RETAIL BUSINESS INCUBATORS
A DOWNTOWN REDEVELOPMENT STRATEGY
Charles Eckenstahler, Craig Hullinger and Jim Mooney
March 31, 2004
WHY AN INCUBATOR?
All across Michigan, mayors and managers seek the magic strategy to refill vacant downtown retail store buildings with viable businesses. Cities and villages construct streetscape beautification projects and establish incentive programs designed to attract customers and new businesses to the downtown central business district. Often these efforts do not achieve the goal of recruiting businesses to fill the vacant buildings with viable activities.
A newer, albeit more risky strategy, is being tried by some communities designed to seed downtown buildings with locally formed new businesses. These communities feel that “growing their own businesses” will provide a continuous stream of new small businesses with ties to the local community. They require small low cost space to start-up and grow their new businesses. Their goal is to fill-up downtown retail buildings with these new businesses and use these new businesses to entice other businesses and revitalize the downtown.
A pioneer of this strategy is Don Beavers, Manager of the Village of Constantine, Michigan. Constantine recently opened its retail mixed-use business incubator in a 30,000 square foot retail building anchoring the south edge of their downtown.
According to Beavers, “the incubator concept has been under study for over 18-months. We believe that we can organize a business assistance system to provide needed guidance to local entrepreneurs giving them a better chance for business success. Housing these new start-up businesses in our downtown will fill vacant buildings, increase the downtown daytime population and begin to provide a market for more traditional downtown services.”
This article summarizes the process undertaken by the Village of Constantine Downtown Development Authority (DDA) as they studied the market for a retail incubator, decided how the incubator should be organized and managed and determined whether it would be financially feasible for the DDA to own and operate the incubator.
STEP ONE - DETERMINING MARKET DEMAND
IS THERE A NEED FOR AN INCUBATOR?
Reading economic news today illustrates the growing trend in entrepreneurialism. Analysis of the difference between federal employment and unemployment data discovered that many persons were not being reported as employed due to lack of tabulating self-employed persons. Historically, this difference was viewed as inconsequential. However, this trend has now been studied by unemployment analysts who have documented a substantial growth of the proportion of the employable population that is self-employed and previously not recognized in the federal employment data. A recent study completed by the US Small Business Administration estimates that home based businesses represent over 10% of the US economy. Small home based business are the most likely tenants in an incubator,
The idea of encouraging the starting of new businesses is not a new economic development strategy. Studies of entrepreneurialism abound in government agencies, universities and private research firms. Many of these agencies and firms also provide formal programs and counseling services to encourage new business formation with the goal of increasing their rate of success.
Study of who is the most likely candidate to start a business is the key to determining market support for a retail incubator. In the case of Constantine, research discovered that 1 in 12 Americans was actively trying to establish a new business in 1999 and 10% of males aged 18-64 years and 10% of females aged 25-54 sought to establish a new business in 2000. For the Constantine market study, 220 business owners registered with the county were surveyed. It was discovered that 78% of the businesses surveyed were headed by males aged 35-48 years with 65% having a minimum of some years of college education.
With these profiles in hand, applying each specific entrepreneurial profile to the population characteristics of the market area yields the number of potential new businesses that could be formed in the market area. For Constantine, a 25-mile market area was chosen for analysis purposes. Population in the market area is projected to increase by almost 4% between 2002 and 2005. The data disclosed that there were approximately 26,000 males meeting the county entrpreneurial profile.
The market study concluded using the three entrepreneurial profiles that the size of the entrpreneurial market ranged between 18,000 - 30,000 potential new businesses with the greatest confidence being about 26,000 new businesses based on the county profile determined from the county registration data.
Beavers noted that “this data confirmed our hunch that if we provided an incubator facility that we could generate enough interest from people living in the area that wanted to start a new business to fill the building with new businesses. Our concern was whether these new start-up businesses would have staying power, add full and part-time employment plus draw customers to our downtown to make a market to revitalize the downtown.”
Estimating the staying power of newly formed businesses is most difficult. However, county registration data provides some indicators which on a countywide basis can be used to determine the longevity of registered small businesses. County data for the period of 1999 through 2002 was analyzed to identify the net increase in businesses registered. Additionally, US Census data for the period of 1995 through 1999 was also analyzed for firms having less than five employees.
The data analysis disclosed that there are approximately 670 - 700 operating businesses having less than five employees and that on-the-average slightly more than 100 new businesses register with the county each year. In any single year, the annual growth in the number of new businesses could range between a loss of approximately 30 businesses to a growth of nearly 320 new businesses.
To estimate the number of these businesses that would locate in the retail incubator, if developed by the DDA, the question was posed to current businesses owners as part of the survey of businesses registered with the county. Of the respondents, 27% indicated that they would locate their business in the downtown retail incubator if it was available.
The consultant concluded on an annual basis that, of all new businesses started in the county each year between 2 and 29 new businesses would be candidates to locate in the retail incubator. According to Beavers, “the results of the analysis left the DDA with a degree of confidence that there was a market for the retail incubator and the DDA should proceed with the review of organization and management considerations.”
STEP TWO - OK THERE’S A NEED - HOW DO WE FORM AN INCUBATOR?
ORGANIZING AND OPERATING AN INCUBATOR
Incubators have been in operation since 1959. Credit for the first incubator is usually given to the real estate development firm Manucso & Sons who, having acquired the 850,000 square foot former Harvester/Massey Fergenson manufacturing plant constructed in 1882, sought ways to increase building occupancy. The developer divided the building into smaller rentable spaces and leased 30 spaces in the first year, some at reduced rates to subsidize the growth of newly organized businesses. One of the first tenants was an egg hatchery and incubator, a term that quicky became the common title for the building that housed several new start-up business operations.
Today there more then 1,200 formally recognized incubators in the US. These incubators can be categorized into one of five types:
Industrial Building Owner Sponsored - these incubators focus on creating industrial jobs by organizing industrial businesses most typically housed in older industrial buildings with minimal or subsidized rent.
University Sponsored - these incubators are usually organized by the research arms of colleges and universities and are designed to transfer business ideas from the academic world to a commercial business venture.
For-Profit Ventures - these incubators are usually formed by financiers who hope to profit from the profits generated by the growth of the business housed in the incubator.
Corporate Venture - these incubators can be described as the new product development arms of major companies who seek to develop products that the company can produce.
Government / Not-for Profit Sponsored - These incubators typically are organized to develop jobs and investment in a community often using an existing building donated or purchased at a discount from the owner.
The decision on how to organize the Constantine incubator was not easy according to Beavers. “First, the DDA did not own a building nor did it wish to purchase a building. Second, unlike many Michigan DDA’s, Constantine did not establish a tax increment financing district till 2002 and had no revenue to subsidize the operation of the incubator. Lastly, there was no specific state grant program that would assure state financial support for building purchase or start-up expenses. We needed to develop an operating form that was operationally and financially sensitive to our limited resources.”
“The DDA, almost by default decided to own and operate the incubator based on four goals: 1) encourage job creation by encouraging entrepreneuralism, 2) diversify the economic base of the community, 3) use vacant property and 4) create ‘good will’ in the community,” notes Beavers
INCUBATOR SUCCESS INGREDIENTS
There are four ingredients necessary for a successful incubator. These include:
Land and building - the right building at the right price,
Operating Knowledge - the right staff capacity,
Capital - revenue for staffing and to operate the facility, and
Tenants - initial and replacement tenants to retain full occupancy.
Beavers research identified four downtown buildings that could serve as the incubator. Each required substantial cost to remove code deficiencies and to renovate the space for occupancy by new businesses. “We spoke with each owner seeking an affordable solution to securing a building for the incubator. We offered to let a private owner operate the incubator as a landlord, to joint venture building ownership, to allow the owner to make a charitable donation of the building to the Village or to sell the building to the DDA.”
After several months of discussion with the property owners, a purchase agreement was reached with one building owner.
STAFFING THE INCUBATOR
Staffing of the incubator became even more complex according to Beavers. “We recognized the DDA would not have sufficient funds to employ a full time staff person to manage the facility and assist the tenants with their individual business management needs.”
To the credit of Beavers, he was able to secure partial financial assistance from the County Economic Development Corporation to provide part-time professional staffing of the facility and technical assistance from several small business service organizations and local university business students.
Services provided to tenants include visitor/customer reception, communications, copy/computer access, word processing, mail and package shipping and receiving. Services brought by others include professional business management assistance, business start-up clinics, business situation case studies, business planning workshops, individual business mentoring and introductions to business financing sources. Local professionals agreed to hold periodic workshops on legal, accounting, personnel, education/training and intellectual property business matters of concern to the tenants.
SELECTING INCUBATOR TENANTS
A problem was identified early in the discussion of occupants of the incubator. The DDA members, several who were also downtown landlords, specified that the incubator should not compete with efforts of private building owners seeking tenants. In other words, according to Beavers, “we needed a selection process that would separate those new businesses that really need assistance to develop successfully from the businesses that might just be seeking cheap rental space.”
The DDA settled on six criteria that would be used to evaluate specific businesses, including that the business:
1. Must be proposing a new product or service not now available in the community,
2. Must demonstrate commercial viability within 3-years,
3. Must have a plan to exit the incubator within a 2 to 3 year period,
4. Must have a written business plan at the time the application is being made (or shortly thereafter) that also addresses topics 2 and 3 above,
5. Has potential to create jobs for residents, and
6. Has sufficient initial capitalization to pay start-up facility and service expenses.
Beavers also noted that the character of the owner is important in the selection process. “We want only individuals who can demonstrate certain personality traits, especially an individual with an entrepreneurial mind-set and has an intimate knowledge of their business plan, knowledge of the product and its market potential, who understands the need for a return on investment (profitability) and can verbalize a plan of execution. In our interview, we also need to assess whether the owner is a team player, a good listener and learner, their willingness to accept performance milestones, and especially their willingness to accept help.”
STEP THREE - CAN WE AFFORD TO OWN AND OPERATE AN INCUBATOR?
DETERMINING FINANCIAL FEASIBILITY
Financial feasibility is an easy concept for most people to understand. Simply stated the operation of the retail incubator must generate enough revenue to pay all expenses. According to Beavers, “we needed an independent third-party assessment of the financial feasibility of our proposed incubator project to assure the DDA members, our Village Council and our citizens that there was a reasonable probability that the incubator would be self financing and not require a subsidy from the Village general fund.”
PROJECTING REVENUE FOR OPERATION
The principal source of revenue for any incubator is the monthly rent paid by tenants. Determining the total amount of rental revenue is a complex exercise that must consider the number of and size of each rentable space, the rental rates that are charged for other comparable buildings in the downtown area, the probability of not collecting 100% of total monthly rent (or not receiving the monthly rent on time), and whether all rental units will be occupied at all times.
For Constantine, several assumptions were employed to project revenue. First, it was determined to have 5 tenant spaces, with lower-level business storage spaces and second floor residential dwelling. To account for late and non payment circumstances plus vacancies, the initial total monthly rental revenue was reduced by 40% and gradually increased to 5% to project the total rental revenue.
Another assumption made was that tenants would also be responsible for a portion of certain joint operating expenses, including telephone, janitorial services and possibly a portion of reception and clerical staffing available for use by any tenant. Lastly, it was assumed that there would be revenue for specific services and materials purchased by the tenants for such items as office supplies, copies, refreshments, etc. According to Beavers, “we were very concerned about the secondary sources of revenue. In our analysis this revenue was estimated to be about 10% of the gross revenue. We wanted to make sure that the rental revenue was more than sufficient to operate the facility and to retire any capital expenses we would incur for the purchase of the building, it’s improvements and all furnishings without relying on these variable sources of revenue.”
ESTIMATING OPERATING EXPENSES AND DEBT RETIREMENT
More difficult for Beavers was establishing assumptions concerning operating expenses. “We didn’t have a real good idea of what costs that we might incur. We figured that we would staff the incubator with a part-time manager and try to secure student or volunteer assistance to keep someone in the facility during business hours. We hoped that we could rely upon a state or other grant to help in furnishing the facility. We anticipated that with Village ownership of the building that the Village general fund would absorb any insurance costs for the incubator. We also figured that the assessor would treat the incubator as taxable commercial property and subject the incubator to real estate taxes.”
Analysis of operating budgets of other incubators led the consultant to conclude that expenses would be approximately 75% of the net revenue. The remaining 25% would provide funds to pay principal and interest on any loans necessary for the building purchase and improvement and furnishings. Hopefully a small amount of revenue would remain to meet monthly operating cash needs.
Based on the pro forma financial statements prepared by the consultant, the concept of the proposed retail incubator was projected to be financially feasible using the assumptions employed. Net revenue after operations and debt service indicated that the incubator would provide sufficient cash flow to meet monthly cash obligations.
STEP 4 -THE DECISION TO PROCEED AND GRAND OPENING
After reviewing the study and the risks involved a decision to proceed to purchase a downtown building and develop a retail incubator was made by the DDA with support of the Village Council. The decision to proceed was difficult according to Beavers, “while the market and feasibility study provided a strong indication that the retail incubator was financially feasible, there was no similar successful project that we could point to demonstrate success. We spent quite a while discussing the risks involved since the concept of a downtown retail incubator may be more risky than the traditional mixed-use subsidized incubators.”
About the Authors
Chuck Eckenstahler’s career in municipal planning and economic development spans more than 30-years. He is owner of Public Consulting Team based in Benton Harbor and was responsible for the Constantine Retail Incubator Market and Financial Feasibility Study. He can be contacted at 219-861-2077 or email@example.com.
Craig Harlan Hullinger AICP has 30 years of experience in economic development. He has developed numerous economic development strategies and redevelopment projects. He can be contacted at 209 634 5557 or E-mail CraigHullinger@gmail.com.
Jim Mooney is President of DeSco a economic development consulting firm based in Valparaiso, Indiana and principal author of Building the Base - The Business Incubator’s Role in Creating Jobs and Investment prepared for use in the Village of Constantine. Building the Base is a basic primer on the process of establishing a business incubator. He can be contacted at 219-548-9999 or firstname.lastname@example.org.
For additional information about the Constantine project or to obtain a copy of Building the Base contact Don Beavers at 269-435-2085 or email@example.com
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