Why Universities are the Worst Shareholders for Spin-out Companies

By Ian A. Maxwell

This article is written in the context of the Australian environment but many of the conclusions are quite general.

Background

Over the last 20 years much more money has gone into global venture capital sectors than has come out. This unprofitable imbalance seems improbable and only exists because of the long and illiquid investment cycle of venture capital that has prevented market forces from properly correcting this oversupply of capital. Venture capital returns in Australia have been particularly bad; a result of many factors but primarily the causes can be tracked back to an unreliable source of high quality investment opportunities, especially from the Australian university sector. The result is this: technology companies that spin-out from Australian universities, when measured collectively as an investment class, are wildly unprofitable for investors. This helps explains why Australian superannuation funds have almost totally withdrawn their investment support for the Australian Venture Capital sector.

From a university perspective, the more shareholdings in spin-out companies that a university owns, the more likely it will ‘regress to the mean’ and end up with a negative financial return. The return is negative because, on average, university shares in spin-out companies end up being near to worthless (either because the companies fail or the common stock held by the university is not ‘in the money’) but there is a real cost to spinning-out start-ups and owning shares in them. Universities often invest cash and in-kind resources into spin-out companies in order to get their shares and the cost of owning and managing shares in a spin-out company is relatively high for universities since, unlike venture capitalists, being a start-up shareholder isn’t their core business so they use a lot of external legal and IP consultants for these purposes, as well as funding their own commercialisation group whose job, amongst other things, is to manage shareholdings in spin-out companies.

Despite rarely getting a financial return from spin-out companies, there are very good reasons why universities should sometimes actively spin-out start-ups. Firstly, genuinely great technology which can benefit mankind is sometimes best propagated via a spin-out company – along with licensing to corporations it is one of the two great models for ensuring investment into a university technology concept. Secondly, spin-out companies can be great marketing opportunities for universities, helping to attract funding and high quality students and staff. Thirdly, spin-out companies can have a positive feedback effect for a university where researchers become more focused on lucrative emerging technology areas due to interactions with the spin-out companies. I would argue that none of these three benefits are enhanced by a university owning shares in spin-out start-ups. These benefits can all be achieved by licencing technology to spin-out companies with no equity position, which is a much lower-cost and lower-risk process for a university.

The Problem with University Shareholdings in Start-Ups

Without the ability to invest in every investment round, from foundation though to the ‘exit’ of a start-up, a university as a founding shareholder of a start-up is even further guaranteed not to get a financial return from shares, often even if the start-up ends up being successful. This is because many start-ups, along their journey, have a difficult round of funding, sometime called a down-round, when the company is re-priced (downwards) and shareholders not contributing fresh investment funds get diluted and also lose prior shareholding rights (such as liquidation preferences and board representation); this is why university spin-out shareholdings are often ‘not in the money’. Investing and holding shares in start-ups really should be left to the professionals who have sufficient capital to play the game properly. Passive shareholders without the skills and investment funds for the whole journey often end up as ‘road-kill’.

Universities, as shareholders in spinout companies, often provide the kernel of technology but rarely offer useful ongoing contributions either by way of financial capital, human resources or additional research that is actually beneficial – hence they become ‘passive’ shareholders. From a start-up company’s point of view a university generally represents the worst possible type of shareholder. Apart from being a ‘passive’ shareholder often a university is also quite ‘unprofessional’ since the university’s interests at a spin-out start-up board are often represented by people without the required skill-set to add value or even follow good due process. Ironically, a university by insisting on holding shares in spinouts can actually be helping to ensure their own negative financial return on such a model!

I should note here that I am distinguishing between universities as ‘institutions’ and individual academic inventors within a university. The latter can sometimes be very useful shareholders in start-ups but only if they have an ongoing contribution to the start-up through employment in the company, or at the very least by continued supportive research and technical advice. However even in these cases it is imperative that inexperienced academic shareholders do not have the rights to veto the critical business matters of a start-up (such as investment rounds) because they rarely have the experience that would enable them to wield such shareholder rights wisely or in context. It is most useful of course if the academic inventors actually join a spin-out start-up in full time employment but unfortunately  in Australia this is much rarer than in the USA and cannot be relied upon.

A passive university shareholder can really harm a company when the company goes through intermittent funding cycles (typically these are every 18 months until a company is profitable or sold). Each funding cycle requires a change to the shareholders agreement of a company which usually requires the agreement of all shareholders, large and small – this is where having a university as a passive shareholder can become a true nightmare. The university can sometimes simply veto an investment deal because they don’t like the dilution of their shares, or hold up a deal for 6-12 months just while they think about it and wonder who can sign their documents. Additionally, universities often have very little ‘corporate memory’ and a spinout company can find itself dealing with multiple university representatives over the course of a few years; again this is the antithesis of spin-out company requirements, where a ticket to success is a tight, cohesive and dedicated board and shareholder group.

A spin-out company is a very hard animal to get right. A CEO can execute every aspect of the deal perfectly but failure can still occur due to factors outside the CEO’s control, such as market conditions or the emergence of a competitive technology. However in my experience the biggest risk to any spin-out company is its shareholders. The perfect set of shareholders consists of the founding inventors, key staff and professional investors, the primary role of the latter being to select the right investment opportunity and the right CEO. Thereafter the investors must have access to sufficient investment funds and simply back the CEO without reservation; they must also be there for the whole journey. Anything less than this usually ends up in disaster. A spinout company is simply a cohort of wise and interested parties, contributing services and/or capital and trying to beat the odds with sufficient investment funds, hard-earned experience, great skills and good luck.

The Bigger Picture

In the US the mean return on university R&D investment (a.k.a. research funding) from licencing is less than 3%. However for 90% of universities the return is negative. Of the top 10% of universities that get a positive return, many rely on a single innovation for their positive return. Basically, most universities involved in seeking a financial return on technology investment are gamblers, continuing to invest in commercialisation and ‘waiting for the big one’. This gambling can be justified because it is often argued the R&D investment would occur anyway and any extra budget required for commercialisation is a small fraction of the total university budget. Consistent with the gambling approach there is also a prevailing view that owning equity in start-ups, as opposed to just having license fees, offers a higher return on the random big opportunities. However I believe that universities would be better off seeking their return solely from license fees, which would decrease their costs and simultaneously greatly improve the chances of their spin-out start-ups being successful. It is really quite a stark choice – to gamble or to systematically invest.

Most university research in Australia is done on the assumed basis that it is never intended to be commercialised, and is purely designed to be added to the stock of human knowledge through publication. In this context, at least in Australia, when something is commercialised from university research it is effectively viewed as a ‘free set of steak-knives’, i.e. something for nothing. This is despite government funding programs increasingly trying to push academic research to be more ‘useful’ and applied, but without going the whole way and metering funding levels against genuine commercial outcomes. There is a sort of phony war going on where university research intended purely for publication is being dressed up as applied and commercial in order to receive funding, but in the process academic research itself has been sullied; much research is simply facile work in complex systems of current ‘fashionable’ applied interest and as a result there is an over-concentration of effort in too few areas, and, on the whole, quantity has won out over quality. Indeed academics have become so efficient at ‘gaming’ the research funding system that it could be argued this is now one of their primary skills.

In the instances where commercialisation of university research does eventuate there is often significant anguish for the academics involved, resulting from the conflicts associated with the need to publish and the ‘black hole’ of commercialization which often comes to nought. There also remains the very unresolved question of an academic’s practical rights to publish freely where an invention may have commercial value. The solution is quite obvious really; some fraction of the academic research budget needs to be carved out for commercial research and funding proposals measured solely on true commercial outcomes (i.e. dollars returned) and not in any way upon peer-reviewed outcomes or the reputations on the participants. For the rest, the pure research, we need to let our academics off the hook and allow them to work in any area, unhindered by the façade of ‘national interests’ and commercial outcomes and also the current over-emphasis on publication citations; this approach would by far ensure they do more rigorous science and explore genuinely new horizons as opposed to clustering in areas of high citation counts in over-researched fields of pseudo-applied value.

The Ideal University Spin-Out Policy

So what is the perfect relationship between a spin-out start-up and a university? The three key elements of the relationship are that, firstly, the university should not own equity in the start-up. Secondly, the university should seek a financial return solely from license fees and lump-sum payments. Thirdly, license terms should be structured to reduce the drag on the early cash flow of spin-out companies and also such that the chances of seed investment funding is maximised. Statistically speaking any university will be much better off by increasing the chances of success of all of their spin-out companies, rather than trying to extracting the maximum short-term ‘benefit’ from each and every license deal.

Far too often I have seen university license deals with spin-out companies with all the usual claw-back and protective terms, as well as aggressive license fees, that one would see in a license deal with a large corporation; this is simply counter-productive since it puts up barrier to seed investment and also reduces a start-up company’s chances of success. The true financial benefit to a university can be achieved when a corporation buys a start-up company or when the start-up company lists on a public market and becomes a large corporation itself. This is the right time for the university to extract a success fee, and it just also happens to be the time when the technology has been successfully disseminated into the public environment via commercialization.

In most cases licenses should be ‘exclusive’ because a start-up is generally a more aggressive commercial entity than any commercialisation office at a university and is normally better placed to monetise commercial opportunities whether that is by selling product or on-licensing. A problem with non-exclusive licenses is that they devalue the spin-out start-up in the eyes of investors due to the possibility of the university actually implementing more licenses in adjacent fields of practice (even though they rarely do).

Venture capital backed start-ups have a very high failure rate primarily due to the high risk and return profile adopted by this sector. Recognising this, the venture capital funding model is structured so that there is maximum chance of getting at least the invested capital back from the failed deals, and the profit is made from the small fraction of companies that are genuinely successful. Venture capitalists themselves do not profit from their activities until a whole investment fund (say across 10 start-up companies) is profitable beyond 20% IRR, which is a tough result to achieve over a 10 year period. Therefore universities would be well placed to allow venture capital investors to ‘sell’ the licensed technology opportunity when a start-up company fails. Universities often insist on repatriating their IP (e.g. cancelling exclusive licenses) from failed start-ups or start-ups that do not to meet certain objectives or are wound-up. I have yet to see a single case of a university successfully recycling such IP (although I know at least one person who claims to have seen such a beast) so I would argue against this since these repatriation conditions simply reduce the value of spin-out companies to potential investors, which in turn systematically destroys more value for universities than the potential upside from the odd commercial winner wrested from recycled IP.

License fees should be calculated based on comparables in the market place and set using experienced licensing attorneys as advisers on both sides of a negotiation. Most importantly, though, license fees should not be payable by spin-out start-ups until after they are systematically profitable, are sold or have been through a public listing. After ‘shareholder behaviour’ the next greatest risk to a start-up is a shortage of capital and the liquidity risks for start-ups, associated with funding and cash-flow, are very, very non-linear. On average, I believe a university licensor would make more money from spin-out companies if they do not extract cash from spin-out companies until after they are profitable or sold. This is simply because by doing so de-risks the companies and this will lead to a higher number of longer term licensing fees; the sum benefits will thus outweigh the lost short-term cash-flow. Universities would be much better placed working the ‘long game’ and waiting for start-ups to be successful before extracting license fees, because this way their spin-outs, on average, would be more likely to be successful. Indeed this approach ensures that spin-out companies are more likely to get funded in the first place.

I do note that there is the odd case of pharmaceutical drug spin-out companies where licenses to spin-outs are a very different than in other cases because the path to revenues is so long and the risks of failure so high. This area of university spin-outs has recently been labelled as ‘one big Ponzi scheme’ by Professor Philip Mirowski of the Notre Dame University in the USA, which is reflective of the fact that the rate of successful new drug releases have slowed to the point that any single university cannot possibly have enough drug discovery research programs in place to systematically profit from the effort (indeed the whole pharmaceutical research sector is unprofitable and relies on ‘free’ government research at the front end and a bunch of loss-making investors along the commercialisation journey) .  Hence universities involved in pharmaceutical  research are all just ‘waiting for the big one’ or alternatively trying to extract as much rent from the spin-out and licensing environment as they possibly can before any individual commercialization program hits the inevitable wall. If there was ever an area of university commercialization activity that needs federal control, this is it, simply because government investment here is clearly based on public good and not financial return.

The most important clause in a license agreement to a spin-out is what I call the ‘take-out’ clause. This clause is a structured set of conditions whereby a start-up or its successors can acquire the licensed IP outright from the licensing university. The trigger for this right can be a trade sale or IPO of the spin-out start-up, where the new owners of the spin-out have a fixed period of time in which to negotiate with a university for the acquisition of the licensed IP. To give the new owners an incentive to acquire the IP the university should at all times retain the right to sell the licensed IP to a third party, so long as the third party maintains the license conditions. This term typically does not overly worry start-ups or their investors but can certainly be a concern for, say, a corporate acquirer of a start-up. In reality this set of terms becomes an area of negotiation prior to any acquisition of a start-up in a trade sale, and a university has about the right weighting in said negotiations to extract a ‘bonus’ for outright sale of the IP.

I note that this clause is not possible in the USA where the Bayh-Dole Act can prevents outright sale of IP by universities if the original research was federally funded; this is a major limitation of the US legislation in this area. However I note that the Stanford University model also has a structure where spin-outs get a substantially ‘back-loaded’ deal without much cash payable up front, but if the spin-out gets acquired by, or flips the licence to, a large corporation then the terms become more ‘front-loaded’, i.e. the university gets immediately compensated. This Stanford University approach is philosophically correct but is limited by the US Federal legislation which prevents them selling the IP. Ultimately the trigger for university commercial compensation is best implemented when the core asset, the IP, is being transferred because this gives the university the maximum benefit and negotiating position. In addition a corporation is never truly comfortable when their core IP assets are being managed by a university or any other third party for that matter; nor is this a fair or reasonable burden of responsibility to place on a university.

Recently I had the opportunity to advise an Australian university on a draft term-sheet of a license deal to a new spin-out start-up. I was not surprised to see a bunch of the usual terms that I advised the university to change or remove. I explained to them that their job was to make the license deal as attractive as possible to potential (high quality) investors in the company (the company had yet to secure funding) and to ‘back-end’ their compensation so that they earned more when the company was successfully sold or listed. This was hard advice for them to take because they felt like they were giving something away for ‘free’.  I explained that their compensation was far more guaranteed if they could just get the company successfully seed- funded in the first place; they had no idea how hard and unlikely this seed-funding is in Australia. And I should note that the quality of money is very lumpy – a poorly structured license deal might result in the company only being able to attract a bunch of angel investors (that often choke their charges due to their limited capacity to invest sufficient funds into the deal) whereas a well-constructed license deal might help attract a tier 1 venture capital investor which would multiply the chances of success of the company many times over. This lack of knowledge and feedback at universities persists because the universities aren’t at all measured on their commercialisation performance nor is any of their funding from government dependent upon commercial returns.

[This post originally appeared at Accordia IP.]