Theory Business Incubation

A Real Options-Driven Theory of Business Incubation

ABSTRACT. This article employs real options-theoretic reasoning to develop a theory of business incubation. This theory seeks to predict and explain how business incubators and the process of business incubation increase the likelihood that new ventures will survive the early stages of development. It conceptualizes the incubator as an entrepreneurial firm that sources and macro-manages the innovation process within emerging organizations, infusing these organizations with resources at various developmental stage-gates while containing the cost of their potential failure. The incubator is the unit of analysis while incubation outcomes—measured in terms of incubatee growth and financial performance at the time of incubator exit—provide indicators of success. Our model of the incubation process and specification of the range of possible incubation outcomes offer implications for managerial practice and policy-making vis-a`-vis incubator management and good entrepreneurial failure. JEL Classification: M13, O2, O31, O32, O38

1. Introduction The failure of new ventures in their early stages of development is a common occurrence (Watson et al., 1998; Zacharakis et al., 1999). Evolutionary theorists contend that the forces of selection that eliminate uncompetitive firms are a necessary phenomena that contribute to the maintenance of healthy populations of organizations (Aldrich, 1 Vanderbilt University Management of Technology Program Box 1518, Station B, Nashville, TN 37235 USA E-mail: [email protected] 2 Vanderbilt University Management of Technology Program Box 1518, Station B, Nashville, TN 37235 USA E-mail: [email protected]

Sean M. Hackett1 2 David M. Dilts

1999). The continuing growth, since 1980, in the number of business incubators operating in North America, however, suggests that many governments, local communities and private investors believe that it is desirable to try to help ‘‘weak-butpromising’’ firms to avoid failure by incubating them until they have developed self-sustaining business structures.1 We define business incubator as a shared officespace facility that seeks to provide its incubatees (i.e. ‘‘portfolio-’’ or ‘‘client-’’ or ‘‘tenant-companies’’) with a strategic, value-adding intervention system (i.e. business incubation) of monitoring and business assistance. This system controls and links resources with the objective of facilitating the successful new venture development of the incubatees while simultaneously containing the cost of their potential failure (Hackett and Dilts, 2004). Although much of the literature centers on incubator facilities, it is important to also recognize the key role that the entire incubator network plays in incubating new ventures. This network typically includes the incubator manager and staff, incubator advisory board, fellow incubatee companies and employees, local universities and university community members, industry contacts, and professional services providers such as lawyers, accountants, consultants, marketing specialists, venture capitalists, angel investors, and volunteers. Theoretical foundations in the incubator-incubation literature are rooted in market failure arguments. Market failure occurs when the competitive transactive space for the production and sale of goods and ideas fails to produce a desired outcome. Sources of market failure include externalities, imperfect information, monopoly power, and public goods. Incubator-incubation researchers who subscribe to market failure theory believe

Journal of Technology Transfer, 29, 41–54, 2004 # 2004 Kluwer Academic Publishers. Manufactured in The Netherlands.

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that structures and strictures within the market impede the successful development of entrepreneurial new ventures, and that incubators-incubation are one approach to remedying these market failures. Other theoretical underpinnings include structural contingency theory (Ketchen et al., 1993), co-production of value theory (Parks et al., 1981) in Rice (2002), and network theory (Nohria and Eccles, 1992). Structural contingency theory suggests that the configuration of the incubator must obtain ‘‘fit’’ with environmental needs in order to achieve incubation success. Coproduction of value theory asserts that the incubation process is co-produced by the incubator manager–incubatee dyad, implying that the time intensity of business assistance interventions must be strategically allocated by the incubator manager to the incubatees, and that incubatees must be properly prepared to utilize the advice and insights resulting from the intervention (Rice, 2002). Network theory proposes that the primary value-added feature of incubators is the set of institutionalized processes and norms that carefully structure and channel knowledge throughout the incubator network in order to create conditions that facilitate the development of incubatees and the commercialization of their innovations. While these perspectives and the incubator-incubation literature in which they are employed serve to adequately describe why and in what configurations and contexts incubator facilities are operated, they do not provide an integrated, theoretically driven explanation of the factors that constitute the incubation process, nor do they account for the underlying dynamics of these factors, nor do they explain how, and why and in what context these factors are related (Hackett and Dilts, 2003, 2004). The absence of an integrated explanation constitutes a gap in our understanding of how and why the incubation process contributes to incubation outcomes.2 In order to integrate the factors in a way that enables us to predict and explain incubation outcomes, a theory of business incubation is required. The literature on incubators-incubation is reviewed extensively by Hackett and Dilts in another article in this issue of the Journal of Technology Transfer. The objective of this article is to address one of the challenges identified in that literature review: To develop new theory that

describes the underlying dynamics of the factors of the incubation process, and explains how and why these factors come together and foster incubatee success (or failure) in the early stages of new venture development. Accordingly, this article employs a conceptual framework of the incubation process (Hackett and Dilts, 2003) and draws upon options theory in order to build a theory of business incubation. Options theory asserts that decision-makers create low-cost options to initiate (but not fully commit to) risky investments; subsequent investments are based on reductions in uncertainty and the perceived likelihood of return on option investment. Previous management researchers have also extended options theory beyond the financial domain from which it is derived. For example, McGrath (1999) uses options reasoning to examine the ‘‘antifailure bias’’ in entrepreneurship research. Hurry and Bowman (1993) apply options reasoning to cast light on the process of developing organizational strategy. Several authors adopt an options perspective to suggest optimal methods for selecting technology development projects (Alvarez and Stenbacka, 2001; Hurry et al., 1992), while Copeland (2002) uses options theory to make clear the benefits of stage-gate capitalintensive project selection-rejection decision-making. Adding to this growing base of applied options theoretical reasoning, we employ options logic to synthesize and extend insights from research on incubators-incubation and, in turn, build a theory of business incubation. In this section, we have provided a working definition for incubators-incubation, described the theoretical foundations of extant incubator-incubation research, and noted our objective of building a theory of business incubation by drawing from options theory. The remainder of the article is organized in the following manner. First, we make explicit our assumptions regarding the logic of business incubators and the process of business incubation in order to establish the terms and concepts of discourse. Second, we consider a number of alternative theoretical foundations for explaining the incubation process and predicting incubation outcomes. Third, we draw from options theory to build a theory of business incubation. Fourth, we offer some concluding remarks.

A Real Options-Driven Theory of Business Incubation

2. Business incubators and the business incubation process In this section, we describe the logic of incubatorsincubation by populating a standard logic model with elements of incubator-incubation phenomena. This logic model emphasizes the fact that the incubator is a means to an end, and not an end in itself, and draws attention to the fundamental importance of the incubation process vis-a`-vis predicting and explaining incubation outcomes. Next, we offer several conceptualizations of the incubator to help anchor our theory development efforts. Finally, we introduce the incubation process model that will be used to organize our theory construction efforts.

The logic of incubators-incubation Business incubators are not the all-powerful innovation hatcheries capable of incubating and taking public ‘‘infinitely scaleable, dot-com e-business start-ups’’ less than a year after entering the incubator that the media made them out to be during the stock market bubble of the late 1990s. Rather, incubators tend to incubate intermediate potential ventures in their early stages of development. These ventures have the potential to generate jobs beyond the position created by and for the founder; annual revenues can range from negative income up to 10 million dollars. According to the National Business Incubation Association (NBIA), average incubation cycle times are between two and three years. To the extent that an incubator is the operationalization of a community strategy to promote the survival of new firms, an incubator is an enabling technology, rather than a critical or a strategic technology.3 This categorical distinction is not trivial: The underlying value of an enabling technology is a function of the critical and strategic technologies it enables. The mere existence of an enabling technology such as a business incubator does not, in and of itself, necessarily translate into the development of critical and strategic technologies embedded in the products and/or services of innovative new firms; a lack of inputs such as capable entrepreneurs and/or critical or strategic technologies for commercialization might go a long way toward explaining why

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many incubators perform so poorly. The logic of incubators-incubation is depicted in Figure 1 below.4,5

Conceptualizations of the incubator The incubator is an entrepreneurial firm (Rice and Matthews, 1995) that performs a bridging function by sourcing and ‘‘macro-managing’’6 the innovation process within emerging, weak-but-promising intermediate potential organizations, infusing them with resources at various developmental stage-gates while containing the cost of their potential failure. In this view, the incubator functions as a place where resources can be rationally invested in stages in selected incubatees that fail quickly, cheaply and often at various stages of the development path to success or terminal failure. Because most incubators do not take equity positions in most incubatees—relying instead on rental and services income as well as public and private subsidies—they are able to select and nurture ventures that have a greater likelihood of failure in proportion to upside potential than either a venture capitalist, or a firm engaging in corporate venturing would be willing to select, thereby resolving market failure in the intermediate potential venture marketspace. Galunic and Eisenhardt (2001) refer to modular organizations as ‘‘dynamic communities’’ in which resources and processes are reconfigurable and deployed in accordance with needs determined through a co-evolution with the market. With its enabling bundle of new venture development capabilities, the incubator is a dynamic community where selected incubatees can plug their emerging organizations into the incubator’s environment, routines, norms, network and expertise in costeffective and efficient ways unavailable to ‘‘weakbut-promising’’ go-it-alone intermediate potential ventures. Finally, the incubator is a manufacturer of new firms. A dominant design for the incubator facilities has been articulated by the incubator configuration stream of research (Hackett and Dilts, 2004). The focus of competition in the incubator-incubation industry is the production process (i.e. the incubation process) occurring within the incubator.

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Figure 1.

Business incubation logic model.

Incubation process model Guided by Campbell et al.’s (1985) description of the value-added contributions of business incubators, an insight that business incubation and venture capitalists’ investment activities share functional similarities, our systematic review of the literature, and fieldwork in North America and Asia, we understand the principal elements of the incubation process to be incubatee selection, monitoring and assistance, and resource infusion. This process is depicted in Figure 2. Briefly, the model indicates that incubatees are selected from a pool of incubation candidates, monitored and assisted, and infused with resources while they undergo early stage development. Outcomes refer to the survival or failure of the incubatee at the time it exits the incubator. Controls include regional differences in economic dynamism, level

of incubator development and size of incubator. The model is atemporal with arrows in the model indicating the relationships amongst the constructs. The arrows that lie between constructs represent the fact that we do not know whether these constructs overlap; because no one has conducted research using these constructs the possibility for interaction must be depicted. Arrows going backward from outcomes to the constructs of interest indicate feedback loops that occur over time and through experience, suggesting organizational learning effects.

3. Alternative theoretical foundations for the study of incubators-incubation In the introduction to this article, we touched upon the theoretical foundations employed in

A Real Options-Driven Theory of Business Incubation

Figure 2.

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Incubation process model.

extant incubator-incubation research. In this section, we consider a variety of theories as alternatives for grounding our incubation process model.

ories cannot be used to adequately address the resource munificence construct in our model.

Economics theories

Behavioral theories Behavioral theories examine the influence of the environment on the unit of analysis (Skinner, 1976). A behavioral approach could be used to study the influence of the external environment on the incubator, and the influence of the internal incubator environment on incubatees. However, the existence of three discrete environments (external, incubator, and incubatee) significantly complicates an empirical behavioral study of the incubation process. Additionally, behavioral the-

Classical theories of economics focus on supply and demand equilibria. A classical economics theory of business incubation would predict the incubation of new ventures centering on innovations that are perceived—from an economic rationality/transaction cost economics perspective (Coase, 1937)—to be capable of satisfying demand while maximizing profit potential when properly commercialized. Classical theories of industrial economics can be criticized, however, for their assumptions that markets operate perfectly rationally and at arms’ length. Such assumptions frequently do not describe the experiences of

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many incubatees, who often rely upon personal relationships and face-to-face transactions when diffusing their innovations.

Resource-based and knowledge-based views The resource-based view (Barney, 1991; Penrose, 1959; Rumelt, 1984; Wernerfelt, 1984) is a strategic view of the firm’s ability to extract rents from ‘‘bundles of innovations’’ as a function of four dimensions: value, rareness, imitability and substitutability (Barney, 1991). From a resourcebased perspective positive incubation process outcomes could be explained and predicted as a function of these four dimensions. For example, a well-funded incubator with impeccable innovation industry contacts and access to a pool of highquality innovations and experienced entrepreneurs and management teams is more likely to be associated with successful incubation outcomes than an incubator without access to these resources. The resource-based view is a compelling theory, and can provide insight into the way in which the incubator values and selects incubatees. However, the resource-based view can be faulted for ignoring issues of process (Foss, 1998) and as such is not an appropriate lens for examining the incubation process. A subset of this lens, the knowledge-based view (Nonaka, 1994; Nonaka and Takeuchi, 1995) of the firm, could be used to explain the incubation process as the accumulation and application of new venture development know-how to the mentoring of the incubatees. However, while the knowledge-based view could provide an interesting foundation for future research, it does not accommodate the selection process component of the incubation process in our model, and is thus an inappropriate lens for this study.

Dynamic capabilities theory An extension of the resource-based and knowledge-based views of the firm, the dynamic capabilities theory focuses on processes that develop through path-dependent organizational learning over time and which enable the firm to achieve and

maintain strategic competitive advantage when market environments shift (Deeds et al., 1999; Teece and Pisano, 1994). These processes can include new product development, strategic decision-making and alliance formation (Eisenhardt and Martin, 2000) and, in high-velocity markets, the ability to ‘‘continuously morph’’ (Kotha and Rindova, 2001). A dynamic capabilities approach would facilitate inquiries into the way in which an incubator, over time, builds new venture development resources and capabilities and allocates these resources to the transformation of incubatees into value-producers. Moreover, a dynamic capabilities approach would serve as a strong theoretical foundation for studies centering on development strategies of incubatees, and new ventures writ large. When the incubator is the unit of analysis, however, the focus on building and maintaining strategic competitive advantage that is intrinsic to the dynamic capabilities perspective is not so important because the typical incubator does not have many local competitors.

Agency theory Agency theory focuses on the relationships between principals who delegate tasks to their agents (Eisenhardt, 1989). Problems arise in the relationship because it is inefficient for the principal to continuously monitor the agent and because of goal or perspectival differences between the principal and agent. Agency theory could provide an adequate foundation for research centering on the incubator manager–incubatee dyad. However, agency theory does not address the issue of network effects that have been identified in previous incubator–incubation research. Specifically, a focus on the incubator manager–incubatee dyad neglects the fact that relationship-building throughout the incubator network is associated with incubation success (Hansen et al., 2000; Lichtenstein, 1992). Moreover, the incubatees do not work for the incubator manager in the traditional sense of the principal– agent dyad: Rather than working for the success of the principal’s firm and shareholders, the incubatees work to attain their own firm’s success.

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Institutional theory

Scaffolding theory

Institutional theory posits that organizations monitor competitors and trend toward isomorphism (Dimaggio and Powell, 1983; Zucker, 1987). Research questions emanating from this perspective center on the ‘‘process of becoming institutionalized, and the . . . impact of institutions on organizations, especially on organizational structure and processes within the organization’’ (Kuhns, 1999, p. 28). From an institutional perspective, the incubator could be viewed as mediating the impacts of institutions on the incubatees, amplifying the positive and mollifying the negative. Alternatively, if the incubator itself is perceived as an institution by its stakeholders, the manner in which the incubator impacts the organizational structure and processes occurring within incubatees could also be examined. Recent research employs an institutional perspective to compare the evolution of various phenomena in the venture capital industries in China and the West (Bruton and Ahlstrom, 2003) suggesting that institutional theory may be useful for future incubator-incubation research that examines the effects of local, regional, national and international institutions on the incubator and its incubatees.

Scaffolding theory is a communicative approach that centers on providing learners with conceptually driven assistance, on demand, and with an initial high intensity that decreases as the learner builds competencies (Presseley et al., 1996). A scaffolding perspective would center on the incubator manager–incubatee dyad, with the manager as teacher and the incubatee as learner. While this approach does not address the selection and resource infusion aspects of our process model, this approach can be recommended for researchers seeking to explore the educational/ coaching aspects of the incubator-incubation phenomena.

Structuration theory Structuration theory is a constructivist approach to understanding the production of and reproduction of social systems (Giddens, 1984). It is related to institutional theory, and has been used to examine the field of entrepreneurship and the process of instantiating a new firm (Jack and Anderson, 2002; Sarason et al., 2002). This theoretical approach could be used to support research on how the embedded incubator context facilitates the reproduction of viable business systems within incubatees. Such an approach is useful in developing a deeper theoretical understanding of the differences between incubated and non-incubated firms, and for studies centering on incubatee development. It could prove particularly useful in participant observation-based case research.

Options theory A real option is created through an initial investment decision, followed by subsequent investment decision(s) (Rosenberger, 2003). Option creation and subsequent incrementally staged investments (i.e. option exercise) confer future decision rights, preferential access to opportunities, access to a potentially valuable upside, and the ability to contain downside risk by limiting the cost of failure to the sunk cost of constructing the option, minus any remaining option value (Bowman and Hurry, 1993; Copeland, 2002; Dixit, 1992; Dixit and Pindyck, 1994; Luehrman, 1998; McGrath, 1999; Mitchell and Hamilton, 1988; Trigeorgis, 1993). Option creation and exercise are impacted by five factors: ‘‘(1) uncertainty, (2) asset value, (3) irreversibility, (4) exercise costs, and (5) competition’’ (Rosenberger, 2003). When investment decisions are encumbered by extreme volatility, option creation increases; as volatility is reduced, options exercise increases (Rosenberger, 2003). A real options perspective would view incubatee selection as the creation of an option, and subsequent resource infusions and monitoring and assistance as option exercises.

Theory selection While some of the alternative theoretical lenses reviewed above show great promise in a variety of future research applications, the real options

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perspective seems to be the best available lens for capturing the operational setting and underlying logic that drives the incubation process of selection, monitoring and assistance, and resource infusion vis-a`-vis incubatees. Accordingly, in the next section—using the incubation process model in Figure 2 as our organizing guide—we employ options theoretic reasoning to build a theory of business incubation, motivating propositions along the way.

containing the cost of potential terminal option failure.

The function described in our theory above is expressed as follows: BIP ¼ f ðSP þ M&BAI þ RMÞ where .

Proposition 1: The options lens is the most appropriate theoretical approach for developing a theory of business incubation that predicts and explains business incubation outcomes.

4. A real options-driven theory of business incubation Ultimately, a theory is a parsimonious description of the causal relationships between observable variables or non-observable constructs that is broadly generalizable to some discrete phenomena (Bacharach, 1989). A good theory ‘‘explains why empirical patterns were observed or are expected to be observed’’ (Sutton and Staw, 1995). In this section, we draw from real options theory and the discussion above to build theory that explains and predicts how and why variation in the measures of the constructs in our model of the process of business incubation can be expected to explain and predict the likelihood that new ventures will survive the early stages of development.

Theory of business incubation Our theory of business incubation is thus: Business incubation performance—measured in terms of incubatee growth and financial performance at the time of incubator exit—is a function of the incubator’s ability, developed over time and with the accumulation of new venture development capabilities and resources, to create options through the selection of weak-but-promising intermediate potential firms for admission to the incubator, and to exercise those options through monitoring and counseling, and the infusion of resources while

. .

.

BIP ¼ business incubation performance SP ¼ selection performance; M&BAI ¼ monitoring and business assistance intensity; and RM ¼ resource munificence.

In the following subsections each construct in our theory is defined, and the causal linkages among the constructs are explained.

Business incubation performance. Business incubation performance (BIP) is measured in terms of incubatee growth and financial performance at the time of incubator exit. Operationally, there are five different mutually exclusive incubatee outcome states at the completion of the incubation process: 1. The incubatee is surviving and growing profitably. 2. The incubatee is surviving and growing and is on a path toward profitability. 3. The incubatee is surviving but is not growing and is not profitable or is only marginally profitable. 4. Incubatee operations were terminated while still in the incubator, but losses were minimized. 5. Incubatee operations were terminated while still in the incubator, and the losses were large. Historically, the literature has suggested that the first three outcome states are indicative of incubation success and the last two outcome states are indicative of failure (Hackett and Dilts, 2004). A real options perspective, however, can be used to argue that, in addition to the first two outcome states, the fourth outcome state is a success because the cost of failure has been limited to the

A Real Options-Driven Theory of Business Incubation

cost of creating the option less any remaining option value.7 Additionally, we recommend that the third outcome state be considered a failure: The incubation of ‘‘zombie companies’’ is not identified in any known incubator’s mission statement.

Selection performance. Selection performance (SP) refers to the degree to which the incubator behaves like an ‘‘ideal type’’ venture capitalist when selecting emerging organizations (options) for admission to the incubator. Relevant dimensions of selection performance include a propensity to select an emerging organization for admission to the incubator based on managerial characteristics, market characteristics, product characteristics and financial characteristics. Managerial characteristics refers to the prior employment experience and technical expertise of the applicant’s management team. Market characteristics refers to the properties of the market which the applicant intends to enter. Product characteristics refers to the properties of the product or service which the applicant intends to commercialize. Financial characteristics refers to the profit potential of the applicant. Ceteris paribus, incubators that operate like venture capitalists and emphasize the importance of managerial team characteristics, market and product characteristics, and expected financial outcomes (Riquelme and Watson, 2002) in selecting candidates for incubation can be expected to outperform incubators that do not.8 Incubators that maintain certain standards for admission create value when selecting options that seem to have greater potential for success and when rejecting those with limited potential (i.e. deferring the option), by (a) helping contain the cost of potential entrepreneurial failure, (b) boosting the chances for success for ‘‘weak-butpromising’’ firms (through systematic incubation in the nurturing environment of the incubator), and (c) offering rejected companies’ management the opportunity to reflexively reconsider the objective potential of their planned business model. Additionally, widespread knowledge of the existence of a selection mechanism can induce positive business-building behaviors and self-corrective measures in the entire pool of shadow

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options,9 leading them to structure themselves so they are better qualified for admission, and, intuitively, better positioned for success in the market. The utility of applying the options lens to selection processes within incubators is underscored by the fact that the options lens helps to explain why the incubator selects firms that the rest of the market rejects. The value of a start-up venture is particularly uncertain during its early stages, when it is struggling to overcome a lack of resources and simultaneously develop its organizational self and its first product(s) (McGrath, 1999). Moreover, the selection of the options is constrained by the need to select ‘‘weak-butpromising’’ options.10 Thus, makes a traditional valuation of an incubator’s option portfolio is particularly tricky. However, because the incubator functions as a remedy for market failure vis-a`vis the survival of intermediate potential new ventures, and because the incubator’s performance is measured in terms of its incubatee’s survival or death, it is possible—and sufficient—to value the incubator’s portfolio in nominal or percentage terms rather than monetary terms.11 With the above points in mind, we motivate our second proposition. Proposition 2: Business incubation performance is positively related to selection performance. The incubator obtains certain future decision rights related to the developmental path of the incubatee when it transforms the incubation applicant from a ‘‘shadow option’’ to a ‘‘real option’’ by recognizing its underlying potential and admitting it to the incubator. In options terminology, these rights include the option to defer, the option to switch, the option to abandon, and the option to change size (expand/contract). While the decision rights that a venture capitalist acquires when taking an equity stake in a portfolio company are explicit and legally bound, the incubator acquires more informal, flexible influencing rights related to the development path of the incubatee. We term the operationalization of these decision rights in an incubator ‘‘macro-management’’ of the innovation process. Macro-management occurs through the value-adding processes of monitoring and assistance, and resource infusion,

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and in extreme cases, through expulsion from the incubator.

Monitoring and business assistance intensity. Monitoring and business assistance intensity (M&BAI) refers to the degree to which the incubator observes and helps incubatees with the development of their ventures, including helping them to learn from low-cost failures and containing the cost of potential terminal failure. Monitoring and business assistance intensity is characterized by dimensions of time intensity of assistance provided, comprehensiveness of assistance provided, and degree of quality of the assistance provided. Time intensity of assistance provided refers to the percentage of working hours devoted to monitoring and assisting incubatees. Comprehensiveness of assistance provided refers to the degree to which strategic-, operational-, and administrative-related assistance (Chrisman, 1989) are provided by the incubator to the incubatees. Quality of assistance provided refers to the relative value of the assistance provided by the incubator to the incubatees. Adapted from (McGrath, 1999; Rice, 2002). The incubator adds value to the options by making available a range of high quality monitoring and business consulting services inside the business incubator (Allen and Rahman, 1985; Brooks, 1986; Hansen et al., 2000; Mian, 1997; Sherman and Chappell, 1998; Smilor, 1987; Temali and Campbell, 1984; Udell, 1990). Monitoring and the provision of real time feedback help contain downside risk to the options by (ideally) preventing them from making stupid but costly, and potentially terminal business mistakes. Monitoring can be both passive and active (Rice, 2002). In the best of cases, monitoring and feedback are provided proactively and real-time in order to reduce the incidents of cost-incurring mistakes. In his case-based exploratory research, Rice (2002) suggests that the time-intensity devoted to counseling tenant companies may be a good predictor of business incubation outcomes. By helping incubatees with strategy formation and monitoring the development of effective strategy implementation mechanisms and sustaining business structures, the incubator can identify developmental stage-gates at which the options to switch

strategies, to expand or contract incubator resource infusions as market and strategic needs dictate, or to abandon the option altogether present themselves. This leads us to motivate our third proposition. Proposition 3: Business incubation performance is positively related to intensity of monitoring and business assistance efforts.

Resource munificence. Resource munificence (RM) refers to the relative abundance of incubator resources and is characterized by dimensions of resource availability, quality and utilization. We borrow from Daft (1983) to define business incubator resources as ‘‘all assets, capabilities, organizational processes, attributes, information, knowledge, etc., controlled by [the incubator] that enable the [incubator] to conceive of and implement strategies that improve its efficiency and effectiveness’’ (Daft, 1983) in Barney (1991), as they relate to facilitating new venture development. Incubator resources can be divided into two sub-categories based on whether they are internal or external to the incubator. Internal resources are resources that are inside the incubator and are related to economics, environment, personnel, or operations. External resources are resources that are outside the incubator and can best be summarized as the combination of the innovation communities encompassing the incubator and the clusters of industrial innovation networks connected to the incubator and related to the incubatees. Resource availability refers to the incubator’s ability to provide incubatees with access to resources. Resource quality refers to the relative value of the resources the incubator provides to the incubatees. Resource utilization refers to the incubatees’ usage of the resources they receive from or through the incubator. Generally, incubator resources are built, maintained and allocated by the incubator manager, sometimes in concert with an incubator advisory board. The infusion of incubator resources into the options (i.e. incubatees) confers access to a potentially valuable upside. For the incubator, this upside is not necessarily an equity cash-out, as not all incubators take an equity stake in their

A Real Options-Driven Theory of Business Incubation

incubatees. However, facilitating the survival of incubatees or containing the cost of failure of the options to the sunk cost of creating the option minus any remaining option value, and reporting these successes, can result in the renewal of annual operating subsidies, a very important upside without which many incubators would close. Intuitively, it seems likely that an incubator high in resource munificence (e.g. a well-funded, well-managed incubator with an impeccable network and access to a selection pool of high-quality innovations and experienced entrepreneurs and management teams) is more likely to be able to infuse its incubatees with resources and consequently to be associated with successful incubation outcomes than an incubator without these resources. Accordingly, we motivate our fourth and final proposition. Proposition 4: Business incubation performance is positively related to resource munificence.

5. Conclusions The objective of this article was to build a theory of business incubation by drawing from options theory. The theory that we developed helps to fill a gap in a stream of research that has been mainly atheoretical. It draws scholars’ attention to the complexity of the incubation process, while providing a parsimonious framework for describing it, and predicting and explaining incubation process outcomes. Our theory challenges the notion that most new ventures must fail, and extends our understanding of options-driven behavior in early stage new venture settings. From an options theoretic perspective, the incubator can be said to function as a laboratory for small- and medium-scale entrepreneurial adventures which are always kept to a boundedly rationally minimum investment cost. By staging investments of incubator resources in accordance with the level of venture development attained, the incubator-incubation process is no longer viewed as successful only if the incubatees survive, but also when incubatees cease operations as quickly (and as cheaply) as it becomes apparent that the reduced potential for venture success no longer justifies continued investment. Alternatively,

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because it recognizes the volatility of entrepreneurial ventures and the indeterminacy—at the time of incubatee selection—of outcomes, the real options lens supports the incubator’s decision to invest resources in incubatees even when a net present value (NPV) analysis suggests that such an investment would not be rewarded (Copeland, 2002). Our model of the incubation process and specification of the range of possible incubation outcomes offer several implications for managerial practice and policy-making vis-a`-vis incubator management and good entrepreneurial failure. First, incubator managers can use the model to develop inspection points and then audit their incubation processes. Second, with a real options perspective, a positive view of incubatees that fail quickly and cheaply can be adopted. The relevance of this approach vis-a`-vis incubator managerial practice and policy-making should not be understated: Incubators that help their incubatees fail quickly and cheaply are successful incubators because quick and cheap failures provide opportunities for entrepreneurial learning, firm recovery and repositioning (or later firm ‘‘reincarnation’’ in the event of terminal firm failure), an optimal allocation of incubator and incubatee owner resources, and an optimal injection of organizational population churn into the local economy.

Acknowledgments We would like to thank Germain Bo¨er, Austin Cheney, Lori Ferranti, James Foster, Josh Johnson, William Mahaffey, Dave Owens, Surya Pathak, Ken Pence, Steven Van Dyk, John Westbrooks and Bin Xie for their comments and suggestions on earlier versions of this paper.

Notes 1. See Storey (2003) for a more detailed explanation of the situations in which publicly subsidized interventions are appropriate for remedying entrepreneurial market failures. 2. We define incubation outcomes in terms of incubatee success and failure. In previous research (Hackett and Dilts, 2004), incubation success was described in accordance with the literature as follows: (a) The incubatee is surviving and growing profitably; (b) The incubatee is surviving and growing and is on a path toward profitability; (c) The incubatee is surviving but is

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not growing and is not profitable or is only marginally profitable. Failure was described in accordance with the literature as follows: (d) Incubatee operations were terminated while still in the incubator, but losses were minimized. (e) Incubatee operations were terminated while still in the incubator, and the losses were large. 3. This categorization of technologies was first introduced by Whelan (1989) and cited in, and made widely known by Coombs and Richards (1991). Briefly, critical technologies are technologies that confer a competitive advantage today, strategic technologies are technologies that are expected to confer a competitive advantage in the future, and enabling technologies are complementary technologies that capacitate the functionality of critical and possibly strategic technologies. 4. We employ the logic model to help clarify assumptions regarding incubator-incubation phenomena. The use of logic models to conceptualize and evaluate intervention programs— and business incubation programs are indeed intervention programs (Rice, 2002)—has an established track record in the public sector, e.g. U.S. Department of Justice (1994); Urban Institute (1997). 5. Although we include New Venture Development and New Product Development in the Activities column in Figure 1, they are beyond the scope of this paper, are primarily the responsibility of the incubatee, and are not discussed in detail. 6. Macro-management of the innovation process is the incubation process; i.e. the value-adding processes of monitoring and assistance, and resource infusion, and in extreme cases, expulsion from the incubator. 7. Financial dependency on annual subsidies forces incubators to operate in a politically charged environment where they must constantly demonstrate the ‘‘success’’ of the incubator and its incubatees in order to justify continued subsidization of incubator operations with public funds. Such a politically charged environment can tempt incubator-incubation industry stakeholders to underreport incubator-incubation failures and over-report successes. By redefining what constitutes success vis-a`-vis an incubation outcome, the real options perspective enables the creation of an environment in which more accurate reporting is less politically and budgetarily dangerous. See Udell (1990) for a discussion of the inaccuracy with which incubators report their successes. 8. Lumpkin and Ireland (1988) note that most incubators use at least some of these selection criteria. 9. A ‘‘shadow option,’’ is an option that has not yet been recognized as having latent value (Bowman and Hurry, 1987). 10. Because the incubator represents an attempt to help entrepreneurial new or young firms overcome some resource gap(s) that prevent them from succeeding in their early stages of development, it is important from an economic rationality perspective to differentiate the types of applicants for admission to a business incubator in the following ways: (a) those that cannot be helped through business incubation, (b) those that should be incubated due to the existence of some resource gap(s) and (c) those that do not need incubation. Ideally, only those firms that are ‘‘weak-but-promising’’ (weak due to a lack of resources, but promising in the sense that they have built a compelling business case) should be considered incubation candidates (Culp, 1996). 11. For example, the options portfolio could be described as

‘‘highly likely’’ ‘‘likely’’ ‘‘neutral’’ ‘‘unlikely’’ or ‘‘highly unlikely’’ to have good returns where good ¼ incubatee survival. Percentages could also be assigned. For example, 80% of the options are expected to succeed while 20% are expected to fail. Ex post-facto assessments (snapshot ‘‘report cards’’) could also be made at discrete points in time. For example, in accordance with our definition of BIP, options that failed quickly and cheaply or that survived and made a profit or were on a path to profitability at time of incubator exit would be counted as successes while options that are marginally viable or were terminated with heavy losses would be counted as failures.

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