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25 July 2017

Principles and myths – sustaining spinout ecosystems

To find an application in the market generally requires an external entrepreneur founder or team

Author: Brian McCaul, chief executive, Qubis, Queen’s University Belfast’s tech transfer office

I have a periodic conversation with one of my friendly local-neighbourhood venture capitalists. It is usually prefaced politely: “Why, when you are usually fairly forward-thinking on university technology transfer…”, then goes into the turn “… are you so old-school on the issue of equity stakes retained by the university in spinouts?” By this he means: why do I seek to capture a decent slice of the value created by the new venture for the university. This is followed by some debate, in which we usually gain consensus, and some deals, none of which actually proves to be that problematic in terms of equity allocation.

But this shibboleth seems to persist as a stick with which to beat UK universities, especially if anyone wants to find a scapegoat for the perceived inefficiencies of university-to-business technology transfer. It has been picked up in government-sponsored reviews, it has appeared as a Sunday Times campaign, and it has been adopted as the go-to tip for entrepreneurial advisers wishing to sound founder-friendly. The allegation is: universities try to take too much equity in the spinouts they form. This impedes knowledge transfer and, so the argument goes, is in stark contrast to the US, where the process is deemed much more founder-friendly.

In my view this is an old belief repetitively cited but untrue. It may make you sound founder-friendly or investment savvy without investigation, but it does not help founders or the development of an entrepreneurial ecosystem around universities. Let us start with some basic principles that I think we should all be able to agree on.

Principle 1: Anything that impedes the flow of intellectual property (IP) in the creation of new ventures is to be addressed, anything that gets in the way of universities creating spinouts should be cracked

This flows from the fact that, generally, spinouts can provide disruptive technology that current market leaders may struggle to invest in – basic economics by Joseph Schumpeter and Clayton Christensen. And specifically, some parts of the UK could really benefit from more new ventures and high-tech jobs. I happen to be writing this from Belfast where we have the lowest level of startups in the UK – and where university spinouts are disproportionately important to rebalancing that deficit. Yes, we need to focus on supporting scale-ups, but this is where they start. So let us have more.

Principle 2: Skin in the game is the most effective risk management tool

Anything that throws off-balance incentives for those building the business should be avoided. Lack of incentive will stunt growth, too many players taking no risk will create tension and perceptions of free-riding. This is hard-wired human nature.

Principle 3: All impediments to building a sustainable process and ecosystem for creating more spinouts should be dealt with

In the same way that it takes a village to raise a child, it takes an ecosystem to raise a new venture. It can be done without that support but it is likely to be hard work, the offspring somewhat stunted and overall less productive. So no decision should be made on the basis of the single transaction alone. Ideally, all deals should help grow the ecosystem to the benefit of all.

So if those principles are common ground, what are the myths and misperceptions that shape the equity shibboleth?

Myth 1: Tech transfer offices (TTOs) do not understand the operation of the market

The most basic misunderstanding is the simple confusion of some of the less sophisticated commentators – to assume that TTOs do not distinguish between their own internal policy and the operation of the market. There are a number of transactions when determining the equity position for early spinouts. The first is pre-investment when the university is simply determining the split between its own staff as inventors or founders, and what it may retain in consideration of its contribution.

But in the rush to brand TTOs as getting in the way of the deal, commentators often conflate this transaction with external equity investors. In this cruder misunderstanding, the argument goes: universities insist on taking too much of a percentage and that will put off the investor. Well no. These are two distinct transactions.

The first transaction is about the internal allocation. Here we are talking about the internal allocation of equity to its staff,  not the proportion for founders – university and academics – versus external investors. The second transaction is a market transaction and will be driven by valuation, availability of cash and all the complex factors that go into determining that company valuation.

The former is generally subject to some form of policy – generally very similar across UK universities. The latter is down to market forces and negotiations. It is never driven by policy. The first transaction has no bearing on the latter. The cost of money is the cost of money – we know that as we do a lot of deals. And even if they happen conterminously, the market will still determine the percentage of the equity sold.

But I often hear advisers to academic founders mixing up founder splits with dilution. I have even heard prominent government advisers conflate these different transactions.

Of course, all parties will seek to optimise their position in a negotiation, but only a real rookie is going to fight the market and destroy a best available investment deal. So for, the avoidance of doubt, no university TTO worth its salt – possibly even any TTO – would ever assume it can impose policy on a market transaction relating to the valuation of a startup. They may disagree with the valuation, they may even be unrealistic and they may even call it wrong to start, but in general most fully understand that the investor will call the tune on valuation, and get the best deal available – if the timing is right.

Myth 2:  Universities do not understand the role of incentives

The argument goes that “we need to incentivise the founders…” The more sophisticated commentator – or begrudgerer – will be on a different track. “But we need to make sure that sufficient equity is given to the founders to ensure they are not turned off.”

And, naturally, as the market will determine even dilution, the only way to protect the academic founders’ slice is to squeeze the university share, as a co-founder. This is sometimes heard from investors or VCs used to dealing with non-university startups. There are a couple of problems with this.

First, every allocation needs to be fair and needs to incentivise the founders. But putting aside the fact that the TTO is a founder for a moment, here again another confusion creeps in – conflating the academic inventors with the founders. They can be the same person, but preferably are not.

Compared with industry, inventor reward schemes adopted by nearly every UK university are generous – crucially they favour inventors over entrepreneurs. This is partly historical, it is partly due to an underappreciation of the value of the business model and leadership in turning an invention into an innovation or a venture.

So, if academics invent something they are generally in for at least half the return – irrespective of whether they helped convert the invention into economic return or not. That is fine. They are not being paid as well as most in industry, and we want to incentivise innovation – as per Principle 2. But this favouring of inventors over entrepreneurs does undervalue the hard-yards in turning inventions into innovations that have real market value. This is what Nassim Taleb, distinguished professor of risk engineering at New York University, calls the “half-invented” – suggesting that only when technology finds an application in the market is it really “invented”.

Crucially, to find an application in the market generally requires an external entrepreneur founder or team to come on board. This itself requires two main things – equity and incentive for the external entrepreneur, who needs to have some skin in the game. It also requires a great deal of effort, mainly for the TTO, to find these entrepreneurs. In most instances in the UK it is the TTO that has to create or tap into an ecosystem to find these rare beasts. It is then for the TTO to broker the deal with the academic founders.

In order to allow the external entrepreneurs to have skin in the game, there has to be some dilution through the grant of starter equity or some option pool created to attract and incentivise them. I am personally in favour of making this generous if they succeed.

This is the piece of the pie that some commentators forget about when discussing incentives. The external entrepreneurs’ share is most likely to be the component of the cap table that is likely to determine whether the venture flies or fails – not the share granted to an academic that goes back to the bench – so encouraging inventors to obsess about their slice of the pie early can impede this crucial process.

On top of this, the TTO not only has to work hard to find these entrepreneurs, it often has to engage them on a fee basis too in order to get them going, before a VC will even look at the project. This has an associated cost, but also the TTO will often have to substitute for this team or play a part of the leadership for a while to ensure the proto-venture is in a position to become a full-fledged spinout. This is very much connected to the issue of place and context – in Northern Ireland this is harder than in San Diego or the southeast of England.

Finally, not only do we recognise the importance of skin in the game, we spend a lot of time rethinking our approach to cap tables and equity allocation to make sure there is a fair outcome. At Queen’s University Belfast, we have a policy dealing with the internal initial allocation, but crucially it is designed to skew the position in favour of inventors that help on the entrepreneurial journey. If they help build the team, if they help find funding, or if they help with customer discovery they will get more. If they become the CEO they will get even more. Perhaps even more importantly we will make sure that entrepreneurs are generously rewarded for their efforts to turn the half-invented into something that has a market value.

Myth 3: Universities can only play the role of feeders, not leaders

The role of an ecosystem is being increasingly recognised as crucial for successful tech transfer from universities. But much entrepreneurial and ecosystem theory imported from our counterparts in the US assumes that universities should be feeders and not leaders in this context. That is, they should let the entrepreneurial community get on with it and stay out of the way, acting as a simple provider of IP via licences to the startup community.

This may apply in parts of the US where the quantum of funding and the networks of serial entrepreneurs are an order of magnitude bigger and more experienced. It may even apply in the golden triangle of London, Oxford and Cambridge in the UK. But it does not apply to other British cities such as Belfast, Barnsley or Bournemouth.

In many parts of the UK, the TTO, on many occasions, will have to substitute for the early venture until such time as it can find the cash – grant or equity – and find and recruit the team. I recently had one example where we had to recruit three proto-CEOs before to the first seed round as each was lost either by an internal team fallout or merely competition for these rare entrepreneurs.

A lot of work in the TTO is devoted to this activity, while simultaneously working to increase the number of these spinouts. In Belfast, the historical need to rebalance the economy has placed extra onus on the universities – with the majority of recent IPOs having Queen’s University Belfast origins, for example.

As an aside, many of the entrepreneurial networks are part-seeded by the university spinouts. Qubis companies themselves have formed an important cornerstone of the entrepreneurial community, with executives being involved in a number of spinouts and even cross-investing.

So it is refreshing that, after years of unfavourable comparison with the US, leaders from American TTO networks have pointed out this very important fact. Katharine Ku, executive director at Stanford University’s office of technology licensing, and Lita Nelsen, former director of Massachusetts Institute of Technology’s (MIT’s) technology licensing office, advised the McMillan Review, which looked into university knowledge exchange frameworks and good practice in tech transfer, that “a direct comparison with terms given by MIT and Stanford is therefore simply not appropriate.”

The review went on to say: “The role of Stanford’s tech transfer office is largely to file patents on potentially exploitable technologies and market these to entrepreneurs, who are usually locally based. The universities have not felt the need to form companies themselves, nor to raise venture funds to support spinouts, nor to assist spinouts once formed. Faculty and students involve themselves as private matters in entrepreneurship, working with the ecosystem around them. This approach is reflected in the terms upon which Stanford and MIT license their IP. They license on an arm’s-length basis to companies that can best take forward technologies, irrespective of faculty or student involvement in these companies.”

That approach probably will not work for what is needed in the UK or parts of Ireland where the entrepreneurial ecosystem is not yet that developed. I can categorically confirm that most of those that we have spun out would not have made it on their own. To reinforce this, Northern Ireland comes regularly at the bottom of the league of equity investment – by number and quantum of deals.

Qubis and the university have often stepped into this breach to fund these ventures at pre-seed and seed stage, but also beyond. Indeed, Qubis is one of the most active seed investors in Northern Ireland. So not just effort and ecosystem development are required, but also seed funding. Qubis has participated in around 11 syndications for university spinouts over the past two years. No other equity funder came close to that level of activity here.

This is most likely because the level of risk at preseed is generally an order of magnitude greater than most VCs would stand – even when they are using publicly provided cash. Rarely do TTOs have direct access to that public cash to support investments. Hence the only way to make this activity viable for the TTO and university is partly to derisk the investments via gaining some equity in return for university IP.

This, if you like, is the crucial balancing figure in the equation, otherwise no TTO could take this risk – as no VC would – if they cannot even the odds a little bit by not always having solely to buy equity in its own spinouts.

Myth 4: The state should not or cannot play a role in enterprise

This is a broader myth on which number three is actually based. Yet the need to derisk early technology and the market fairly in this space is as well understood as the “valley of death”. Mariana Mazzacato, professor in the economics of innovation and public value at University of Sussex and director of the Institute for Innovation and Public Purpose at University College London, has argued the state can also be an economic player and investor, as much as a provider of grants.

And most evidence suggests that public money crowds in private investment. Of course, more needs to be done with public procurement and related aspects, but the active role of TTOs like Qubis as an investor is partly facilitated by the fact that we take equity for IP too. This has allowed us to generate income that we largely reinvested in education and, crucially, in starting and supporting new ventures.

However, this raises a matter of principle not fully addressed in Myth 3 – why should quasi-state bodies like TTOs and universities not benefit from successful stimulation of enterprise activity? Where some may see the individual spinout deals as one-off transactions, for the TTO there is a need to create a sustainable process, for which we have the staff to help spinouts and recruit entrepreneurs, and the cash to risk on getting them going.

By denying the TTO the ability to have skin in the game – like others – we simply choke that process. This is not only shortsighted, in that it favours the current deal over the health of the system that produced it, but worse still, it often also introduces a degree of angst in the academic founders that emphasises getting the best deal at the expense of the university.

This transactional model arguably does more to introduce tension to the founding team. I have seen it kill spinouts. Put simply, if the TTO and the university are key to the formation of a startup and the formation of an ecosystem, it deserves and needs to share some skin in the game. And if this is spent on teaching a few students instead of founder lifestyles, so be it.

Myth 5:  Let them have the IP for free and they will donate back to the university

The next line that might be taken is: “We understand this is risky and that the university needs some share of the upside, but that is more likely to come back as a philanthropic gift.”

Again based on a US model, the argument is then made that if you give the IP away free or for little, then grateful founders will donate back to the university in spades. Sorry, there is no evidence of this in the UK, and sorry, ideas like the “golden share”, that is a stake that will not be diluted, will simply complicate negotiations.

Personally, I think we are missing a trick here If alumni development offices and TTOs worked together more effectively to exploit the emerging crowdfunding markets, we could increase the resource drawn into universities. But currently there is no developed culture of giving that would replace anywhere near a fraction of the resources that universities generate from equity and licence deals, and which they recycle back into the system. This is just wishful thinking at the moment. We could experiment, but let us not bet the process on an untested hypothesis.

Moreover, the mechanisms that are proposed to support this untested assumption are problematic in themselves. The golden share approach will not simplify the process, mainly because the equity position is not the difficult part – creating ventures and supporting them is. The “golden” bit is the problem. If a TTO, for example, took a 5% undilutable share on the assumption that the anti-dilutive impact of this golden share would pay off, it is dependent on this being accepted by external investors. There is a good risk this may not be the case.

The university has most power at the outset when it is investing its IP. And if it were not contributing money in future rounds, it would be even harder to argue for non-dilutable shares to be honoured. At the very least it could cause tension with new investors at each round.

In any case, establishing the precedent of non-dilutable shares becomes meaningless if all parties seek to benefit from them, and thus encourage inventors to ask for the same. Even if it worked and the stake remained undiluted at the end of the investment cycle, I know we would be down on the deal for our overall portfolio. If it were changed and ripped up in future rounds we would certainly be down on the deal.

But would it stimulate more activity and a bigger portfolio? We also have some data for this. A southern English university has inverted its proposition to make it significantly more favourable to the academic inventors – to its own expense – and it has made no difference in terms of activity. Conversely, I suspect that those that have seen a positive impact really have entrepreneurship methodology programs such as Lean Launchpad and iCure to thank.

The economics of this could be bettered by the use of a hybrid model that seeks a dual transaction – combining a licence and an equity deal at the outset only takes a small equity position. But this would be more complex.

Therefore, if the objective is to reduce the room for lengthy debate and accelerate the startup process, it is debatable if this would achieve that. Unless both are fixed, it may even increase transaction costs. Otherwise it would just double the legal aspects – shareholder and licence deal – because it means we have arrived at a valuation and at a royalty rate for a proposition that is too early a value on either. The downside of this fixed rate would be that it is likely to result in a reduced return to the university.

At the end of the day, it is the noise around this issue that is slowing deal completion. If we can develop the entrepreneurial ecosystem across the UK and Ireland to the extent that we can all sit back and let the business community lead the charge into the valley of death and undertake this high-risk activity without aid, then we can all relax. 

This is an edited version of an article first appeared on Medium. It has been republished with permission from the author.

Copyright Mawsonia Limited 2010. Please don´t cut articles from www.globaluniversityventuring.com or the PDF and redistribute by email or post to the web without written permission.

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