The reading level for this article is Novice
In the late 1990’s, a new breed of commercial technology incubators appeared and enjoyed spectacular stock market success for a short time. Their success was driven principally by launching unproven new ventures onto the IPO market. Over the last few years, these outfits have slashed investment budgets and shut down or sold many of their portfolio companies. In the meantime, traditional incubators of technology — namely research universities and other nonprofit research organizations — have continued to invest heavily in scientific research, generating thousands of new technologies. These research institutions have also grown more aggressive and sophisticated about transforming innovative technologies into new businesses. This article discusses some of the opportunities and challenges associated with transferring or "spinning" a technology out of a university into a startup company.
The Opportunity
Universities and similar nonprofits make enormous investments in research and development. According to a survey published by the Association of University Technology Managers (AUTM), the fiscal year 2000 saw over $29 billion in sponsored research expenditures at member institutions responding to the survey. During the same period, over 3,700 U.S. patents issued and at least 454 new companies were formed to develop and commercialize some of these inventions. North Carolina has seen similar trends with its universities and other research organizations directly involved in the creation of dozens of companies focused on biotechnology, drug discovery, medical devices, microelectronics, software and wireless technology, among others. With initiatives underway at many area universities and institutions to improve and accelerate the commercialization of technologies developed on campus, there is a great deal of potential for exciting new companies to start and grow in the Research Triangle and throughout North Carolina.
Challenges
University spinout companies resemble other early stage technology ventures in many respects and face many of the same challenges. One major challenge is raising capital to fund development of a technology that appears promising. Attracting capital generally requires the ability to demonstrate to investors or strategic collaborators that the company has control over proprietary technology, that there is a large addressable market for the company’s planned product or service and that the company has or is putting in place a management team capable of turning the technology into a valuable business. While sharing these basic characteristics with other technology startups, university spinouts face additional hurdles. First, scientific founders of a university spinout are likely to remain associated with their universities, often meaning the company will need to recruit a qualified person to serve as its first full-time manager. For a company without funding, enticing qualified people to turn down other opportunities to take a chance on building a technology into a valuable company can be a struggle. Second, a university spinout will not own its core technology. Instead, the spinout will have only the rights to the technology specified in a license agreement. Moreover, the license agreement will impose ongoing obligations on the spinout. These obligations, if not carefully tailored to the needs and capabilities of the spinout, can present obstacles to raising capital and to achieving commercial success.
Management that investors believe can move a company toward its objectives is usually a prerequisite for investment. For many startups, the core of an initial management team is an entrepreneur willing and able to invest all of his or her time and resources getting the company started. With university spinouts, the inventors or other budding entrepreneurs typically have university obligations that prevent them from devoting the time and energy necessary to get the startup going. This means the startup must induce an experienced executive to forego other opportunities to work full-time in a risky venture that usually lacks funds to pay the executive a market-rate salary, or perhaps any salary at all. Moreover, shortage of funds means the startup cannot look to an executive search firm to help fill the position. This presents a common dilemma to a university spinout: it cannot raise capital without qualified management and attracting talented personnel without funds can be very difficult.
Overcoming this problem requires patience, luck and a willingness to give up a significant ownership interest in the company. The university personnel and the company’s advisors must publicize the opportunity among their networks. In many cases, the best candidates will emerge when a corporate merger or similar event displaces experienced people, giving them time to pursue a new opportunity and financial resources which allow them to work for reduced or no compensation during the initial stages. In some cases, investors can provide interim management and assistance in finding a full-time replacement. In almost every case, it will be necessary to provide the new CEO with an opportunity to earn a substantial equity stake.
If a spinout can find the right person to manage business through the start-up phase, the other key component in positioning the company for financing is securing a satisfactory license from the university. While universities and similar institutions take seriously their obligations under federal law to promote the commercialization of federally-funded technology, these same obligations and other institutional policies and politics can hinder the licensing process or result in license terms that impair the ability of the spinout to raise capital. Under a typical license agreement with a university, the university will retain ownership of the relevant intellectual property but will make it available on an exclusive basis to the spinout company. This balances the needs of the company to have exclusive control over the technology with the research university’s interests. These university interests range from generating income to support university programs and fostering economic development to providing opportunities for entrepreneurship that can attract top faculty. At the same time, the institution must honor the mandate under the Bayh-Dole Act which states the university must promote the commercialization of inventions that result from federally funded research. This obligation to promote commercialization generally translates into the spinout obtaining a license which includes "due diligence" clauses that provide, in essence, that if the company is not diligently pursuing commercialization, the university can revoke the license and reclaim rights to the technology.
The institution’s right to revoke the license is meant to prevent a company from locking up the technology through an exclusive license and then neglecting to make the investment necessary to develop the technology into a product. Unfortunately, licenses all too often include milestones that make sense in a "model" agreement but that fail to take into account the circumstances or business model of a particular company. While some form of due diligence requirements are appropriate, parties have a great deal of flexibility in crafting due diligence requirements that make sense in light of the startup’s goals and capabilities.
In exchange for granting substantial commercial rights to the spinout company, the university will be compensated for its past investment in developing the intellectual property with one or more types of compensation. The financial components of a university license agreement generally include a mix of license fees, patent cost reimbursement, royalties, milestone payments, sublicense revenues and, increasingly, an ownership interest in the company.
License fee. A license fee is generally a fixed cash payment for the right to use certain intellectual property. In some types of intellectual property transactions, such as buying off-the-shelf software, the license fee is the only payment ever made by the licensee for the use of the property. For a university spinout, the license fee is only one component of the transaction. Often, university spinouts will agree to pay as a license fee an amount sufficient to reimburse the university for out-of-pocket costs to obtain patent protection for the technology. In many cases, all or a portion of this fee may be deferred until the spinout has adequate funding.
Patent Costs. In addition to paying a license fee to cover past patent costs, the spinout will generally be responsible for future patent expenses. In some cases, this will simply be a direct undertaking by the spinout to pursue patent protection and to cover the costs. In other cases, the university will maintain some degree of control over ongoing patent prosecution and will seek reimbursement for these costs. Spinouts need to ensure that the license agreement gives them sufficient rights to prosecute patents and to enforce patents against third parties while limiting their obligation to pay for patents only to the extent necessary to support the spinout’s business strategy.
Royalties. The spinout will usually agree to pay a percentage (generally in the single digits) of revenues from sales of products that utilize the institution-owned inventions. Typically, royalties are based on the amount of "net sales" (essentially gross revenues, less taxes, shipping, returns and certain discounts) by the spinout of products or services which involve the use of the university’s intellectual property. While negotiations about royalties will begin with a simple percentage, the discussions get more complex as the parties confront "royalty stacking" issues. Royalty stacking comes into play when a company must pay royalties under two or more licenses on the sale of the same product. It is customary for license agreements to include a mechanism to reduce royalty rates paid to the university when the spinout must pay a portion of its revenues as royalties to a third party.
Sublicenses. License agreements typically address the ability of the spinout to grant sublicenses to third parties, with spinouts generally seeking the maximum flexibility for sublicense rights and universities preferring limits on the ability of the licensee to grant sublicenses. In some cases, sublicenses will effectively be disregarded, so the university will continue to earn the standard royalty on sales by the sublicensee. More common, however, is an arrangement that allocates a share of the proceeds from a sublicense between the spinout and the university. In determining how to allocate sublicense revenues, the parties should carefully consider the company’s business model so the revenue-sharing can be supportable and equitable. For instance, where a sublicense is part of a broader transaction, the university should participate in the revenue reasonably allocable to the sublicense but not in all aspects of the transaction.
Milestone Payments. These are lump-sum payments payable to the institution upon the completion of major corporate events, such as the closing of a significant financing, obtaining regulatory approval for a medical product or completing the first commercial sale of a product or service. Milestone payments provide a mechanism for risk-sharing. These payments reward patent holders for technologies that prove to have commercial value. By making a substantial portion of the payment contingent upon some level of commercial success, the up-front cost to a start-up can be much lower. By reducing up-front costs, the number of startups launched increases and each startup has more capital to invest in product development. The net effect is an increased probability of successful ventures. Accordingly, the milestone approach serves the interests of both the one-time player (the start up) by lowering the up-front cost and risk, and the repeat player (the university) by increasing the number of spinouts, the probability of success of each one and, therefore, the likelihood of launching successful ones.
Stock. It is increasingly common for research institutions to receive a stock ownership interest in spinout companies. Spinout companies tend to support this type of arrangement because, like milestones, it tends to reduce up-front cost components of the license agreement and to increase the long-term alignment of interest between the spinout and the university. Universities are supportive because these arrangements facilitate technology transfer to the private sector and provide an opportunity for substantial financial reward to the university if the spinout company is sold on favorable terms or experiences share price appreciation following an initial public offering.
The mix of compensation in a license to a spinout will vary from company to company. The particular mix of compensation in any instance will be negotiated taking into account a number of factors, including the level of the university’s investment in the technology, how close the technology is to commercialization, the presence or absence of competitive bidders for the technology and prevailing conditions in private and public equity markets. For instance, at a time when equity markets are depressed and investors are more reluctant to risk capital on new businesses, a university should be willing to accept less favorable terms in order to help enable the startup to raise the capital necessary to develop the technology. At the same time, if the proposed spinout seeks financial terms that are viewed as too unfavorable to the institution, the university might insist on very demanding due diligence requirements or might simply seek to license the technology to a more established business. With so many different ways to compensate the university for its intellectual property, reasonable and creative entrepreneurs and technology development personnel should be able to craft an agreement that will create the positive incentives for the business to commercialize the technology without hampering its ability to raise capital.
Conclusions
The sustained investment in technology research by nonprofits and the increasing focus of these institutions on commercializing technologies have created opportunities for entrepreneurs and investors to start companies based on innovative technologies with solid intellectual property positions. However, spinning a company out of a university presents significant challenges. These include striking a fair balance of the interests of the institution with those of the spinout and finding the right people to lead the company at the startup stage. When prospective entrepreneurs and universities clearly communicate their respective needs and thoughtfully tailor agreements to fit the unique circumstances of each startup, they enable universities to fulfill the promise of serving as incubators of innovative businesses.
This article was published in the September 2002 issue of the Triangle TechJournal.
