In this blogpost, Abhijeet Anand, Technical Sales Support Engineer,  Schlumberger, writes about, what is an incubator,  Strategic Features of an Incubators-Startup relationship and the important terms to be checked before signing the agreement with the Incubator

Today, there are a number of start-ups growing every minute and so do the incubators are heading in the market with the same increasing proportion. The relation of start-up and incubator especially in the US is now very mature with some of the incubators having a great reputation among many where the chronology of a start-up getting into an a top 5 Incubators (sometimes also referred as accelerators, although there is a narrow gap among the two) is the same as for a student getting into the top 5 management schools in the US.

Understanding Start-ups and Incubators

However before jumping in the legal terms between Start-up and Incubators, it is extremely important to understand the difference the two. Start-up company or business is a venture by an entrepreneurial team (one or several) that is aimed at filling up the voids in the industrial eco-system through a scalable and sustainable business model with great growth potential. Incubators are organizations to help them find such business model, assist in making them scalable and support them with resources and services to accelerate its development. While entrepreneurs have limited time, knowledge and resources wherein many can be first time entrepreneurs or may be first business venture of any kind, the Incubators with a diverse pool of experts, experienced and knowledgeable people, provide start-ups the right kind of atmosphere, resources and guidance to accelerate its growth and make the business model scalable, marketable and sustainable.

Strategic Features of an Incubators-Startup relationship

The startup-Incubator relationship although may seem just as a mentor-mentee relation from outside, however, it does have a more definite implication in reality. Some of the main advantageous features include the following:

Motivation: The atmosphere of the incubators is inspiring and encouraging because it hosts several similar encouraged groups with successful examples.

Access to veteran advice: Been there, Done that. This is the most lucrative pool of knowledge resource available for startup founders. Access to this ensures non -repeatability of the same mistakes done in the past and skip to the bigger challenges seeing, the bigger picture.

Resource: Initially most of the startups are cash-crunched and require to work with the survivable resources. Pooling the resources in a startup conducive environment, incubators turn out to be the perfect for the early stage startups.

Connections: This is the one of the most aspects of incubator relationship as this ensures better market picture through better connections and media or marketing strategy.

Although all the above look very positive, there are several loopholes as well which can be mainly summarized into two:

Equity in the company: In lieu of all the resources and services provided to the startup, the incubator wants a portion of the same piece of bread that is shared among the founders i.e stake in the startup in the form of common stock and mostly not preferred stock. For them is a diversification of their investment risk into various startups and they will negotiate for the maximum equity up to 10% or may be higher in some cases.

Incubator is also a startup/company: Incubators also have the same DNA of an institution and run like a business. At times, the incubators may not even be serious with their own stuff and are in the race of being just another institution as in the case of a “bubble”. This calls for serious consideration from the startups to find the most appropriate incubator according to their needs and not just fit in. one important thought that must be borne by any startup before getting into an incubator is that Incubators are also a business and is there in the ecosystem to make money and not only do charity.

Important terms to be checked before the signing the agreement with the Incubator

Once all the hard work has been done by both the parties i.e. startups as in to research the most suited incubator in terms of their requirement and Incubators as in to select the most prolific startup which they can support better, the two have to get into an agreement detailing the terms and conditions for the relationship until the startup graduates and even beyond. This generally raised by Incubators are not paid much heed by the startups, however, could result in drastic consequences in future in case of disputes. The most important considerations which must be taken into account is detailed as under:

Information Rights: Incubators having been invested in the startups expect to stay informed of the major activity being executed by the startup including financing, acquisition offers, periodic financial reports of the company’s performance. These rights should be critically seen by the founders and a timeline defined. Preferably, such rights may hold good until series A funding and anything after that may hinder the future investments.

Approval rights: Incubators may require you to obtain written consent from them before entering key transactions such as selling the company, issuing securities to employees or founders through an option plan which was not on the table while signing this agreement. Generally, it shouldn’t be an obligation for the startup to take permission from Incubator. However, the latter should be in a state to advise the former for the correct action.

Anti-Dilution Rights: The shares issued to the Incubators should hold good until a major VC financing is received for which the amount should be agreed upon. Thus, in order to protect their rights, Incubator would include an Anti-Dilution Right such that the common shares issued to them are not diluted until that priced financing is obtained where the company issues “preferred stock”. The Anti-Dilution rights should stop at a priced VC financing of between $500k-$1 million and shouldn’t exceed beyond this limit as it would be (i) very aggressive than market terms, (ii) will certainly create problems for raising further funding. The other option, however not always conducive for the startups may be Weighted Average anti-dilution.

Preemptive Rights: Preemptive or pro-rata rights allows the incubators to purchase their pro-rata share in any future financings. This means that if they own 8% of the company at the time of signing this agreement, they can take 8% of your future financings, as long as they are willing to pay whatever price is set in that round. Startup founders at their sole discretion should negotiate this as this will only limit their freedom to have a broad spectrum of investors in the future.

Investment Rights: In addition to Anti-Dilution and Preemptive rights, some incubators with a strong investor component would typically include some form of additional investment such that they may be capable of purchasing an additional fixed $ amount of securities at a later date while also ensuring they maintain their ownership %.

Confidentiality Rights: This should generally be mutual responsibility and obligation to preserve the confidentiality of the information exchanged between the two parties. However, the startup must in specific ensure the confidentiality terms are well understood by them as most times it is the idea on which the startup work once they enter an Incubator.

Marketing terms: It should be clear from the terms of the public image of the startup, use of company logos, public statements, and publicity events. Incubators having a diverse experts panel would have terms inclined more to their interests, thus making it important for the startup founders to ponder on this point at the time of signing this agreement.

Conclusion

Incubators are definitely one of the incredible things in the eco-system for the startups. However, the success of the startup incubator relationship lies on the ground work done prior to establishing this by both of them individually. It must be clearly understood by the startup founders that Incubators as well are in the market to make money, protect their financial rights and thus would require the founders to sign agreements which have serious obligations. Entering into an Incubator, Startup must understand it’s rules and obligations and have a plan defined to meet them in future until it graduates from the Incubator as it may not only destroy the valuable relationship between the two institutions, the people associated but may also lead to expensive clean-up of the garbage created in the process. A final word of advice for the startups for entering into an Incubator “Find your weakness, understand your needs, research the options and go with your eyes and ears open”.

References:

1. “Thinking of Joining an Incubator? Check Off These 5 Things First” published in The Entrepreneur on July 29, 2014.
2. “5 Questions Every Startup Should Ask Before Choosing an Incubator”, as published in the Entrepreneur.
3. “How to Evaluate a Startup Accelerator Offer”; Startup Lawyer.
4. “Startup Accelerators: The Legal Terms”; Silicon Hills lawyer
5. “Startup BluePrint Incubator Program Terms and Conditions”; PayPal and Blueprint Agreement.