One for all, and all for one 

This is the last post in a short series about university spinouts, contrasting our experience of regional versus Golden Triangle practice, particularly as partially codified in TenU’s USIT Guide.  

Today, we consider the wisdom of universities in plucking the golden goose when it’s just a little gosling. Instead, we argue the case for investors and universities working in complete alignment, neither of them taking cash off the table until the exit, and for the university being a partner in SpinCo – not a supplier. 

What ails thee? 

In the last post, we looked at the Golden Triangle / USIT approach to transferring IP – licensing the IP for a long time until SpinCo can prove its success, only then considering a full assignment. Structurally, as we explained, this approach creates a bunch of practical problems for SpinCo. 

In this post, we will look at the financial choices in transferring IP to SpinCo. Our particular concern is that SpinCo’s cashflows should be protected – but that’s not how Golden Triangle and the USIT Guide practice see things. Let’s look at some examples.  

Plucking the goose with the least hissing1

The university policy on taking cash payments from a licensee (whether SpinCo or a large corporate) is to charge for the IP at various milestones in the technical and commercial development of the IP. In principle, and certainly as regards licensing to the large corporate, this makes sense: the idea is to mitigate the licensee’s risk in the early days and to share in later success. These payments take many different forms, scheduled below with comments about some of the specific problems that each generates for a spinout: 

• A signing fee: very simply, a one-off payment from SpinCo to the university on signing the initial IP licence to sweeten the university’s equity shareholding.  

• Annual / maintenance fees: the clue is in the name – set amounts paid annually, justified on the basis that they encourage SpinCo to actually do something with the IP and not sit on its hands (in our minds, SpinCo is already well motivated to do stuff without being routinely jolted with a cattle-prod). 

• Milestone payments: a series of increasingly large payments referenced to technical and commercial achievements such as starting a clinical stage evaluation, achieving regulatory approval, signing a sub-licence, or making a first sale. Some of these triggers are matched with SpinCo generating revenues, so are more affordable. That said, even with some licensing income, many spinouts will remain loss-making all the way through to exit, and would love to hang on to such revenues, not rebate them in part back to the university. 

• Royalties: increasing in value depending on how well progressed the technology is when spun-out. Various methodologies are noted in the USIT guide. To give an example of the burden on SpinCo, it cites the 25% rule which mandates a royalty rate of 25% of gross profits. Given the overhead burden of a scale-up company, this may even translate into the lion’s share of net profits. 

• Windfall success: this mechanism triggers a cash payment to the university calculated as a percentage of the valuation achieved (say, on a funding round) beyond a certain threshold. It can be a pig to determine, and amounts in essence to a non-diluting, self-liquidating additional shareholding. More importantly, it’s a massive deterrent to a follow-on investor to know that much of their monies aren’t going into SpinCo to grow the business, but are being paid to a shareholder.  

• Payment for assignment: if the university allows for assignment of IP to SpinCo on achievement of a hurdle (say, on exit) then they may have the right to a further payment in return for that outright ownership. In addition to being more cost on top of all the other costs, in the worst case we have seen this expressed as a payment to be agreed. The university holds all the cards so, having agreed to agree, when the time comes to negotiate SpinCo would be entirely exposed.  

• Reimbursing the university for its initial patent registration and maintenance costs; and ongoing payments for use of university facilities and staff – both items being fair requests. 

Why it makes better sense not to tax SpinCo 

The issue with the USIT guide is not that it absolutely mandates draining the blood from SpinCo. In fairness, it specifically notes the value in, say, balancing off a bigger equity stake versus early cash payments from SpinCo. It mentions also that “in some instances a university may not request any royalties on net sales, or other milestone payments, in exchange for much higher equity holdings.” The problem is that this approach is treated as an exception to a rule, and a rule which is expanded into pages of detailed notes. It’s clear that TenU believes that bleeding cash from SpinCo is the way to go. 

The USIT guide also notes, contrasting the position of a licence to Big Pharma with SpinCo, that “while it is common and broadly supported that the spin-out will want to preserve early cashflow to develop technologies and grow the company, the university’s desire for an early return to support their own cash position should also be considered”.  

Well, the first part of that sentence makes sense. The second part less so. In 2022, UK universities had an income of £44.1billion2 while the average first-investment into a UK spinout3 was just a little over £600,000 – so who needs the cash most? And that’s before considering that SpinCo’s cost of capital is a multiple of the typical university. 

Making SpinCo run short of cash is not the only reason that these arrangements hurt its prospects and investors’ returns. The implications are wider: 

• The ultimate value of SpinCo on exit depends on the value of its technology. Any royalties based on future cashflows from that technology deplete its value. As a result, unless SpinCo has the absolute right to require IP assignment from the university for a nominal sum, the present value of that royalty on exit comes straight off SpinCo’s price-tag. That is a deterrent to invest in the first place, and a deterrent to follow on investors (who are hard enough to find at the best of times). 

• The value of the various payments to the university is non-diluting: their value is not reduced by the cost of commercialising the technology. In contrast, shareholdings are diluted down as more monies are raised, or as more staff are hired and need optioning-up. In other words, the university is no worse off if SpinCo were to need £100m of new capital to get to an exit than if it needed nothing more after a £1m first-round funding. It’s not just that this could make the university’s IP very expensive (adding together their shareholding plus the value of their rights to a running return) this approach puts a wall between university shareholders and venture capital shareholders. In contrast, we would rather be shoulder to shoulder with the university, knowing on day one that we succeed or fail together and in equal measure. We also value SpinCo having the university’s ongoing support as a stakeholder, not as an historic vendor of IP.   

• The more variables in a negotiation, the more complex. It is easier for a university technology transfer office and its senate to evaluate an A-for-B transaction, rather than A being sold for B-plus-a-bit-of-C, D, E, and Z. Similarly, on the VC’s side of the table. Complexity equals time, cost, and probably lost deals. There’s real value for everyone in keeping it simple. 

Our approach 

So, minded as we are to protect little ol’ SpinCo’s fragile finances, here are some thoughts on how best to structure the relationship between it and the university.  

It’s very simple: the university assigns the IP to SpinCo at the point when it raises any meaningful amount of external capital. In return, it receives a meaningful shareholding. And that pretty much summarises the deals we’ve been happy to invest in: a structure that aligns all shareholders, is simple to negotiate and to document, doesn’t need revisiting in the future, and – crucially – leaves SpinCo with no ongoing cash burden.4 

Of course, if we’re asking the university to go easy on cash, the deal still must stack up for them. The Golden Triangle practice of taking an ongoing cash return seems to impact their equity stakes: the USIT guide recommends holdings as low as 10% before dilution from any funding: Cambridge, Imperial, and UCL each take initial stakes in that region.5 In contrast, we can take a slightly more relaxed view on the university’s initial stake, not just as compensation for them taking no running return, but also because we think there is benefit in retaining the university’s hearts and minds. 

Round up 

A spinout’s best chance of success is when management, university, and investors are in partnership: so let’s invest together, and win together. 

David Smith 

Partner, DSW Ventures 

 

Footnotes

1 Jean-Baptiste Colbert, effectively 17th century French chancellor: “The art of taxation consists in so plucking the goose as to obtain the largest number of feathers with the least possible amount of hissing”, a lesson clearly lost by the end of the next century. 

2 Universities UK  

3 Beauhurst 2021: £63m over 102 spinouts 

4 We routinely make an exception for patent costs incurred by the university as these have in essence been paid in advance for SpinCo and, in similar vein, for payment for the  provision of ongoing facilities and staff. 

5 Beauhurst