A Real Options-Driven Theory of
Sean M. Hackett1
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-à-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: sean.m.hackett@alumni.vanderbilt.edu
2 outcome. Sources of market failure include extern-
Vanderbilt University
Management of Technology Program
Box 1518, Station B, Nashville, TN 37235 USA
E-mail: david.m.dilts@vanderbilt.edu
Journal of Technology Transfer, 29, 41–54, 2004
# 2004 Kluwer Academic Publishers. Manufactured in The Netherlands.
David M. Dilts
2
1999). The continuing growth, since 1980, in the
number of business incubators operating in North
America, however, suggests that many govern-
ments, local communities and private investors
believe that it is desirable to try to help ‘‘weak-but-
promising’’ firms to avoid failure by incubating
them until they have developed self-sustaining
business structures.1
We define business incubator as a shared office-
space facility that seeks to provide its incubatees
(i.e. ‘‘portfolio-’’ or ‘‘client-’’ or ‘‘tenant-compa-
nies’’) 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 incu-
batees 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 recog-
nize 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 com-
panies and employees, local universities and
university community members, industry contacts,
and professional services providers such as law-
yers, accountants, consultants, marketing special-
ists, venture capitalists, angel investors, and
volunteers.
Theoretical foundations in the incubator-incu-
bation literature are rooted in market failure
arguments. Market failure occurs when the com-
petitive transactive space for the production and
sale of goods and ideas fails to produce a desired
alities, imperfect information, monopoly power,
and public goods. Incubator-incubation research-
ers who subscribe to market failure theory believe
42 Hackett and Dilts
that structures and strictures within the market
impede the successful development of entrepre-
neurial new ventures, and that incubators-incuba-
tion 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. Co-
production of value theory asserts that the
incubation process is co-produced by the incuba-
tor 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 care-
fully structure and channel knowledge throughout
the incubator network in order to create condi-
tions that facilitate the development of incubatees
and the commercialization of their innovations.
While these perspectives and the incubator-incu-
bation literature in which they are employed serve
to adequately describe why and in what config-
urations 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 exam-
ine 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 capital-
intensive project selection-rejection decision-mak-
ing. 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-incu-
bation 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 incubators-
incubation by populating a standard logic model
with elements of incubator-incubation phenom-
ena. 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-à-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 develop-
ment. 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. Accord-
ing to the National Business Incubation Associa-
tion (NBIA), average incubation cycle times are
between two and three years.
To the extent that an incubator is the oper-
ationalization 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 exis-
tence 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 commerciali-
zation might go a long way toward explaining why
43
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 innova-
tion 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 cost-
effective and efficient ways unavailable to ‘‘weak-
but-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.
44 Hackett and Dilts

Figure 1. Business incubation logic model.

Incubation process model of incubator development and size of incubator.

The model is atemporal with arrows in the model
Guided by Campbell et al.’s (1985) description of
indicating the relationships amongst the con-
the value-added contributions of business incuba-
structs. The arrows that lie between constructs
tors, an insight that business incubation and
represent the fact that we do not know whether
venture capitalists’ investment activities share
these constructs overlap; because no one has
functional similarities, our systematic review of
conducted research using these constructs the
the literature, and fieldwork in North America and
possibility for interaction must be depicted.
Asia, we understand the principal elements of the
Arrows going backward from outcomes to the
incubation process to be incubatee selection,
constructs of interest indicate feedback loops that
monitoring and assistance, and resource infusion.
occur over time and through experience, suggest-
This process is depicted in Figure 2. Briefly, the
ing organizational learning effects.
model indicates that incubatees are selected from a
pool of incubation candidates, monitored and
assisted, and infused with resources while they
3. Alternative theoretical foundations for the study
undergo early stage development. Outcomes refer
of incubators-incubation
to the survival or failure of the incubatee at the
time it exits the incubator. Controls include In the introduction to this article, we touched
regional differences in economic dynamism, level upon the theoretical foundations employed in
 A Real Options-Driven Theory of Business Incubation
Figure 2.
extant incubator-incubation research. In this sec-
tion, we consider a variety of theories as alter-
natives for grounding our incubation process
model.
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-
45
Incubation process model.
ories cannot be used to adequately address the
resource munificence construct in our model.
Economics theories
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 innova-
tions 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 ration-
ally and at arms’ length. Such assumptions
frequently do not describe the experiences of
46 Hackett and Dilts

many incubatees, who often rely upon personal maintain strategic competitive advantage when
relationships and face-to-face transactions when market environments shift (Deeds et al., 1999;
diffusing their innovations. Teece and Pisano, 1994). These processes can
include new product development, strategic deci-
sion-making and alliance formation (Eisenhardt
and Martin, 2000) and, in high-velocity markets,
Resource-based and knowledge-based views the ability to ‘‘continuously morph’’ (Kotha and
Rindova, 2001). A dynamic capabilities approach
The resource-based view (Barney, 1991; Penrose,
would facilitate inquiries into the way in which an
1959; Rumelt, 1984; Wernerfelt, 1984) is a strategic
incubator, over time, builds new venture develop-
view of the firm’s ability to extract rents from
ment resources and capabilities and allocates these
‘‘bundles of innovations’’ as a function of four
resources to the transformation of incubatees into
dimensions: value, rareness, imitability and sub-
value-producers. Moreover, a dynamic capabilities
stitutability (Barney, 1991). From a resource-
approach would serve as a strong theoretical
based perspective positive incubation process out-
foundation for studies centering on development
comes could be explained and predicted as a
strategies of incubatees, and new ventures writ
function of these four dimensions. For example, a
large. When the incubator is the unit of analysis,
well-funded incubator with impeccable innovation
however, the focus on building and maintaining
industry contacts and access to a pool of high-
strategic competitive advantage that is intrinsic to
quality innovations and experienced entrepreneurs
the dynamic capabilities perspective is not so
and management teams is more likely to be
important because the typical incubator does not
associated with successful incubation outcomes
have many local competitors.
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 Agency theory
such is not an appropriate lens for examining the
Agency theory focuses on the relationships
incubation process.
between principals who delegate tasks to their
A subset of this lens, the knowledge-based view
agents (Eisenhardt, 1989). Problems arise in the
(Nonaka, 1994; Nonaka and Takeuchi, 1995) of
relationship because it is inefficient for the
the firm, could be used to explain the incubation
principal to continuously monitor the agent and
process as the accumulation and application of
because of goal or perspectival differences between
new venture development know-how to the
the principal and agent. Agency theory could
mentoring of the incubatees. However, while the
provide an adequate foundation for research
knowledge-based view could provide an interesting
centering on the incubator manager–incubatee
foundation for future research, it does not
dyad. However, agency theory does not address
accommodate the selection process component of
the issue of network effects that have been
the incubation process in our model, and is thus an
identified in previous incubator–incubation
inappropriate lens for this study.
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
Dynamic capabilities theory
(Hansen et al., 2000; Lichtenstein, 1992). More-
An extension of the resource-based and knowl- over, the incubatees do not work for the incubator
edge-based views of the firm, the dynamic cap- manager in the traditional sense of the principal–
abilities theory focuses on processes that develop agent dyad: Rather than working for the success of
through path-dependent organizational learning the principal’s firm and shareholders, the incuba-
over time and which enable the firm to achieve and tees work to attain their own firm’s success.
 A Real Options-Driven Theory of Business Incubation
Institutional theory
Institutional theory posits that organizations
monitor competitors and trend toward isomorph-
ism (Dimaggio and Powell, 1983; Zucker, 1987).
Research questions emanating from this perspec-
tive center on the ‘‘process of becoming institution-
alized, and the . . . impact of institutions on
organizations, especially on organizational struc-
ture 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 interna-
tional institutions on the incubator and its
incubatees.
Structuration theory
Structuration theory is a constructivist approach
to understanding the production of and reproduc-
tion 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 under-
standing 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.
47
Scaffolding theory
Scaffolding theory is a communicative approach
that centers on providing learners with concep-
tually 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.
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; Cope-
land, 2002; Dixit, 1992; Dixit and Pindyck, 1994;
Luehrman, 1998; McGrath, 1999; Mitchell and
Hamilton, 1988; Trigeorgis, 1993). Option crea-
tion 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
48 Hackett and Dilts
perspective seems to be the best available lens for
capturing the operational setting and underlying
logic that drives the incubation process of selec-
tion, monitoring and assistance, and resource
infusion vis-à-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.
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 capabil-
ities and resources, to create options through the
selection of weak-but-promising intermediate poten-
tial firms for admission to the incubator, and to
exercise those options through monitoring and
counseling, and the infusion of resources while
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
. 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 profit-
ably.
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 incuba-
tion 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-but-
promising’’ 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-cor-
rective measures in the entire pool of shadow
49
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 under-
scored 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 organiza-
tional self and its first product(s) (McGrath, 1999).
Moreover, the selection of the options is con-
strained by the need to select ‘‘weak-but-
promising’’ options.10 Thus, makes a traditional
valuation of an incubator’s option portfolio is
particularly tricky. However, because the incuba-
tor functions as a remedy for market failure vis-à-
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 influen-
cing rights related to the development path of the
incubatee. We term the operationalization of these
decision rights in an incubator ‘‘macro-manage-
ment’’ of the innovation process. Macro-manage-
ment occurs through the value-adding processes of
monitoring and assistance, and resource infusion,
50 Hackett and Dilts
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 monitor-
ing 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). Moni-
toring 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. Mon-
itoring 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 coun-
seling tenant companies may be a good predictor
of business incubation outcomes. By helping
incubatees with strategy formation and monitor-
ing the development of effective strategy imple-
mentation mechanisms and sustaining business
structures, the incubator can identify developmen-
tal 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 with-
out 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 net-
work 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 conse-
quently 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 describ-
ing 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 incu-
bator can be said to function as a laboratory for
small- and medium-scale entrepreneurial adven-
tures 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,
51
because it recognizes the volatility of entrepre-
neurial 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-à-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-à-vis incubator managerial
practice and policy-making should not be under-
stated: Incubators that help their incubatees fail
quickly and cheaply are successful incubators
because quick and cheap failures provide oppor-
tunities 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 organiza-
tional population churn into the local economy.
Acknowledgments
We would like to thank Germain Böer, Austin
Cheney, Lori Ferranti, James Foster, Josh John-
son, 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
52 Hackett and Dilts
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 monitor-
ing and assistance, and resource infusion, and in extreme cases,
expulsion from the incubator.
7. Financial dependency on annual subsidies forces incuba-
tors 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-à-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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