Although web3 is a new ecosystem yet to solidify its processes and culture, it shares one trait with previous technological revolutions: the influx of capital.
Forbes found that venture capital firms (VCs) deployed $30B+ globally in 2021 into crypto startups, a ten-fold increase from the year before. If the trend continues, we should see VCs starting to play a more active role in web3 development. One such medium for greater involvement is startup incubation.
What could startup incubation in the web3 space look like? In a post-pandemic startup culture and a new frontier of technology, there will likely be differences from previous incubation models. With that in mind, let’s dive into this ecosystem’s potential.
Background: Business Incubation
I'd like to offer some operational terminology for clarity because this article will delve into the details of incubation (particularly, startup incubation by VCs in the seed/pre-seed stage).
To begin, business incubation and business acceleration are two distinct offerings. Incubators typically attract early-stage firms that are still establishing their business strategy, whereas accelerators typically attract startups that have a minimum viable product (MVP), some users/testers, and are eager to scale.
A paper by Peters et al. sets the criteria for the modern business incubator:
- A shared office space, which is rented under more or less favorable conditions to incubatees (also known as tenants)
- A pool of shared support services to reduce overhead costs
- Professional business support or advice (‘‘coaching’’)
- Network provision, internal and/or external.
Of course, these features have changed since the first business incubator was established in the late 1950s. A paper by Bruneel et al. describes the evolution of their value proposition can be separated into three distinct generations:
- Generation 1 — office space and shared resources
- Generation 2 — coaching and training support
- Generation 3 — access to professional, technological, and financial networks
Generation 3 incubators include the current flagship incubators in the tech world. Firms like Venture Catalyst, On Deck Founders, and Creative Destruction Lab position themselves as the first advisors to a company, helping founders go from zero to one on their idea.
On the other hand, firms like Techstars and Y Combinator are known as accelerators. As I’ve mentioned, accelerators focus on scaling and improving the business model and scale of the company.
The time has come for the next evolution of business incubators. Following a global pandemic and the shift toward web3, we have already begun to see Generation 4 of business incubators.
I’ll also only be focusing on VC incubators, rather than academic institutions and non-profit development corporations. At this stage, VCs are looking more for founder-market fit during their due diligence rather than a specific product. VC incubators have been the most popular format in web3, and I believe they’ll soon develop flagship incubation programs (e.g. Chapter One Studios).
For the sake of the article, I’ll call this evolution of incubators “Generation 3.5” because they follow similar investment theses as Generation 3 but are still somewhat different because of their focus and strategy.
Current Web3 Investment Practices
To understand why incubation is pursued by VCs, we must first understand what value VCs see in web3 as a whole. Frankly, I'm not an expert in a VC's due diligence process for web3 companies. It is unknown territory for most firms, so I suspect that they all have similar criteria when considering companies.
Still, I’ve observed some general trends of web3 investments by VCs.
Decentralized finance: Decentralized finance (DeFi) applications are built on top of decentralized protocols and allow users to trade, borrow, and lend without the need for a centralized intermediary. This is a huge opportunity for VCs, as DeFi has the potential to disrupt the traditional financial sector.
Data and storage: Web3 technologies offer the potential a more secure and decentralized way to store data, which is a major advantage over traditional centralized storage solutions. This is an important issue for VCs, as data security is becoming increasingly important in the age of data breaches and cyber attacks.
Identity and security: Web3 technologies offer a more secure and decentralized way to manage identity data in addition to a way to aggregate your digital identity across platforms. This is an important issue for VCs, as identity theft and ownership is a major problem in the digital world.
Onboarding and accessibility: Providing on-ramps and easy-to-use platforms in web3 promotes new users to join the ecosystem, thereby promoting greater adoption. This is a huge opportunity for VCs, as encouraging greater web3 adoption could have ripple effects on the ecosystem’s ROI as a whole.
VCs are still testing their investment theses. In this uncharted territory, they have the potential to win big or lose it all. Many VCs are competing for the most promising deals, and the value they have beyond money is less in this space.
Some of the most notable firms — like Andreessen Horowitz, Union Square Ventures, and Sequoia Capital — are deploying significant capital into the space.
On the other hand, web3-native funds — like Paradigm, Variant Fund, and Chapter One — are focused on providing mentorship and thought leadership to steer their portfolio towards success.
Business Incubation Design: Generation 1-3
As a reminder, the value proposition of business incubators have evolved in generational phases. Here’s a quick recap:
- Generation 1 — office space and shared resources
- Generation 2 — coaching and training support
- Generation 3 — access to professional, technological, and financial networks
The modern-day incubator offers features that the paper by Bruneel et al. grouped into three categories: infrastructure, business support, and network access.
- Infrastructure refers to office space, meeting rooms, reception, and specialized equipment. It allows the incubatee to reduce overhead and get access to more professional amenities without the cost.
- Business support refers to coaching and training. Incubators give advice and host internal practice events for companies to get better at pitching, outreach, and hiring. It allows the incubatee to learn how to efficiently run their company at a faster pace.
- Network access refers to the people that the firm connects incubatees with. High network access gives incubatees opportunities with people they couldn’t contact themselves. It allows the incubatee to gain legitimacy and find effective operators to scale their company.
For each role, the incubator chooses what type it wishes to be. A paper by Bergek and Norrman highlights some design questions for incubators.
Before providing their services, incubators must choose between selecting companies because of founder fit or idea strength. They must also consider the size of the cohort. Like an ecosystem, they can either be k-selected (small population and high survival) or r-selected (large population but low survival).
For business support, incubators must choose when and how to provide counseling.
- Proactive continual counseling requires firms to create permanent resources — like blogs or videos — for their incubatees.
- Proactive episodic counseling requires firms to conduct regular check-in meetings with their incubatees, offering advice and suggestions before it is urgently needed.
- Reactive episodic counseling requires firms to respond to urgent issues of the incubatees by providing support in times of need, such as practice runs of a pitch.
Lastly, network access largely depends on the composition of the incubator. An incubator can have a geographic niche, a sectorial/technological niche, or a niche involving both geographic and sectorial/technological factors.
With a myriad of options for incubator composition, it’s difficult to determine what the landscape for incubating web3 startups will be like. Nevertheless, there will likely be a correct combination of choices in the three roles that results in success.
Most modern-day incubators have all the features listed above. Where they differ, however, is in the relative importance of each feature. One incubator might be network-heavy, while another could focus on a robust advisory team. These design choices are fueled by what the market (in this case, the incubatees) wants. So, what will web3 companies want?
Web3 Business Incubation: Generation 3.5
To anticipate the wants and needs of web3 startups, I’ll start by describing the trajectory of business incubation. The evolution of business incubation was prompted by changing incubatee sentiment. Based on feature usage, later generations adopted and added more to the incubator’s business model.
As seen in the table above, the study found no significant changes in the infrastructure offerings. All three generations offer office space and meeting rooms to their incubatees. However, the size of the space varies between different firms.
Business incubators also chose between in-house or outsourced coaches. While all generations provide training to tenants, technology has enabled the use of materials (newsletters, videos, etc.) to inform their tenants rather than face-to-face mentorship. Business support has also risen in relative importance.
Depending on the type of incubator, there are different types of networks — financial or service — introduced. Only second and third-generation incubators provided financial resources to tenants, and more incubatees took advantage of the access to capital in later generations
Usually business incubators have internal values that they select for, which makes the criteria inconsistent within generations as well as between generations. However, tech focus, innovation, and growth potential were all consistently chosen as criteria.
The demographic of incubatees has also evolved. These changes could reflect the emphasis on technology startups in recent generations, which could be exacerbated by the young web3 demographic.
A notable trend in the study was the rapidly declining time spent in the incubator. VCs have shown their willingness to invest larger amounts pre-seed, resulting in a lower demand for extended incubation periods.
Another interesting trend is the lowering of relocated tenants. Many founders know that the chances for startup success is much higher in tech hubs around America, like San Francisco or Miami.
These trends show that business incubation is moving away from simply offering a bundled office space for promising companies. VCs are spending their time cultivating a broad network of mentors, providing access to funding, and developing their incubatees’ business models.
So, what does this mean for web3 business incubators?
I believe that web3 incubators will provide the most value through their thought leadership and capital. These incubators will also find new ways to add value, while discovering that previously important features are now unnecessary. These will be the defining characteristics of Generation 3.5.
It’s hard — even for experts — to predict the web3 market and its needs. With any rapidly-changing sector, it demands adaptability and determination. Successful incubators will be able to provide the services their incubatees need outside their core business development. Functions like legal support, product design, and business strategy will be how the incubator adds value.
In addition, varied perspectives in the incubator will be helpful. Having mentors with backgrounds in different sectors could help web3 companies create original and sustainable business models, taking inspiration from unlikely places.
The volatility in the web3 space makes the industry daunting for potential founders. Nevertheless, the volatility can only be quelled by companies solving the major problems in the space. This cyclical paradox needs an intervention, which occurs in the form of funding.
Rather than granting access to many services at a low price, web3 incubators will have to act as first-check investors. Making sure that the founding team has a stable income allows them to build and ship reliably while the space is stabilizing.
Infrastructure provided by incubators will be different as well. In the aftermath of the pandemic, incubators have started to rely more on providing network access in comparison to infrastructure access. There isn’t a need for office space or meeting rooms when everyone is working remotely.
On the contrary, the rise in remote work has made virtual meetings mainstream. The network access that incubators provide are much more important. These connections could take the form of outsourced advisory teams or simply just ideation sessions.
Taken as a whole, it seems like a lot will change in business incubation. However, it’s too early to tell whether it will be drastic enough to entail a new generation. For now, I’ll simply refer to it as Generation 3.5.
Takeaways
Business incubation in the web3 space will serve a different purpose, which will be reflected in their composition. Whereas previous incubators were focused on company growth, web3 incubation is focused on ecosystem growth.
We are in a unique time where incubation is a positive-sum action. Competitors in web3 can both be very successful, as the vast majority of our society has not yet entered the space. Thus, every new user onboarded is helpful not only to the intended company but also its competitors and other companies in web3.
The purpose of this article was to highlight some possibilities. My takes could be all right or all wrong. I anticipate that I’ll land somewhere in the middle, hopefully more right than wrong. Nevertheless, I’m certain of one thing: a lot is about to change.
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