The real cost of a university’s stake

We put out a short series of posts last year about the terms on which universities would agree to in their spinouts and the impact of the (at that time) novel USIT guides. Our concern was that guides made some problems go away only to introduce others. In this post, we look at further experience and our increasing concern that the university sector is splitting into two tiers: universities that we can work with, and ones we can’t.

A quick recap about USIT

A University Spin-out Investment Terms guide was published in 2023, with an addendum in 2024, by Ten-U – a UK government-funded consortium of Golden Triangle-dominated universities and a few large VCs and law firms.

The guide was helpful as part of a trend of policy-makers focusing attention on the importance of university spinouts, and in offering a useful how-to guide for first-time academic founders: for them, it is a particularly valuable and instructive read. Importantly, it has also given university staff reasoned arguments to support decisions about, for example, taking a more liberal view on the equity split.

One of our objections to the USIT guides was the patronising attitude to the rest of the sector. The guides reflected practice at Imperial, Oxford, Cambridge, a few other big-brand universities, and their acolytes. They were created without wide consultation. Without wanting to sound too much like the country mouse, the message was “You want to be successful. Well, we’re successful. So do what we do. “ There is enough wording in the guides for the authors to deny the claim – they are not mandatory – but that would be disingenuous in underestimating the evident power of the authoring institutions to influence the whole sector.

What’s the beef?

I’ve been working with the university sector since the early 1990s. At that time, university spinouts used to be hard to engineer. Most institutions had limited experience. Concern to uphold fiduciary duties to the university meant that staff would err on the side of caution: better to have no spinout than looking idiots in letting SpinCo’s team buy the cure for cancer for two-and-six. The biggest barriers were high equity stakes, routinely 50% of SpinCo’s equity. On top of that, most tech-transfer offices had no real reference-points about what if any royalties were fair, or what patent costs they should recover.

By 2023, though, that was no longer the case. Equity stakes had been trending down for a long time and in 2022 the mean stake taken by universities during spinout formation was down to 17.8%. The market didn’t require the Golden Triangle cabal to lead the way. It was already there.

So in that respect the USITs’ guidance on equity stakes was rather pointless, save for rounding up a few stragglers.

In other respects, the USITs’ guidance has proved positively harmful. Here’s a selection of additional costs that the guides list in their menus:

• A signing fee – initial payment for the IP licence on top of the university’s equity shareholding.
• Annual / maintenance fees – amounts paid annually, justified on the basis that they encourage SpinCo to actually do something with the IP and not sit on its hands.
• Milestone payments – a series of increasingly large payments referenced to technical and commercial achievements.
• Royalties – increasing in value depending on how well progressed the technology is.
• Windfall success – more cash to the university on exit. Crucially, unlike a shareholding, this is non-diluting. The founders might get wiped off the cap table, the university survives.
• Payment for assignment – and after all the above costs and equity give-up, SpinCo doesn’t even own its IP. Unless it finds some more money to pay off the university.

We covered why these were bad ideas in previous posts in this series last year although, dear reader, you have probably gathered from the above that there’s a severe risk of SpinCo simply collapsing under these burdens.

Of course, the USIT guides are not mandatory. But pity the poor tech-transfer officer who is asked by their boss “Why have you not negotiated for the university to receive all these revenues?”

The Golden Triangle experience – and true costs

The justification for Cambridge, Oxford, Imperial and the rest dictating these terms is, in part, that they simply can. They have strong brands. VCs are keen, and are perhaps virtually obligated, to back their spinouts. They have captive VCs and willing alumni investors. And their round sizes are typically much bigger, so the university levies are more affordable.

Another justification for taking these income streams was that these universities went easy on the equity: higher cost in cash terms, lower cost in ownership terms. But was that really the case? We looked at a Golden Triangle spinout recently. This was unusual for us but, as it was relocating into the regions, it fitted our investment thesis. On the face of things, the deal looked fine: the university took 10% of the day one equity, and offered an express IP licensing deal. Fine.

Not.

The equity wasn’t 10%. It was 20%. This university has a captive VC fund and it procured third party investors in that fund by gifting it the other half of its spinout shareholdings. For free. Regardless of whether they invest or not. Any actual investment from the fund is made at market rates. Technically, of course, the university has only a 10% stake – but only because they have already flogged the other
10%.

In passing, I guess the lower shareholding percentage is what analysts like Beauhurst pick up when they show the Golden Triangle universities leading the way, but it’s misleading. It confuses inter-university comparisons. It would be a useful study to see to what degree – if at all – the Golden Triangle universities’ shareholdings are lower than their regional peers.

Now, how about that express licence. What was its true cost?

Some universities including this one publish their template licences so we were able to see that for this spinout the costs would be:

• £50k cash signing fee on spinout;
• Patent cost reimbursement;
• Royalties on product sales depending on tech maturity and margin: 0.5% to 2.5%;
• Royalty on licence income depending on how much in-the-bag on spinout: 5% to 15%;
• Both royalty streams survive past exit until the patents expire; and
• Exit fee capped at £5m at 2% of exit consideration (lower percentages above £25m).

We’ve seen worse: for example, this template licence doesn’t require milestone payments which can bleed a company dry as it goes through later funding rounds. Even so, for a company whose first tentative steps are funded by the Seed EIS maximum of £250k, that’s 20% of the round gone back to the university for the signing fee.

The royalties should at least be self-funding, but they’ll bite into the value of the business. They are a drag on profits made both by SpinCo and – more importantly – whoever buys the business. Crucially, they also take the first bite out of revenues, being calculated on sales, not profit.

The exit fee sounds innocuous. It is not. That 2% is non-diluting. So regardless of how much money SpinCo has to raise, and whatever harsh terms it has to swallow to get that cash, the university pushes in front of the shareholders to take its 2% of exit consideration. This matters to management and early stage investors who can get squeezed to the edges of the cap table by series A or later investors.

What would this amount to in practice?

Well, it depends, so let’s look at one scenario and you the reader can extrapolate. In this case, therapeutics pioneer SpinCo is owned 80% by management and 20% by the university and its tame fund. So far so good. Over time it raises, say, £30m of VC monies for which it gives up 60% of the enlarged equity. It generates negligible revenues prior to exit but at that point the technology has received FDA approval and has just started human use: the acquirer reckons on achieving £20m annual revenues on which it will pay 2.5% royalties to the universities: assuming a 12 year remaining patent life, that amounts to £6m. Let’s assume that their simplistic M&A department pays 5X forecast revenues for acquisitions: so SpinCo would be worth £100m, but they hold back £6m due to the royalty obligation. Then there’s the exit fee: based on the £94m that would be £1.1m leaving just under £93m for the shareholders. The university’s 20% stake was diluted by the £16m of VC monies to 8% so they get £7.4m for their shares. And let’s not forget the £50k signing fee. Total university take: £14.6m, of which approaching half is from the add-ons rather than their shareholding.

Headlines: that attractive 10% stake is really 20%. And the IP licence will cost the founders an amount equal to nearly another 20% on top. Wow. No really – wow.

Bad habits spread by imitation

…to misquote George Orwell slightly.

We do not invest in Golden Triangle spinouts, for various reasons, including all of the above. To some degree, we don’t care how they structure their spinouts. Not our circus, not our monkey. Frustratingly, though, and to a degree due to the ill-formed USIT guides, those bad habits are being picked up by regional universities. And that we do care about.

Last month we had to pull out of funding a spinout whose Northern alma mater wants a meaningful royalty stream out of the company whilst we will still be pumping money in. This was a real shame. No other VC lined up. We liked the technology. We liked the management team. But the terms have to be right. Outcome for us – we had to bin a ton of work, but we’ll invest with a different university on a different startup. Outcome for management – back to academia, dreams on hold (and by the way, the university TTOs are paid by the university: don’t look to them for advice on your relationship with the university). Outcome for university – principles upheld, royalty stream of zero, share value of…… oh, that’s zero as well. Nice one.

If all this sounds rather downbeat, it isn’t. Plenty universities we engage with and invest alongside are business-like and pragmatic, and we’ve invested alongside plenty of them. We’re making good progress on another spinout where a university is taking a very modest royalty but only as they’ve agreed to take zero equity, and no bells and whistles. Fair and pragmatic. We just need to see more universities to take that approach.

Our ask

Universities – read the USIT guide. Some of the stuff in there is helpful. Then offer to sit down with investors and management and flex a deal that works for you, investors, management, and the business itself.

Other VCs – take this post to heart: things that work in the Golden Triangle don’t necessarily work in the regions. In fact, they might not work well anywhere. We can’t kick the can down the road and hope to resolve these issues in later-stage rounds – they need resolving on spinout.

Investors – if your VC manager isn’t worrying about these issues, then you should be worrying about them. Ask!

David Smith

Partner, DSW Ventures