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October 30, 2000

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Hard Times in the Hatchery

By LAURA M. HOLSON

Kim Kulish for The New York Times
The warehouse near Los Angeles of Sameday.com, a product distributor nurtured by Idealab, a so-called Internet incubator.


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Bill Gross, chief of Idealab, has canceled an initial stock offering.


Call them instigators. Or catalysts or accelerators. Just please don't call a company that hatches Internet companies an "incubator" anymore.

Now that the fiery crash of Internet stocks has many investors cursing dot-coms as the devil's spawn, the investment companies that hatch dot-coms consider incubator a tainted term.

"It's like if your name was Monica before the Clinton scandal, it was fine; but it's not now," said Bill Gross, chairman and chief executive of Idealab, a Pasadena, Calif., company that was the first and best-known, um, I-word.

Mr. Gross knows the ignominy. Twelve days ago, tired and dragged down by a cold, he canceled a much-anticipated initial public stock offering for Idealab, warning that tough times were ahead. Two days later, Eve.com, one of the largest beauty sites on the Web and a company that Idealab had fostered, said it was shuttering its doors and laying off most of its 164 employees. And last week, Scout Electromedia, another company Idealab invested in, went out of business.

For an entire segment of the technology-financing industry, Idealab's string of bad news has been a chilling sign of the times. If Mr. Gross is losing faith in the incubator approach these days, who else might hope to make it work?

"It's pretty clear by pulling the offering they admitted what everyone knew all along," said David Dusenbury, a research analyst in Credit Suisse First Boston's technology group. "There is no market for incubators right now."

It was five years ago that Mr. Gross, already wealthy from the sale of his software company Knowledge Adventure, conceived and executed the idea of a technology incubator. The notion was to offer shelter and succor for new Internet-related businesses intent on getting quickly to market. By providing office space and administrative support, marketing and public relations in return for an equity stake in each of its wards, Idealab was offering much more than venture capital firms — which typically dispense only money and advice.

Mr. Gross's concept was widely imitated as other entrepreneurs and financiers watched fledglings like CitySearch (which later merged with Ticketmaster Online) emerge from the Idealab hatchery and show signs of taking flight. In 1999, when Idealab spinoffs produced some of the year's hottest stock offerings, like the e-tailer eToys and the Web search company GoTo.com, Mr. Gross seemed to be sitting on a nest of golden eggs.

Now, though, with the stocks of eToys and GoTo.com trading at a fraction of last year's highs, the business model that Mr. Gross cultivated is being called into question. Within two days of Idealab's Oct. 18 announcement, Garage.com, which provides financing and other services for high-technology start-ups, announced that it, too, would delay its initial stock offering.

And publicly traded investment companies like CMGI and the Internet Capital Group, which have managed and nurtured Internet start-ups but bristle at the I-word, have seen their own stock prices plummet. CMGI's shares, which touched a high of $164.75 in January, closed on Friday at $16.75. Internet Capital, which traded at $212 last December, ended last week at $12.

CMGI's chairman, David Wetherell, is as insistent that his company will ride out the current turbulence as he is adamant that CMGI is not and never has been an incubator. It is, according to the Web site, a "leading global Internet operating and development company."

"There is a method to our madness," Mr. Wetherell said. "There aren't a lot of incubators with $1.5 billion in revenue."

In any case, whatever they may be called, there are now some 400 companies, all pursuing a business similar in many ways to Mr. Gross's Idealab. And some analysts and academics are predicting that within a year, fully half these companies will be out of business.

"The success of Idealab portfolio companies was noteworthy but was not proof that the incubator model works," said Dave Witherow, chief executive of Venture One Economics in San Francisco, which tracks the venture capital industry. "It proves the challenges and suggests that the model itself is not so simple."

But like many of his peers, Mr. Gross contends that there is nothing wrong with the business plan. Idealab has spun off 55 companies over the years, company executives said. About 50 are still in business, while the rest have failed. It is currently incubating 12 companies and will continue to create new ones.

"It's a mistake to read too much over all into this," Mr. Gross said of the recent gloomy announcements. Investors are now focused on profitability, he said, and any layoffs at the companies Idealab backs are simply a reflection of that concern. Besides, he added, Idealab spends only about $72 million a year and recently raised $1 billion in a round of financing.

"I need to show people I can create value in bad times," he said. "When people see what we can do, then they will come back."

Of the $1 billion raised, two-thirds has already been spent, said Howard Lee Morgan, Idealab's vice chairman. Much of that money went toward buying larger stakes in companies in which Idealab has already invested, but needed to increase ownership so it could retain control, including CarsDirect.com. As for the remaining $300 million or so, "we have enough money for the next two to three years," Mr. Morgan said.

According to Morten T. Hansen, an assistant professor of business administration at Harvard Business School, the median first round of financing for a start-up at an incubator is $690,000. But that does not take into account the additional money burned if a company has to stay under incubation longer than planned (say, for a third or fourth round of financing) or if jittery investors demand that an incubator commit money of its own as a show of confidence.

"You can go through money quickly," Mr. Hansen said. "For the average incubator, that is expensive depending on how many ideas fail."

In the old, time-honored approach to starting a business, start-up expenses used to be paid for by the entrepreneur (remember all those stories about plucky young companies financed on the founder's credit card?), or by a venture capitalist.

But after the notion of "Internet time" caught on and made the old evolutionary approach to entrepreneurship seem as quaint as carbon paper and Dictaphones, incubators popped up as the sort of place where entrepreneurs could hatch their embryonic ideas while getting instant access to technical experts, marketing strategists and executive recruiters until their businesses matured and could thrive on their own.

Of course, none of this came free.

Generally, like some venture capitalists, incubators command a 25 percent to 40 percent stake in a company, according to a study conducted by Mr. Hansen and his colleagues. And many of the incubators in the study required a fee along with an equity stake. Idealab, for its part, generates most of its own ideas so it is able to keep a larger equity stake than in cases where an entrepreneur brings an idea to the incubator.

Innovative as the concept might have been in the early going, Mr. Hansen said that by now more than 8 of 10 incubators are providing the same basic services, like public relations and accounting. "It is a commodity," he said.

Of the 400 or so incubators in existence today, he said, at least half have never hatched a company and will probably fail in the next 12 months. "They have no viability," he said, citing inexperience as a widespread problem.

Another criticism voiced by several analysts is that some incubators that were formed more recently have focused too much on the Internet fashion of the moment. Often mentioned in this regard is the Internet Capital Group, which specializes in the business-to-business e-commerce market. As that sector has fallen out of favor, so have the companies that Internet Capital invested in — like Breakaway Solutions, a provider of e-business products, and Onvia.com, a marketplace to help small businesses buy and sell services and products. Shares in both companies have tumbled more than 90 percent since reaching 52-week highs. And Internet Capital has also suffered from the collapse of its own share price, making it difficult to use its stock as currency for acquisitions.

"The size of the opportunity hasn't decreased," said Ken Fox, co- founder of Internet Capital. "But building companies is hard, and the Internet didn't make it any easier."

In Idealab's case, it may have focused too much on Internet companies aiming their products or services at the consumer market.

Idealab's portfolio of companies lets you buy almost anything on the Web — from pet products and cookware to bridal wear and cosmetics. But analysts say the failure of the beauty site Eve.com, which had almost all the makings of a winner — lots of traffic, $1 million in monthly sales and name recognition, but no profit — could foreshadow doom for the rest.

"We crushed everyone in the market and it wasn't enough," Mr. Gross said. He said that in the future, Idealab would not limit the types of companies it would create or invest in.

Mr. Hansen of Harvard contends that perhaps the most valuable service incubators can provide start-ups is access to a network of business relationships with more established companies. Some incubators already do that, he said, pointing to Hotbank, a Mountain View, Calif., company managed by Softbank Venture Capital, an affiliate of the big Japanese investment company Softbank.

Hotbank gives entrepreneurs access not only to the usual incubator services, he said, but also to Softbank's roster of partners, including Yahoo and Cisco Systems. But only about one in four incubators are able to provide this kind of relationship network, Mr. Hansen said.

In various ways, some incubators have begun to adapt to the new, less hospitable financial climate. Ecompanies, an incubator set up last year by Sky Dayton, founder of Earthlink, and Jake Winebaum, the former chairman of Disney's Internet unit, had trouble last summer raising a new round of financing. So it has formed a partnership with Sprint to develop wireless communications ideas. And last month, Ecompanies sold a stake in itself to Evercore Partners, a long-established, New York-based investment bank that was an adviser in the Viacom-CBS merger and has traditionally put money in old-economy ventures.

In the meantime, Mr. Wetherell's company, CMGI, has put the brakes on acquisitions and is concentrating on consolidating what it already owns. In the last few years, CMGI has acquired 34 companies and started eight others, Mr. Wetherell said. But by next July, he intends to whittle those holdings down to 15 companies.

Idealab's Mr. Gross acknowledges that he has learned hard lessons these last few months. "We've become very self-reflective," he said. "Maybe it was hubris to think it was easy."

He said Idealab would no longer acquire other companies, a strategy he said had not paid off for his company anyway. But it is conceivable that, if he regains investor confidence, Mr. Gross would consider trying to take Idealab public again though he would probably not call it an incubator.

"I believe I can take an `idea generator' public," he said. "Just not in this market."


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