-profile “demo days” at the culmination of an incubation or acceleration programme. For example, at Y Combinator, the latest batch of startups present their businesses in front of large groups of investors, with each startup having one minute to pitch its business and breaks throughout the day. Investors are often provided with startups’ contact information by the incubator and can then approach founders directly. Some incubators also follow up with investors after the demo day to understand their investment intentions, and support startups who have been approached by investors to negotiate fundraising deals. Investor-linkages can also be fostered by incubators through smaller networking sessions that offer more regular and targeted opportunities for startups to interact with groups of investors. As an example, the TechFounder accelerator in Germany organises two “pitch nights” with potential clients and investors at the mid-point of the programme. These sessions provide an opportunity for the startups to engage with investors and act as a rehearsal for the larger demo day at the end of the programme. In Portugal, many incubators are part of Portugal Ventures’ – the public venture capital fund – network of “Ignition Partners”, providing opportunities for their clients to interact with this major startup investor. Incubators also leverage digital platforms to link investors and startups, often creating large databases of investors and startups with user-friendly interfaces and matchmaking functions. On these platforms, investors can submit information on the types of investment opportunities they are interested in exploring and are provided with curated lists of startups that meet these criteria. Incubators’ clients can also benefit from curated introductions to relevant investors that are initiated by their coaches or mentors (McAdam and Marlow, 2011[1]).
Signalling	Participation in incubation programmes can provide a quality-stamp for startups by virtue of the due diligence undertaken by incubators in granting entry onto what are usually quite competitive programmes (McAdam and Marlow, 2011[1]). This can help to offset the information asymmetries between startups and investors that can make it difficult for companies without a sales track record and an unclear profitability potential to obtain financing (Zana and Barnard, 2019[16]).
Training	Incubation programmes often include training courses where a key topic is building investor-readiness. Many incubators offer training focusing on the skills founders need to develop their startup and interact with investors. For instance, the German accelerator Xplore offers a structured curriculum which includes multiple pitch training sessions and personal coaching sessions on other relevant topics. Some of these modules are available on the accelerator’s online learning platform. Similarly, the Estonian accelerator StartUp Wise guys offers masterclass training courses in four focus areas, one of which is fundraising and pitching. The British accelerator Founders Factory’s training also includes a focus on fundraising alongside other key aspects such as strategy and product development and marketing.

Signposting to public funding programmes

Incubators also play an important role in signposting startups and scaleups to relevant funding supports from public entities. Indeed, research on the UK’s Help to Grow: Digital programme found that trusted third parties can be among the most effective vessels for raising awareness of public support programmes (Department for Business, Energy and Industrial Strategy, 2023[18]). Public agencies can strengthen the signposting function of incubators by holding regular office hours or installing contacts from relevant government departments at incubator premises. A prominent example of this can be found in Station F in France, where multiple public agencies have a local contact point that can provide tailored information to startups on the range of public supports available and how these can be accessed. Similarly, the French Tech Central programme enables entrepreneurs to meet with representatives of various government departments at their local “French Tech Capital”.

Subsidised facilities and services

Business incubators offer their clients access to subsidised facilities and services, such as office infrastructures, testing facilities, and coaching and training. These supports help startups to conduct their operations and product development without having to make substantial expenditures themselves, thus reducing requirements for external financing and enabling internal resources to go further (Tripathi and Oivo, 2020[19]; Kehinde Feranmi Awonuga et al., 2024[20]).1 Training on financial literacy and management can also help to improve cash flow and reduce or delay the need for startups to seek external finance. In these ways, the subsidised facilities and services offered by incubators free up entrepreneurs’ internal resources for use on other development activities – for example hiring or marketing. This can potentially extend the window of time that startups have before they need to pursue external financing. (Lange and Johnston, 2020[6]) find that reduced expenses are the top-ranked improvement in business outcomes reported by users of business incubators.

Conclusions and policy lessons

Helping startups and scaleups to meet their financing needs is one of the most important ways in which incubators support their clients. The direct funding and subsidised facilities offered by incubators are often essential in enabling entrepreneurs to pursue the development of their companies during the incubation period. For example, access to testing facilities within incubators can allow entrepreneurs to refine their products in a way that would not have been affordable outside of the incubator, while the allocation of grants can enable entrepreneurs to recruit a small team around them or invest in customer acquisition or product development. However, this assistance amounts to little if firms graduate from the incubators without a source of revenue or external funding. The evidence from the literature points to the need for incubators to supplement any direct funding provided to startups with non-financial supports in order to be most effective. For example, (Gonzalez-Uribe and Leatherbee, 2018[21]) show that business acceleration schemes only affect ventures’ performance when the basic provision of funding and co-working space is topped up with access to entrepreneurship training. Meanwhile, (Lange and Johnston, 2020[6]) find that the networks and connections facilitated by incubators are the most valuable aspect of incubation programmes from the perspectives of the users. Similarly, (Bone et al., 2019[22]) find that networking opportunities and mentoring have a clearer impact on startup performance than direct funding.

The provision of direct funding in isolation is not enough to address the financing gaps of incubators’ client companies. Where incubators can have an even greater impact in boosting the longer-term financial sustainability of their clients is through initiatives to build investment readiness, for example by providing training in pitch development, raising awareness of funding opportunities, and establishing investor connections. This involves deploying the broad spectrum of non-financial support measures commonly found in incubation programmes – including coaching, training and networking – and making sure that the advice, guidance and contacts that startups access through these channels contribute towards building their investment readiness to make them more viable investment propositions for investors.

Perhaps the most important way that incubators can facilitate access to external financing is by opening doors for startups to meet and pitch to potential investors. The embeddedness of incubators within entrepreneurial ecosystems and, in particular, the strength of their linkages with investors, define their ability to provide this type of investor networking and matchmaking support. It is essential for governments to take these factors into account when determining which incubators to fund, including through the design of selection criteria for competitive public funding programmes. The provision of investment readiness support can also be made a condition for incubators’ receipt of public funding. Coaching is another important aspect of building investment readiness, and it is important for policymakers to apply firm criteria and frameworks that govern the quality of coaching being delivered via publicly-funded incubators, as discussed in more detail in Chapter 5.

Another lever for governments is to enhance connections between public investment entities and business incubators. In many countries, some of the largest venture capital funds have a strong public component, which creates an opportunity to integrate them more deeply within the incubation system. For example, public investment funds can be encouraged to create networks of incubators as a means of improving their deal flow and at the same time providing startups in the incubation system with enhanced access to potential investment opportunities.

References

[3] Akerlof, G. (1970), The market for “lemons”: Quality uncertainty and the market mechanism, https://doi.org/10.2307/1879431.

[7] Allen, D. and R. Mccluskey (1991), “Structure, Policy, Services, and Performance in the Business Incubator Industry”, Entrepreneurship Theory and Practice, Vol. 15/2, https://doi.org/10.1177/104225879101500207.

[22] Bone, J. et al. (2019), The impact of business accelerators and incubators in the UK.

[8] Carayannis, E. and M. Von Zedtwitz (2005), “Architecting gloCal (global-local), real-virtual incubator networks (G-RVINs) as catalysts and accelerators of entrepreneurship in transitioning and developing economies: Lessons learned and best practices from current development and business incubation practices”, Technovation, Vol. 25/2, https://doi.org/10.1016/S0166-4972(03)00072-5.

[14] Clark, C. (2008), “The impact of entrepreneurs’ oral ’pitch’ presentation skills on business angels’ initial screening investment decisions”, Venture Capital, Vol. 10/3, https://doi.org/10.1080/13691060802151945.

[18] Department for Business, Energy and Industrial Strategy (2023), Evaluation of Help to Grow: Digital.

[9] Douglas, E. and D. Shepherd (2002), “Exploring investor readiness: Assessments by entrepreneurs and investors in Australia”, Venture Capital, Vol. 4/3, https://doi.org/10.1080/13691060213713.

[21] Gonzalez-Uribe, J. and M. Leatherbee (2018), The effects of business accelerators on venture performance: Evidence from start-Up Chile, https://doi.org/10.1093/rfs/hhx103.

[5] Grimaldi, R. and A. Grandi (2005), “Business incubators and new venture creation: An assessment of incubating models”, Technovation, Vol. 25/2, https://doi.org/10.1016/S0166-4972(03)00076-2.

[20] Kehinde Feranmi Awonuga et al. (2024), “Business incubators and their impact on startup success: A review in the USA”, International Journal of Science and Research Archive, Vol. 11/1, https://doi.org/10.30574/ijsra.2024.11.1.0234.

[6] Lange, G. and W. Johnston (2020), “The value of business accelerators and incubators – an entrepreneur’s perspective”, Journal of Business and Industrial Marketing, Vol. 35/10, https://doi.org/10.1108/JBIM-01-2019-0024.

[4] Martin, S. and J. Scott (2000), “The nature of innovation market failure and the design of public support for private innovation”, Research Policy, Vol. 29/4-5, https://doi.org/10.1016/S0048-7333(99)00084-0.

[15] Mason, C. and R. Harrison (2001), “’Investment readiness: A critique of government proposals to increase the demand for venture capital”, Regional Studies, Vol. 35/7, https://doi.org/10.1080/00343400120075939.

[13] Mason, C. and J. Kwok (2010), “Investment readiness programmes and access to finance: A critical review of design issues”, Local Economy, Vol. 25/4, https://doi.org/10.1080/02690942.2010.504570.

[1] McAdam, M. and S. Marlow (2011), “Sense and sensibility: The role of business incubator client advisors in assisting high-technology entrepreneurs to make sense of investment readiness status”, Entrepreneurship and Regional Development, Vol. 23/7-8, https://doi.org/10.1080/08985620903406749.

[23] MYERS, S. (1984), “The Capital Structure Puzzle”, The Journal of Finance, Vol. 39/3, https://doi.org/10.1111/j.1540-6261.1984.tb03646.x.

[2] Oranburg, S. (2020), “Start-up financing”, in Start-Up Creation: The Smart Eco-efficient Built Environment, Second Edition, https://doi.org/10.1016/B978-0-12-819946-6.00004-7.

[17] Pattanasak, P. et al. (2022), Critical Factors and Performance Measurement of Business Incubators: A Systematic Literature Review, https://doi.org/10.3390/su14084610.

[12] Queen, M. (2002), Government policy to stimulate equity finance and investor readiness, https://doi.org/10.1080/13691060110104331.

[19] Tripathi, N. and M. Oivo (2020), “The roles of incubators, accelerators, co-working spaces, mentors, and events in the startup development process”, in Fundamentals of Software Startups: Essential Engineering and Business Aspects, https://doi.org/10.1007/978-3-030-35983-6_9.

[10] Vaznyte, E. and P. Andries (2019), “Entrepreneurial orientation and start-ups’ external financing”, Journal of Business Venturing, Vol. 34/3, https://doi.org/10.1016/j.jbusvent.2019.01.006.

[11] Westerik, F. (2014), Increasing the measurability of Investor Readiness.

[16] Zana, D. and B. Barnard (2019), “Venture Capital and Entrepreneurship: The Cost and Resolution of Investment Readiness”, SSRN Electronic Journal, https://doi.org/10.2139/ssrn.3353078.

Note

← 1.  A significant portion of the costs of external finance are linked to the information asymmetries that exist between startup and investor (Akerlof, 1970[3]). As a result, funding activities through internal resources – for example entrepreneurs’ personal savings – is considerably cheaper than acquiring external finance, making it the first port of call for new startup companies as per the “Pecking Order Theory” of company financing (Oranburg, 2020[2]; MYERS, 1984[23]).