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Public Policy on Business Incubators: an OECD Perspective

This presentation draws directly on two recent publications prepared by the OECD’s Local Economic and Employment Development (LEED) Programme. Those publications are Good Practice in Business Incubation (2000, LEED/SOFIREM Notebook No.28) and Business Incubation: International Case Studies (OECD 1999). In keeping with the broad goals of the OECD, the purpose of these publications is to provide sound guidelines for policy.

Broadly stated, a business incubator is a tool to facilitate enterprise creation and development, usually (but not always) comprising physical workspace and co-located business advisory and other services. Physical facilities are often provided on the basis of leases that are flexible, and sometimes below the market rate.

The spectrum of services offered is extremely varied, ranging from strategic business planning, to administrative services, to guidance on issues of intellectual property (particularly in the case of technology incubators). Business incubators have variously been referred to as enterprise centres, nurseries, shared workspaces, managed workspaces and venture units. As this varied terminology indicates, there is no unique business incubator model. The incubator industry is in fact an assortment of diverse types of facility operating in a wide range of circumstances.

In many countries, both members and non-members of the OECD, business incubators are a widely-used instrument for local economic and employment development. There are approximately 600 business incubators in the United States, some 200 incubator-type structures in France, and more than 100 incubator schemes in the United Kingdom, with these numbers growing rapidly. Over the last 15 years business incubators have been one of the most important instruments of regional and urban development in Germany. There are, in addition, large numbers of unenumerated incubator-like projects run by subnational bodies across the OECD. And it was also recently announced that France intends to press for a European network of incubators and technological research institutions.

However, in most countries this is still a young service industry. In Australia, for instance, as of 1999, 40 per cent of incubators were less than 3 years old.

Slide 2

Especially in local and regional tiers of government, policymakers have turned to business incubation as a means of achieving a wide range of economic and social objectives. For example, incubators have been used to combat unemployment, raise rates of enterprise formation, upgrade the technological standing of firms in a given locality, commercialise university research, assist socially disadvantaged groups - such as youth and minorities -, and expand the supply of infrastructure. In a small number of cases incubation has even been employed as a way of protecting legitimate entrepreneurship from criminal activity. However, job creation is by far the most common goal of incubation schemes.

As regards the sources of incubation sponsorship, the public, private and non-profit sectors have all established incubator schemes. Programmes have been funded by local and regional governments, universities, chambers of commerce, science parks and private real estate developers. Even management consultancies have taken an interest in incubators, sometimes providing services in exchange for equity in tenant firms.

The routes through which incubators can influence local economic development are varied. Aside from the obvious direct contributions from increased employment, incomes, and taxation, incubators sometimes introduce previously lacking infrastructure. They can also generate income by extending services to nearby firms (one estimate from the late 1990s was that some 34 per cent of the firms served by U.S. incubators are located off-site). Incubators can likewise serve as a point of referral for local companies, offering information and guidance on the range of business, training and financial support services available for start-ups. Some incubators offer marketing services to facilitate supplier linkages between tenant and local non-tenant firms. And the link with the local economy is often heightened when municipal governments, industry representative bodies and local financial institutions play a role in the funding and management of business incubators.

The Internet is likely to affect business incubation, both through the changes it is effecting in the medium for providing business services and through the expanded opportunities it brings for enterprise creation. However, the Internet is unlikely to remove the need for face-to-face contact between service providers and client firms, particularly during the early stages of a firm’s development. Recent years have seen the establishment of a wave of private for-profit incubators, the majority of which concentrate on Internet start-ups. Towards the end of 2000, according to the National Business Incubators Association, for-profit incubators have been opening in the United States at a rate of about four per week. Many of these incubators serve as vehicles for owners’ investments in a portfolio of companies. The market quickly embraced Internet business incubation given the previously high valuations of Internet companies. It appears, however, that there should be little if any public sector role in supporting such for-profit incubators. The Internet incubators will not replace traditional incubation programmes, as they do not share the social goals pursued by traditional incubators, such as developing distressed communities. While shifting equity valuations are likely to cause many of the for-profit incubators to disappear, successful commercial incubators may well provide operational lessons from which the traditional incubators can learn.

Slide 3

The combination of real estate supply with technical services makes business incubation a potentially cost-effective way of supporting business. This is because the unit cost of providing technical assistance can be lowered by supplying to a collection of firms, while synergies can be created among tenant enterprises.

While there is a mass of good literature on a variety of operational issues affecting the management of incubation schemes, there is a marked scarcity of methodologically sound studies on the impact of business incubators. Much of the available writing on incubation is promotional, affording little information of real value to those who formulate public policy. Nevertheless, the available material generally indicates a positive effect in terms of improving rates of enterprise survival.

However, while employment creation is one of the most frequently stated objectives, it appears not to have been a main achievement of incubator programmes, especially over the short-term. In Germany, for example, studies suggest that significant improvement in local job markets has not occurred as a result of incubation. SPI - Italy’s premier agency promoting incubation (recently merged into a new institution, Sviluppo Italia) - planned to create around 2,500 new jobs a year nationally with a network of 30 incubators. These numbers are small when taken nationally, and smaller still when one considers that at least some of these jobs would have been created anyway outside the incubators. From a local perspective however the impact on employment may be more significant.

It should also be borne in mind that the bulk of job creation in incubated firms often occurs after these firms graduate from the incubator. This finding reiterates that sizeable short-term employment gains are unlikely from programmes for enterprise development.

The available assessments suggest that the cost of public support per job created in an incubator can compare favourably with other public job creation programs. As I recall, the 1994 report of the Australia and New Zealand Association of Business Incubators estimated that the cost to government per job created through incubators was A$4, 000, a figure that compared well with other labour market programmes at the time.

Incubators can also have long-run indirect effects that are difficult to quantify. For example, area development effects may be important. In Genoa, siting a business incubator in a derelict steelworks prevented the abandonment of a sizeable industrial zone in the heart of the city. A few successful start-ups may exert a demonstration effect, helping local communities recognise that entrepreneurship is a realistic option. Similarly, entrepreneurs whose ventures fail will often learn from the experience and establish successful businesses later on, perhaps outside the incubator. Technology incubators can also sensitise academics to the problems of industry. And in Germany some have held the networking of organisations involved in local economic development to be the most positive effect of incubators.

In assessing the merits of business incubation as a policy tool there is a need to reflect on the meaning of some of the criteria used in the evaluation of business incubators. For example, a widely used performance measure is the public subsidy per job created. Aside from notorious methodological difficulties in estimating such a measure, this criterion is of little use if the jobs would have been created anyway outside the incubator.

Similarly, it is difficult to gauge the significance of improved survival rates among incubated firms if those firms enter the incubator after a selection process. That is, the success of such companies may be attributable to intrinsic characteristics rather than the effect of the incubator. Even surmounting this evaluation problem - the problem of attribution - an increased rate of survival and improved corporate performance are only to be expected in firms receiving assistance. This underlines the critical point for the evaluation of public policy: that it is the ratio of costs incurred through incubation to benefits generated which matters.

Furthermore, high rates of business survival may not be a good indicator of incubator effectiveness if a major share of the surviving firms are marginal survivors or "lifestyle" enterprises. And the interpretation of rates of enterprise failure and survival should also recognise that these rates vary systematically with the age of a business. So, ideally, incubator clients would be divided into age cohorts and survival rates calculated, and weighted, by group.

And caution also needs to be exercised in the interpretation of business failure statistics, with much so-called "failure" being temporary. For example, a 1999 study of small business bankruptcy filings - which constitute a major aspect of "failure" - sponsored by the U.S. Small Business Administration found that: "Among businesses who filed for bankruptcy over the last five years, 13% opened another business and 11% plan to open another business…41% of the 3,400 businesses surveyed continue to operate…".

Interestingly, survey evidence shows that incubatees often indicate greater appreciation of service effectiveness after graduation from the incubator than during the period as an incubator tenant.

Contrary to common practice, the focus of incubation should be on enterprise development rather than employment growth (as already mentioned, most job creation seems to occur after the graduation of tenant firms). Employment growth will follow successful commercial outcomes. Therefore, measures of incubator performance should record different dimensions of enterprise development (such as reducing the time which enterprises take to establish market niches; reducing the time to develop new products if the incubator has a technological orientation; and improving management practices and/or the technology of enterprises).

In fact, many practitioners understand that there is a need for studies that assess the degree of "additional" job creation and enterprise performance brought about by incubators (by comparing firms within incubators against similar firms outside). Also needed are comparisons of the costs of incubation against other measures that might be employed to achieve similar outcomes. Unfortunately, such work is badly lacking.

There is an immediate and understandable attraction for policymakers in the idea of being able to grow or incubate affluence. This is often combined with pressure on policymakers to be seen to be active in rectifying local economic problems. As incubators can afford visibility to policy - given that they often involve the construction and opening of premises - there may be a tendency for local policymakers to oversupply incubation programmes. This underscores the need for careful consideration of the economic rationale for public investment in incubation. An explicit recognition amongst policymakers of exactly what public funds are being employed for is essential. Policy should be formulated on the understanding that public investments do not duplicate resources available elsewhere. In the U.K., for example, one of the earliest proponents of business incubation, British Steel Industries Ltd., established as a principle that resources not replicate already existing services.

Before investing in incubation, policymakers need to ask how well markets are working in the provision of those services that incubators supply - in technical services and industrial real estate. Market failure in the supply of advisory and financial services to new and small firms is a contested subject, but may be less frequent than is often claimed. The Internet is certainly augmenting information supply to small firms, and many providers of technical and managerial information have a strong interest in demonstrating products, equipment and services to potential SME clients. In addition, manufacturers associations, chambers of commerce, universities and other bodies often provide a range of technical and managerial services tailored to the needs of SMEs.

Market failure in the supply of industrial real estate is likely to be more common. Data for western Germany from 1993/1994 show that over 88 per cent of firms in incubators considered the rented space to have played a significant role in the development of the company.

Supplying industrial accommodation often holds little attraction for private investors without public support. In economically distressed areas there may be difficulties in securing tenants, especially if auxiliary infrastructure is poor, and there are long time periods in recovering investment outlays. But there can also be serious problems in the supply of accommodation for small firms in dynamic property markets, such as in London. These difficulties relate principally to the superior returns from using real estate for office space and/or housing. For owner/managers of SME accommodation, transaction costs are high, for example in invoicing and collecting payments from large numbers of small firms. Dealing with the movement of firms in and out of the property, pursuing rent arrears, and maintaining optimum occupancy are skilled and expensive undertakings. These costs are not incurred in the market for high order office space or housing, for which demand is considerable in an international business metropolis such as London.

Furthermore, corporate property investors are often averse to the risk which unknown business propositions - such as enterprise start-ups - entail. They demand a quality of covenant from prospective tenants that many new ventures cannot meet, even if these ventures have business plans accepted by external financiers. For the private property developer an adequate quality of covenant might entail the submission of audited accounts for the previous five years showing profits in excess of the annual rental, or one year of rent paid in advance on a rolling basis (it has been observed that this conservative attitude towards new business ventures as prospective tenants is not justified by experience. At least in the United Kingdom, few companies go out of business owing rent).

However, the public policy response need not involve government investment in incubator buildings. This is a capital-intensive use of public funds, with limited prospects of cost recovery through onward sale of the property (because of the investment behaviour of private property developers described above). A preferred alternative may be for the public sector to guarantee the rent of a privately funded building, which practice shows to be a low-risk undertaking if tenant firms are well selected (and well managed). This policy option, with the public sector acting as head tenant, avoids tying up large amounts of public money in the incubator building, while also gearing in private finance.

A case-by-case approach must also be taken in advancing infrastructure provision as an argument for public expenditure on incubators, because private infrastructure supply may sometimes be preferable. If public policy towards incubation is intended to go beyond the correction of failures in property markets - if for example it is founded on the premise that incubation supplies some form of public good such as education - then this should be made clear in the stated goals of the programme. Clarity in the formulation of objectives will facilitate management and the evaluation of public support.

Aside from the need to follow economic rationality, other policy principles derived from the LEED Programme’s work on business incubation include the following:

• When considering incubation, policymakers should be aware that other options might achieve similar effects but with lower costs. The degree to which ‘incubation’ is the tool of choice depends on such factors as the extent of business advisory and training services in the local environment and the skills of the workforce. Under different circumstances a local training programme, efforts in investment promotion, or other measures may be more appropriate than business incubation. Similarly, the goals of any incubation programme must be made explicit. Not only will this assist evaluation; it can also help resolve tensions that sometimes arise between the role of an incubator as a financially self-sustaining venture and its role as an instrument of economic development.
  

• A sound feasibility study and business plan are fundamental. In addition to determining financial viability, the process of feasibility assessment can be used to create consensus, motivate participation, solicit funding, and avoid known sources of error.
  

• Incubators must be given realistic objectives. Business development should take primacy over job creation, especially in the short-run. Job creation and economic development are vital goals, but they are best achieved over the long run through the creation of well-functioning businesses.

• Significant benefits can be had from local business and community support, which should be encouraged to the extent possible. In the U.S., for example, the pro bono supply of services to incubators by local business people is not uncommon. And in Germany, industry chambers, municipal savings banks and building societies have all played important roles in incubation programmes.
  

• The recruitment of suitably qualified managerial staff is crucial. The success or failure of an incubation programme will often turn on the quality of management. Capable managers are essential in selecting suitable tenant firms, advising these firms and in creating links to investors and the wider business community. Indeed, practice suggests that the time a manager spends working with tenants or developing business assistance networks should be maximised.

• Due consideration should be given to the scale of incubation programmes. Increased size opens possibilities for the reduction of costs and diversification of risk, as well as the leveraging of private finance. Cost reduction can come about both because of a lower ratio of overhead costs to revenue, and because an increased number of deals can allow for some standardisation of processes (with a consequent reduction of unit costs).

I understand that the Australian industry has determined that incubators offering commercial office space usually need around 1,500 square metres - with more if the tenant firms are from light industry - in order to generate sufficient income to employ a full-time incubator manager and support staff (the efficient scale of operation of an incubator will in part be determined by the service mix). In the United Kingdom, 3 to 3.5 thousand square metres is considered a minimum size for an incubator.

We have already noted some of the problems of high transaction costs facing commercial managers/owners of SME accommodation. One way to address these problems may be to scale up activities (Greg Clark’s point, see "Good Practice in Business Incubation", OECD/LEED Notebook No.28), moving towards the adoption of a portfolio management approach. By offering a larger number of units of different sizes in different sites a provider of SME accommodation could better diversify risk, achieve economies of scale, re-house the same SME tenants a number of times, and be better placed to raise investment against the asset base and balance sheet. Hence, an approach of providing public incentives to help scale up the commercial supply of industrial real estate may be superior to local public subsidy of SME accommodation (aimed at covering high transaction costs for example), although the subsidy option may seem compelling when the problem is viewed from a local perspective only. In essence, one would be seeking to encourage investment in portfolios of incubation sites, rather than investment in a local single site.

• For small communities incubation should probably be treated with caution. Incubators may be more difficult to operate in remote areas with smaller populations, smaller markets, and fewer community resources. If incubation is to be attempted in such circumstances it may be advisable to embed the incubator in a larger umbrella organisation. So-called "virtual" incubators may be a cost-effective means of providing non-property-based services in areas with small numbers of potential tenant firms.
  
• Public support, when it is given, should primarily come in the early stages, not through the subsidy of operational costs. In Germany a positive correlation has been found between the presence of subsidies and high operating costs. Without a commercial mindset the incubator is unlikely to provide competitive services. Furthermore, when there is a need for operational subsidy, management and staff often spend precious time searching for additional funding, and less time assisting tenant firms.
  
• Also important is the creation of a competent Board of directors embodying a breadth of skills and experience. Political and community support - and associated funding - can fluctuate, but the Board must provide continued commitment and guidance to an infant programme.
  
• Incubators should provide good quality accommodation. The unattractive image projected by sub-standard facilities may deter high-potential start-ups.
  
• In many countries there is a need for some degree of standardisation in incubation, combined, although it may seem contradictory, with local flexibility. In too many countries the incubation industry is characterised by numerous isolated initiatives engaged in unproductive experimentation. Industry representative bodies can be helpful in disseminating best practice and creating benchmarks. Public financial support was helpful in creating United Kingdom Business Incubation, the U.K. industry representative body. The roles of UKBI are: to promote the benefits of business incubation and act as a focal point for relevant information; to assess and compare a variety of initiatives, compiling a record of best practice, based where possible on reliable academic research; and to encourage networking among incubators and all their participants. The creation of industry representative associations of this sort should be encouraged.
  
• Evaluation and monitoring are critical for improving operational procedures and collecting data with which to inform public policy. Despite the diversity characteristic of business incubator schemes there are core objectives common to most programmes, and these should form the basis of evaluative work. Those involved in business incubation often need to become more professional in quantifying, benchmarking and evaluating incubation schemes. Far from being an encumbrance on project implementation, evaluation data gleaned as part of a proper management information system can greatly facilitate effective management. Postponing evaluation and monitoring can also add to expense because, when some form of assessment is required, data will need to be established that could have been kept throughout.

While much is known about how to manage incubators, more information is needed on their long-term and sometimes indirect effects on local economies. Such effects, which are often difficult to quantify, may include: impacts on area development through various channels (even by providing a visible symbol of public commitment to new local and regional development); changed attitudes towards entrepreneurship; the enhanced networking of organisations involved in local economic development; beneficial effects on entrepreneurs whose ventures fail but create successful businesses at a later date; the sensitisation of academics to the workings of industry, etc.. Evidently, more longitudinal studies are called for. As stated above, analysis is also required of the cost-effectiveness of incubation compared with other measures to achieve similar goals.

In closing, it may be worth considering that an eventual aim of policy should be to make the need for incubators redundant. The underlying goal should be to create an entire locality having the institutions propitious for enterprise birth and development. There is no logical necessity to providing services, finance and property to the same incubatees. Clients in receipt of property services need not require advisory or financial services as well. Some localities, such as the area around MIT in Boston, effectively serve an incubation role on account of the breadth of services networks they offer. While Boston may be unique, the aim of providing the best-possible quality and range of services to the entire population of established and nascent firms - not just the incubator tenants - should be common.

Lastly, productive entrepreneurship is central to economic growth, employment creation and innovation. Fast-growing subnational economies usually have high rates of enterprise start-up. While not all areas with high start-up rates also grow rapidly, growth is difficult without a significant level of enterprise creation. Local and regional authorities today employ a range of policy instruments to encourage enterprise creation and development. It should be recalled, however, that while critical to an area’s development, the promotion of entrepreneurship does not constitute a developmental panacea. The encouragement of entrepreneurship is unlikely to yield major benefits in the short-run. And as entrepreneurship programmes expand and eligibility is extended positive impacts often weaken as marginal participants are attracted (indeed, entrepreneurship-centred strategies may favour those already possessing significant assets, both human and financial). Becoming an entrepreneur is a daunting challenge, especially if leaving salaried employment means giving up healthcare coverage, pensions, and insurance against invalidity or unemployment. Therefore, entrepreneurship promotion - through instruments such as business incubation - should form but one component in an array of developmental programmes and policies.