STAGE 3
How do you get approval to spinout?
Image: © This is Engineering
In Stage 3
University approval
Here, you seek official confirmation from the university that you may spinout. Despite being the final stage of the cycle, it serves as a useful introduction to a section where we see the stakeholders frequently butt heads. This is inevitable due to how singularly important the decision is. While all sides want your company to succeed, differences between them will usually remain, and your role will be to see it from all sides and steer them all towards a compromise.
Your investigations must lead yourself, the TTO and any other stakeholders to agree that spinning out is the best option to achieve your goals for the innovation. That’s the case whatever those goals may be, and a frequent catalyst is securing an investment contract to provide the necessary finances to continue the process. This is one of the most onerous and well-known tasks associated with startups and spinouts – raising finance.
Different points of view
With raising finance being such an important task it inevitably brings competing viewpoints, often being the biggest point of contention between stakeholders. Our survey showed that the barriers of university bureaucracy, risk appetite and inflexibility were all identified by academic entrepreneurs, investors and TTOs alike. At least they all agree on the difficulty, if not the solution!
Among academic entrepreneurs, 27% of responses contained commentary around university bureaucracy. This was second only to issues related to academic culture (workload, job security, and incentives) which were present in 29% of answers. For investors, university bureaucracy and commercial awareness among academic entrepreneurs were tied as the most frequent theme, present for a significant 38% of responders. To their credit, TTOs also acknowledge the issue, but only as the 7th most frequent theme in their answers at 20%. While this misalignment in relative importance should be borne in mind, consider their position. The TTO must operate within the constraints, incentives and targets set by the wider university; they’re more used to them, and often more accepting of them. As one TTO put it: “There are still about five layers of bureaucracy for approval, all seeing spinouts as a high-risk activity rather than a driver to impact”.
“The amount of equity taken by some universities detracts from attractiveness to take an idea forwards, coupled with the long and cumbersome spinout approval process and the protracted negotiations with the University.”
Investor
Key takeaways here are that all sides acknowledge the negative aspects of risk-appetite and bureaucracy. You’re unlikely to be in a position to effect change in the short term, so you should focus on helping to ease passage through the process by working with your TTO who knows it well, and in particular by reducing risk.
Freedom to operate
Here, you double-check that you can legally do as you propose. This is a rather long and administration-heavy step, but it’s a necessary one which requires expert legal input. The process and timeline is mapped out in detail earlier in stage 2 (IPR audit), but at this stage, you may need to collate all the information to confirm your findings once more. Without evidence that this step has been conducted thoroughly and independently, no investor is going to come on board.
If you have not done so already, now is the time to register your company through Companies House. You will need to have:
- Decided upon a name
- Appointed at least one company director
- Have agreement in principle upon the equity split between the university and your co-founders
- Prepared some basic documents such as your memorandum of association and articles of association. This process is covered in section 4 and in detail here, which is also where you will need to go to register your business.
In addition to the above, you’re likely to want to register a web domain and prepare a website (which should only be launched once you’re happy with the content). Create social media channels for launch, open a business bank account and register for VAT, more information on which can be found here. You should consult your TTO again at this stage as you may need to be charged VAT by the university for the consideration paid for your IP.
As part of the process you will also need or visual identity and tone of communication. Don’t overcomplicate it; less is definitely more, and your time is better spent elsewhere. Resist the easy option of naming your company after the product. Many people do this only to later realise they need an expensive rebrand as their name does not align with later product lines, potentially stifling growth.
“Negotiate on your terms. Learn negotiation skills to handle investors, employees and the TTO offices to make sure you understand the terms presented and you are happy with the results. This is a steep learning curve (investor documents, articles of association, shareholders agreement, IP licences), and feeling comfortable with the terms of engagement is crucial.”
Academic entrepreneur
Validate a business plan
At this stage, you obtain evidence that it’s a good commercial plan, or adapt your plan until it is. There is a wealth of information available on creating your first business model canvas, validating your business plan and creating the perfect pitch in existing videos, books and blogs. Many commercialisation grants and programmes provide training on this as the starting point to commercialisation, and you should become well versed in them as a priority.
There are many alternatives to the Business Model Canvas (BMC) out there, so pick one that works for you. These are not the tick-box exercises people sometimes mistake them for, where they write one and roll it out for display as and when required. These are living documents, to refer back to and edit whenever you learn something new. Expect this document to change significantly over time; your first attempt is never your best, and will likely be unrecognisable from the one you implement. If you don’t make any changes at all, it’s likely you haven’t learnt anything from the feedback, which will worry other stakeholders.
“Don't necessarily wait for the university! Always keep them informed, but go ahead if they are delay the process unnecessarily. Complete a business model canvas at an early stage and engage with potential stakeholders/customers at an early stage to understand requirements.”
Academic entrepreneur, spinout incorporated in 2004 with over £30M secured through 11 fundraisings
Put it to the test
The BMC is your hypothesis for a good business. Yet no matter how confident you are in your plan, it is as yet unproven or unvalidated, which you must now address through testing all your assumptions. Validating the plan with objective data is not just helpful for putting your mind at ease – it’s essential to securing investment. As much as investors say they look for a great story and team, they will not commit cash on your say-so and charisma alone. They will need independent evidence.
Validation involves identifying every part of the plan (be it a number, theory, relationship; anything and everything contained within it), and accepting that these are assumptions rather than facts. Test each and every one to see if it is true or not, or more likely, how confident you are it’s correct. Testing can take many forms, be it fact-based research, talking to experts, or selling and testing the product itself. It all depends on the nature of the assumption.
The more of your assumptions that you can tick off as true (validated), the more you can reduce the risk of failure that the stakeholders fear. Proper validation is evidence that will convince your stakeholders, not just yourself. Don’t simply validate what you think needs answering – ask your stakeholders what they need to see.
Building your pitch
If your chosen method of finance is investment, then you are going to need to pitch. This is essentially the investment world’s equivalent to job interviews.
To pitch, first you need a pitch deck – a short and snappy presentation outlining the opportunity and your long-term goals. Pitch decks and pitches are very different from academic lectures or work presentations, something we find our awardees can struggle to adapt to. Less is most definitely more in this case, and three-slides-in-three-minutes pitch events are quite common. The in-depth, evidenced, genius complexity of your innovation is not wanted here. This will take some getting used to, and it’s worth attending pitching competitions as an audience member to see it in practice.
Messages are generally received better when they are in the recipient’s favoured form, rather than the sender’s. In academia, this means detail, facts and proofs – but investors are not academics. Resist the urge to send a full business plan and technical spec, with reams of text extolling the virtues of your innovation. The harsh reality is that investors are unlikely to read such unsolicited documents. They may want such detail later if they are interested, but as a starting point they’ll probably prefer just a pitch deck.
Good practice is to follow the 10, 20, 30 rule: “a PowerPoint presentation should have ten slides, last no more than twenty minutes, and contain no font smaller than thirty points.”
The length of the pitch
A key mindset to adopt is that a pitch is a sales pitch – more akin to a TV advert than a presentation. Make it short and sweet, light on detail, enthusiastic, aspirational. Grab their attention with the big picture and core facts. Make it memorable and visually engaging. Line graphs, equations, and black text on white paper have no place here! The design you use is important as it must reflect your business and its brand, and values, whilst crucially distilling information down so that it can be quickly and efficiently understood. It might be worth paying a professional if graphic design isn’t your thing. If you think the brand you present doesn’t matter and only the technology counts, you haven’t understood the commercial world yet. It matters.
“Understand what investors want and target this, which requires a dramatically different pitch to that which academics might usually make at a conference or funding application.”
Academic entrepreneur
Image: © Axial Medical
When writing your pitch, consider your ideal investor and the likely questions they would ask, before answering them. Your pitch deck should be clear and concise; explain the problem you are solving, why now is the time to solve it and how you will generate revenue. Many online guides break down what to include and why. Most of these guides are aimed at traditional startups rather than academics, so it’s worth remembering that your competition for investment is other companies, not other academics. No-one here will ask for your publication history or reference list; they want to see evidence of commercial experience, so underline that wherever your team has it.
“We see a few hundred pitches a year, but invest in less than 10%. Half or less are university spinouts. Lots of founders don't appreciate how competitive getting funds could be. It's a competition – you filter and find the best match at the end of the day. Coming from a university, they often don't have the experience necessary to appreciate what it takes to run a company. Mentoring by people who've been there and done it is really important.”
Investor
Competition
So why the focus on short and snappy pitch decks? Firstly, consider the sheer level of competition for investment that exists. It’s often said that a VC receives a thousand approaches a year, interviews a hundred, and funds ten, generating a 1% success rate. Survey respondents who identified themselves as any type of investor (32 responses) show a huge spread (see below), and an average success rate of 2.64% (4.83 SD).
Averages of investor responses to questions on approaches, offers and investments
By comparison, the grants sector typically aims for success rates averaging 10%, to get a balance between competition and efficiency. As mentioned previously, the 160 university spinouts each year in the UK is not a lot, but you are not just competing with spinouts. There are also around 4,000 graduate startups a year to contend with, over 450 accelerators and incubators, typically supporting ten or more aspiring startups each, not to mention thousands of older businesses and unconnected startups in the UK. They’re all competing for one of the 9,000 raises listed on average each year by Beauhurst.com. And remember, just as you may approach investors overseas, those investors will themselves be receiving similar approaches from all over the world.
“Some academics that I have worked with have been a pleasure to be around. Others are in dreamland or live in the belief that their academic excellence should allow them the same standing in the commercial world as they have in the academic world.”
Investor
Lastly, and most importantly, understand that you are asking people to give you hundreds of thousands of pounds, if not millions. If you were in their shoes, would you be receptive to a stranger coming to you cap-in-hand three months before their company runs out of funds? People don’t give that kind of money to strangers, so you need to engage with investors early, potentially at least six months before you even start raising. Allow time to build a rapport, assess mutual interest, and understand what they are looking for in an investment case so you can then address their priorities in good time. Your contact at the investment firm will be your champion, putting your case forward to the rest of the team, so you need to get them on your side as they become the third (unofficial) member of the team after yourself and the TTO. They know best what their colleagues are looking for in an investment, so listen to them and question their advice to ensure you understand it fully.
Approach investors
“The only way to approach investors is with enormous preparation, by the TTO and team. That means anticipating questions and trying to give a reasonable answer, even if the answer is ‘We've thought about this and don't have an answer yet, but we're excited at the prospect of getting there’.”
Investor
As you might expect for people who give away money, investors are in high demand and often hard to pin down. You can tell who they are at pitch events by the hoard of entrepreneurs surrounding them.
While that’s one way of making their acquaintance, a warm introduction will go a long way towards gaining their attention – this is something your TTO will be able to assist with. Your TTO may also guard their network carefully, and reasonably so. They will not want to damage the relationship by introducing investors to colleagues before they are ready, so your first step is to get the TTO on your side (which you should have done by now). Your TTO has done this before, and can steer you away from common pitfalls by pointing you towards suitable resources and friendly investors more willing to give feedback.
“We have worked hard at seeking to develop relationships with investors. We have a strong relationship with local existing investors, but have now looked to extend this out to a range of international VCs. We seek to provide investor-ready proposals that make it easier to secure seed or Series A investment. We have had great success with this approach, and we are keen to extend this further as we gain more and more success.” – TTO employee
You would ideally meet your preferred investors even before you start formally pitching to them, or meeting them at events. When speaking with VCs and angel investors, one point was consistently raised in our research – you should be engaging with them as early as possible. It takes a long time to get people on your side, prepared to hand over large bundles of cash. It’s important to speak with as many investors as you can, to understand what they’re looking for in a proposal and to warm them up for when you’ll start pitching properly.
“TTOs typically do an exceptionally poor job in preparing spinouts. They need to get to the academic and build a relationship with them often years earlier, and provide training and mentoring to the more promising academics in fields ripe with commercial potential... Tech Transfer is often called a contact sport, but the extent of the contact needed is almost always drastically underestimated.”
TTO employee
If initial pitch events and meetings go well, you may be invited to submit a full business plan and give a pitch with around ten slides. A presentation of this sort would take around 30 to 60 minutes, in which time you should expect to be questioned in detail about your business proposition. During this pitch, you’re trying to convey the story of the business and the story of you as a founder. You must articulate why you, why now, and how you’re going to deliver. The whole management team should be present at this meeting, as the investment proposition is as much about the team as it is the technology. You are unlikely to succeed at the first attempt, so always ask for feedback and note down what questions they ask so the next pitch covers all these points already.
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You should expect to be questioned in detail about your business proposition
“Pitching to investors was a positive experience and it took three attempts, but the feedback given was very constructive. The network of investors became quite complex as the company progressed through the process and the founders became very remote from the process, and disadvantaged to some extent. In comparison with public support, investors will obviously take equity, but they did become actively involved in the company, which was generally a positive.”
Academic entrepreneur
A few key points to consider when approaching investors
- Raising finance is lengthy and time consuming. Start at least six months before you need the money to arrive, and expect it to take up most of your time. Often leading the raise is the primary role of the chair (if you recruit one).
- You will be expected to be up to speed with all relevant sector news on market trends, legislation and competitors, including recent sales and acquisitions.
- Investors aren’t wallets – they offer much more than just finance. Recognise what skillset or network would help you most, and seek out investors who fill this need. Examples might include those with good sector links, or a network to build out your team.
- There are hundreds of VC firms in the UK with thousands worldwide, and many more angel investors. Each covers different sectors, and with different exit timelines. Do your due diligence, targeting those who have a verified history of investing in your sector and who want a return on a timeline that works for you.
- Investors often want founders to have their own money invested in the venture. This demonstrates the founder is committed to the business, and will not walk away when it gets tough. Universities can demonstrate this through various forms of contribution. For the academic, it’s likely your commitment is in time only, and perhaps a demonstrated willingness to leave the university and join the startup. Seriously consider what you are prepared to commit.
- Investors often say they invest in the team, not the technology. Consequently, you need a team; going it alone is hard, and less likely to convince others of your credentials.
“I find the greatest challenge is getting them [academics] to the point they are happy to start talking to lots of investors by themselves. We approach it with the idea that they are used to a 75% failure rate with grants, and that approaching investors has a higher failure rate, but that there are more investors than grant funders and they are approachable at any time, not just when calls are open.”
TTO employee
This initial stage of introductions is a numbers game. It may take you several months and many attempts. During this time, you may wish to consult the British Venture Capital Association’s website, which has a keyword-matching tool for identifying the most suitable VCs based on funding requirements and fields of business activity.
How to spot the right investor for you
- You like them as people The relationship you have with your investor will last for years, so make sure you get on with them. You want to rely on these people for differing perspectives, lived experience and strong opinions – you’d better get on well with them and trust them! Plus, if you get on well, it’s easier to work together to fix any crisis you may subsequently face.
- They have useful skills and contacts Investors are often (but not exclusively) former investment bankers or entrepreneurs. Consider what background and network access would best compliment your team’s existing skillset and business goals. The best investors will understand your background, and can help guide you on that journey.
- Your timelines and ambitions align You don’t want the investor encouraging a sale before you are ready, just so they can meet their internal targets. Equally, if you’ll need multiple investment rounds, you want a lead investor that can support you through each of them.
“The best investors are not 'dumb money' or 'best valuation'. They are the ones who can truly bring their network, advice and high-quality management to the company. Bad case studies tend to be seduced by the valuation or big cheque – good case studies get a supportive, high-quality syndicate of specialist investors who bring real value beyond cash.”
TTO employee
Due diligence
Interested investors will carry out their own due diligence on you, the team, the market and the innovation. This process can take months, during which time you will be expected to be available and provide detailed information as requested. When there are multiple investors, the lead investor (who is proposing to invest the most money) may conduct the bulk of the negotiations and due diligence and share it with the rest.
The TTO will lead with the lawyers, but there are several key points for you to consider and keep up to date during this time. These include:
- Your corporate documentation. All accounts, legal filings, employment contracts and other essential documents must be kept updated and be on-hand when requested. Not having your house in order will slow process down, and is a red flag to any potential investor.
- Website and marketing materials. Investors will look at your website, as well as social media accounts such as LinkedIn and Twitter. Make sure all material is accurate, up to date and consistent, so there aren’t any discrepancies to explain. An out-of-date website indicates a potentially dead company.
- Diaries and planning. Ensure critical members of your team are available as much as possible through the fundraising process. Investors may raise many additional questions and you want to respond quickly and clearly.
- Investment costs. In addition to the equity you’re giving up, investors may charge for arrangement fees (up to 5% of the total raised). They may also levy legal and due diligence fees, with ongoing monitoring and non-executive director fees paid annually.
“Good investors are incredibly supportive throughout the venture development process, through the good times and the bad. It’s important to identify investors who are competent in your domain, have had experience in it before, and can understand your business. The road will be bumpy but when there's turbulence, a good investor will remain calm and look for solutions. Look for signals the investor is competent and a good investor – do due diligence on them as much as they do on you. Ask to speak to some founders they've backed, and specifically ask to speak to founders they've backed where things didn't go so well. If the company folded or the founder was sacked, this will give a good indication on how well they handle challenging situations, how principled they are, and how supportive the investor is.”
Academic entrepreneur
Documentation and completion
Once you have completed due diligence and your term sheet is in place, your investors will expect to move onto finalising the rest of the documents required for investment.
Your TTO will typically lead on negotiations with the investors and legal teams. It will create a body of documentation that sets out the rights and obligations of investors, the company and its management.
This will comprise:
- The due diligence pack: Finalised and approved just before investment
- IP license agreement: Signed after incorporation, but before investment
- Share subscription: When a shell company is formed with the academic founders as shareholders
- Articles of association: Adopted on completion of this process
- Subscription and shareholders agreement: Signed on completion of this process
- IP option (pipeline) agreement (if applicable): This can be created at any time
- Investment agreement: Signed when investors come in, replacing the original shareholders agreement
When the new investor becomes a shareholder, the existing shareholders’ agreement will need to be amended, or a new one put in place.
This will likely contain the following additional provisions:
Warranties
Essentially promises by the management team as to the accuracy of key statements and facts made to date.
Restrictive covenants
Investors may expect key individuals to commit full-time to the company. They may also impose non-compete clauses on the university and any employees who leave the company. Negotiations can become difficult if the investor attempts to restrict further academic activity using the IPR, as the university will want to continue research unhindered. You need to make sure that any investor realises this.
Reporting
Investors will require regular updates on progress, probably at a much more detailed level than you’re used to. It is important to consider the practicalities of producing the required level of information within the timescales expected by the investor.
Good and bad leaver
If you cease to be an employee or director of the company, you may be required to give up all (or a proportion) of your shares. Negotiations with the investor on what constitutes a ‘good leaver’ can be protracted. A bad leaver may well end up with next to nothing.
Negotiating terms
Warning – iceberg ahead! This stage may be difficult or run smoothly; it varies greatly, and is hard to predict. The negotiation of spinout and investment terms is one of the key stages at which you’ll begin to see and hear very different interpretations of what each stakeholder thinks, feels and considers to be fair. Talk to other people who have been through the process already. Your experience may end up completely different to theirs, but it would be useful to get some first-hand insight regardless.
“The accelerator experience was incredible, as I was amongst several others who were venturing out of their university or institute. It was helpful to share stories and feel part of a community that was supportive. It was also an eye-opener into other institutes, their terms and issues; it seemed like there were consistent issues across a lot of institutes. The training and mentorship at the accelerator came from entrepreneurs who had done it before, which gave very practical advice that supported the venture tremendously.”
Academic entrepreneur
Image: © This is Engineering
Our survey found that views vary wildly. With investors, the average expectation of university equity holding varied from 5% to 50% (with the stated expectation that this would drop), achieving an average of 23%. The TTO group expected upon founding to own an average of 35% equity, with the range varying from 20% to 60%. Interestingly, many investors stated (VCs in particular) that they would absolutely refuse to invest in any spinout with a university holding of more than 10%. Although this sounds obstructive at first, when you understand the numbers of companies you are competing against for investment, you begin to understand this is a luxury some investors have, given how choosey they can afford to be.
Our survey found that investors see a huge number of approaches each year but only support a very small minority. Some of the larger VCs are sifting through approaches from two or three thousand companies in an average calendar year, hundreds of which are spinouts. The number of investments these firms go onto make in spinouts varies; on average, they see a success rate of approach to investment of around 6.6%. This is significantly higher than the anecdotal 1% for investment trends in general, implying you will need to approach about 15 investors. However, complicating this is how investment rounds often involve more than one investor, thereby increasing the number you will need to approach.
The success rate of spinouts approaching investors
Average number of university spinout approaches received annually by investors in our survey = 70.2
Your university’s policies will likely dictate whether a spinout is initially formed between the founding team and university only, or if a spinout will only be allowed to be formed when investment is secured. Each case will impact the negotiation process, as it impacts on the number of parties engaged. It’s important for you to understand how their core opinions and stances contrast, as ultimately you will be required to negotiate with both.
Negotiating with your university
Many investors consider spinouts to be entities created and run by the founding team, and that universities deserve little to no stake as they are not adding future value. This may seem an attractive point of view as it means the founders take a higher stake, but it won’t go down well with the university. It also ignores an inescapable fact – you ultimately need something the university owns, be that access to IP, people, or facilities. This creates the need for negotiations.
Universities may refer you to internal policies on equity and suggest that such policies are non-negotiable. However, in practice this is rarely the case: you should assume that everything is negotiable and you can always walk away if it doesn’t work for you. Our survey shows negotiation is actually the norm, with 76% of respondents having negotiated their terms. Your aim here is to negotiate terms that work best for your longer-term ambition, whatever that may be. Do you just want the experience of running a spinout, to get the technology used, to make money or to raise investment? Different goals will require a different approach.
Proportion of academic entrepreneur survey respondents who accepted or negotiated terms of equity deal offered by their university:
“Large percentage shareholding claims by a university at the start reduces investor appetite.”
Academic entrepreneur, managing director at a spinout for over ten years
In response to “What principles should govern the distribution of returns/rewards including equity, licencing and royalties between universities and spinouts and the academic team at point of spinout” the top three themes in the TTO responses surrounded recognition of the university’s contribution (60%), fairness and consistency (56%), and equity to the individuals and founders involved in the future of the spinout (40%). Several aspects of the university contribution were discussed in responses: resources contributed to technology development and technology transfer, providing the environment for research and innovation to thrive, and covering IP costs. There was recognition that the extent of these different contributions varies substantially by institution, and the staff and resources they have available. In terms of fairness, this related to the university contributions, but also the desire to ensure fair returns for the public sector and other third parties such as funders and collaborating institutions. An undefined sense of fairness is the main theme for universities.
There were a smaller number of themes within the responses:
- Consideration of external management teams and future staff (16%)
- A majority stake for founding academics (12%)
- Consideration of returns to the tax payer or public sector (8%)
- That rewards should reflect risks taken (8%)
A single response emphasised the importance of having discussions around these issues early on in the spinout process. From the experience of our own programme, we would strongly advise you to have these discussions early on. You will not reach a conclusion in the early stages, but it’s essential to assess early if reaching alignment is possible, or if the terms on offer from the university and founding team are not conducive to success.
Shares in the new company can form part of the final agreement. So could licensing fees, the sale of IP to the company, a revenue share model or any combination of these. Your university should have an established policy that determines the starting point of a negotiation, and these vary significantly. Some are known to begin negotiations at 60/40 in favour of the university, others will begin negotiations at 20/80 in your favour, and many smaller institutions deal with negotiations on a case-by-case basis. See our Spotlight on Spinouts reports (2020 & 2021) for more on the policies of different universities. Any agreement between yourself and the TTO will need approval from a chain of individuals, ranging from the head of your department to the university’s executive board, and you should consult your TTO to understand the process and timelines.
Negotiating with investors
Investor responses around what principles should govern the distribution of returns and rewards such as equity, licencing and royalties focused on a minority stake for universities (mentioned by 50%), a fair stake for the universities (mentioned by 31%), and the chances of future spinout success (mentioned by 31%).
The implication with many of the investor responses talking about universities receiving minor stakes was that the respondents had previous experience or knowledge of the process. Answers reflected both positive and negative experiences with this part of the process in the UK, and saw respondents talking in theoretical statements on what universities ‘should’ do, and concerns around the implications for the future of a spinout. In some instances, this was explicit; “…my own experience is that universities often value their own IP 'too much', i.e. that it's 'oven-ready' for success and just needs a push. That's rarely the case in fact.”
The concept of ‘fairness’ to the investor respondents is linked strongly to the chances of a spinout being successful, and ensuring that key staff will be sufficiently motivated through equity distribution. Their views on what constitutes a fair stake for the university cluster around several different factors, such as the amount and kind of support being given by the TTO or whether the IP was being transferred to the spinout. There is recognition that the universities and TTOs can and do contribute to the process (especially in the early stages), but that this varies quite substantially by the university or the type of technology.
Conversations around proportions and fairness of university stakes shouldn’t be prioritised over thinking about the overall success of the spinout. Chances of future spinout success (31%), sufficient founder team equity (28%), and motivation of the founding team (22%) also featured among the responses. These are all closely related but subtly different themes.
Considering how often the following controversial points are raised anecdotally (of which the quotes below are representative), a surprisingly smaller number raised the themes of the importance of speed (13%) and simplicity of the processes and negotiations around licensing and equity agreements (13%). The same is true for the sentiment that rewards should reflect risk taken (13%), and that there should also be consideration around the management and commercial expertise being brought into the spinout, and how these individuals can be rewarded and motivated (9%).
“My experience with helping companies spinout from universities is that the process is too complex and bureaucratic. TTOs have historically placed too much effort on protecting universities, rather than enabling spinouts to succeed.”
Angel investor
“Assuming the business concept is viable and has potential, the biggest barrier is the university itself. In my local experience, unrealistic expectations in terms of equity are set, and internal processes are very bureaucratic and take a lot of time. This can discourage investors and entrepreneurs alike.”
Angel investor
“[Barriers include] risk appetite of the university. There are still about five layers of bureaucracy for approval, all who see spinouts as a high risk activity rather than a driver to impact. Secondly, seed investment for often very complex technologies is not a particularly well-served area for the UK outside the golden triangle. Of the last three spinouts I have supported, only one has received significant UK investment; the rest have all had to go to the States/Europe/China to find people with both the technical understanding and the risk appetite for the project.”
TTO employee
What will be negotiated
The previous two sections have given you an insight into what the investment and university community generally think, but what does their opinion mean for you? The three issues you will need to negotiate when spinning out are respective equity stakes, IPR and company valuation. These are intrinsically linked, and each stakeholder will make arguments summarised below on why their stance is ‘correct.’
Remember there is no objective ‘right and wrong’ answer for these issues; it's all a matter of opinion, and you are unlikely to change anyone’s opinion significantly. Understanding the opinions you will likely encounter may help the process run more smoothly, particularly if you find yourself as a go-between for the investor and university (which the entrepreneur often can be, at least in the initial stages of discussion). The key is to ascertain how much wiggle room or margin of error there is in each stance, and to find common ground.
The closest you can get to an objective answer about what constitutes ‘fair’ equity distribution is to look at what’s currently happening in other investment deals. Ask your TTO to see deals they have done recently, preferably in your sector, and approach other academic entrepreneurs for input. The investor may also be willing to share info, and much of this data is available online, here. The Academy’s latest Spotlight on Spinouts report with Beauhurst includes a wealth of data; the average stake taken by universities in the year of spinning out was 23.8%, and the average stake of all founders combined in the year of spinning out was 53.4%.
“The overarching principle should be to conclude an arrangement between the company and the university that does not fetter the chances of building a significant business, i.e. creating an uninvestable cap table at an early stage.”
VC investor
Always remember this is a business relationship that will last for years, so it’s worth taking the ‘principled negotiation’ approach, which teaches that the best outcome is one where everybody wins. Following ‘the customer is always right’ mantra, if the product doesn’t sell, there is something fundamentally wrong with it. Investors see many offers and can easily go elsewhere; the ultimate test of whether the deal you offer is any good is whether an investor takes you up on it. If the business idea is objectively great but no one is willing to invest on your terms, then something else is the problem – your communication, the team, or the terms you are offering.
It's easy at the point of failure to blame the university terms if a deal falls through, but remember you’re a team. You sink or swim together, and blaming university policy is not productive. Get feedback from the investor on what killed the deal, and see what changes can be made.
Founders vs university equity stake
A common sticking point is the relative equity stake of the founders and the university. For the founder, they are interrupting a potentially rewarding academic career to take on an even more precarious situation, but with the potential for a larger pay-off many years down the line. Swapping relative certainty (or at least a more well-known and defined career path) for high risk and long working hours, the potential pay-off has to be worth the risk to get them on board and keep them motivated through dilution rounds.
Aspects of academic culture and structures were the most frequently cited barriers among the responses from academics (29%). A range of issues emerged; precarious job security, lack of time and balancing workloads between spinout activities, teaching and research, through to the incentives for these other activities sometimes directly conflicting with one another. Core perceptions in the responses were that to spinout is a job in itself, in addition to a full-time role. It’s also a complete career change, going against the grain, and not something that is truly valued or promoted as an option to academics. Alongside time concerns, there was recognition that this isn’t really a situation where it’s easy to do both.
“For a full-time academic, you need to decide whether to jump to the spinout, perhaps a one-way career change. You need to be really sure, and that's hard for an established academic. I never did, so had to be content with handing over some control.”
Academic entrepreneur
These barriers relate directly to pressures and incentives from the wider research and innovation system; what are universities valued on in terms of what constitutes ‘success’? This trickles down, meaning the success of university spinouts and other entrepreneurial endeavours aren’t always valued the same way as other outputs in academic career progression. Comments we received included “patents not as valuable as papers” and “My promotions… were based purely in research income, papers, PhDs, teaching. Having 30 patents and helping bring in £15 million from a spinout counted for nothing.”
A lot at stake
For the investor, equity should be decided predominantly based upon continuing contributions rather than past contributions. A good team is essential to success, and the founder is the cornerstone of a good team. The founder needs a healthy stake to stay motivated, even after several investment rounds dilute them. Both the founder and investor are aligned in the founder having a high stake. One mistake to avoid that is commonly made by academic entrepreneurs is being overly-generous in allocating equity to colleagues who have contributed to the innovation in the past, and yet plan to commit minimal working time to the spinout in the future. The investor will view their contribution as having been largely rewarded in the past through salary and status, and so deserves less equity than those joining the team.
“Company founders need to have a very honest discussion on what's needed to make the company a success. In my opinion, anyone that is not greater than 0.8 FTE working for the company should not have a large equity stake.”
Academic entrepreneur
Not everyone can have a high stake, so investors often expect the university stake (and that of any peripheral staff) to be lower than their own. They see the university contribution as complete once the IPR exists and is transferred to spinout, so the university doesn’t need any motivation to act further. It’s often unflatteringly referred to as ‘dead equity’ (equity owned by people who will contribute little of value in future), and investors hate it.
From the university’s perspective, they have the law on their side as the IPR is legally theirs. They paid for it and their employees came up with the idea, so they expect a decent share of any potential profit resulting from it. Knowing they will be diluted by future investment rounds, and given the amount of time and funding they put into it, they want a decent share. Nobody would argue with this stance if the university was a company.
“The founders – and by founders, one means those who will operate the business on a full time basis – must have a meaningful percentage of the equity (+70% at the time of spin out). Otherwise, it is problematic for equity investors who will be coming later on and dilute the founders. Investors in general do not like ‘dead equity’ on the cap table and they tend to try and find ways to dilute it by introducing options pools for founders/operators. In my experience, the most common problem with spin out is ‘messy’ cap tables.”
VC investor
Both universities and investors have their reasons for wanting healthy equity, but they are not the only parties. You should do the maths at this point. If a spinout takes five years until sale, and three investment rounds reduce your stake by 25% each time, ask yourself if it’s worth your time to take a lower salary and work long hours for the potential rewards of an exit. Consider what your overall income would be in various scenarios, and how likely you think each scenario is to occur. Do the scenarios motivate you to carry on and accept the deal on offer, or do you pull out now before too much of your time is wasted? A lot of praise is heaped on those entrepreneurs that keep going in pursuit of their dream, but a lot more should go to those who realise early on it’s not going to work out, and that it will be better to pursue another opportunity.
Founders’ equity share can reduce with each investment round
“The university proportion should relate to the value of the founding IP (e.g. multiple patents based on seven-figure research vs three months’ coding by a PhD student), the resources invested by the university in technology development and technology transfer, the market expectations and if the company value is built by ongoing research or by entrepreneurial drive/endeavour... The founders should receive a majority stake, but with consideration for how complete the founding team actually is. In most cases, I would expect to leave a significant amount of equity on the table for recruitment of other managers/late founders. This can be as an option pool (10-20%) or shares in treasury. Finally, historic funders, particularly charities, might expect to have a similar shareholding to the university, so this needs to be factored into the cap table.”
TTO employee (runs a TTO)
From the Academy’s perspective, we do not accept applications to our programme where the university wants to take more than a 50% stake. That’s because we know the uphill battle they will face in seeking investment, and prefer to support those applicants with a better chance of success. This doesn’t mean we believe the university or investor view to be correct, it’s just being pragmatic as to what works for the types of spinouts we support – normally ones that require significant investment.
Assured profit now vs risky large profit later
Often referred to as ‘double dipping,’ sometimes a university will want an equity stake as well as one or more of the following:
- A royalty agreement
- A license agreement
- Milestone payments
- Patent costs
Each of these are technically different, but essentially they all do the same thing; they require the company to make payments to the university when a specific event occurs. These might be one-off payments or regular, time bound or cash-limited payments as per contract specifics. The university likes such arrangements because it lessens the potential impact of dilution in future rounds. Even if the university stake is diluted dramatically, they can be assured they’ll still get some income through the other payments.
“There should be some recognition of the inputs (grant funding, commercial support, IP costs, etc), but the emphasis should be on the future of the company and its ability to raise appropriate investment, offer appropriate incentives to founders and future employees. Therefore, the equity share and royalties should reflect that.”
TTO employee
Investors strongly dislike such systems. One-off payments take money out of the company which could be used to aid growth and so increase its value for everyone. Investors argue that regular payments such as royalty arrangements are a ‘tax’ on profits, and subsequent investors will use this to argue for a lower value of the company, reducing the profit for the original investors and founders. The answer is to try and find a balance between the two; the higher the payments expected, the lower the university’s equity stake should be. On patent costs specifically, remember a patent costs about £15,000, and universities hold many. It’s understandable they may want to recoup some of the costs incurred.
Overall, the investor wants a simple deal, and everyone benefiting in the same way so all parties are aligned and risk is reduced. The university wants multiple routes to income, minimising the risk that they don’t see much of the future profit. Getting agreement here can be tough, but all parties want the same thing – a successful company that value can be derived from. Don’t let any disagreements distract from that shared goal.
“If the IP is being transferred to the spinout in exchange for equity in the company, then there should not be a second material reward to the university by way of royalties/licensing.”
VC investor
Assignment vs license
The investor and entrepreneur typically want the IP rights assigned to the company. If ownership is transferred to the company, there are no potential conflicts in future and no ability for the university to withdraw access. This increases the value of the company. For the university, remember that research is likely their primary or secondary goal (the other being teaching), and the university has many other researchers working on the same or related areas. They may want to build upon the research, so will want unhindered access that only comes with outright ownership. Transferring it to the company may not be an option to them.
A key factor here is how a successful company will typically move on from the initial research, superseding it with their own. Consider what the company truly needs to establish itself. Will an exclusive license suffice, and satisfy both sides? The university wants the company to succeed too, and to increase in value, so how do you structure a license agreement to best enable that?
“There should be a standardised and simple template for licensing and equity agreements across all universities for spinouts. The university should have no more than 1-5% in ordinary shares, should charge no more than 1% royalty on net sales, and the IP/patents should always be assigned into the company before an exit / acquisition.”
VC investor
“Fees and royalties should be modest and weighted to later stages and success. Few or no fees before the company is cash positive. IP assignment fees are acceptable because there is a significant risk for future opportunity to gain from IP that is no longer owned if the company should fail.”
TTO employee
Normal shares, preference shares and golden shares
Preference shares are a special type of share that come first in the queue upon a sale. There are variations, but in effect, the owner gets their money back first on sale. Any money remaining is then distributed in accordance with the equity distribution in the normal way. If the company did poorly, the investor may get their funds back entirely but everyone else gets little to none. If it does well, the investor gets everything back, and then receives their share of the increase.
Once one investor gets preference shares, subsequent investors will want them too, reducing the likelihood of ordinary shareholders seeing any profit at all. Investors like them as it minimises risk in that they can get a return even if the company performance is lacklustre. Conversely, entrepreneurs and universities dislike them because it reduces and potentially wipes out any profit they can make.
“All too often, venture-based investors will create share structures that seem reasonable and equitable. However, if the business runs into challenges and/or at future investment rounds, the value of the former can be wiped out entirely at the expense of the latter. As someone once said to me ‘you can end up swimming with alligators when you take investment from some of these people’; i.e. the investment share structure can often be heavily biased towards the investor in a manner not immediately obvious to a logical and scientifically trained founder.”
Academic entrepreneur
Share and share alike
A counterpoint to preference shares is to use anti-dilution clauses, or golden shares. A university might stipulate their stake is 10%, and this will not be diluted by any rounds up until a valuation of £3 million. After this point, these golden shares would become ordinary shares and so are dilutable. Universities like this because it satisfies investors about being a low stake, but it also reduces the risk of significant dilution without corresponding growth in value. Investors and entrepreneurs dislike it because their stake will initially be diluted faster as any dilution is applied to them alone. However, the cap until golden shares apply tends to be quite low by the standards of company valuations, so it may have little impact on a fast-growing company.
Many argue for just having normal shares so that everyone is always in the same boat, with their interests aligned. However, as a first-time entrepreneur, you may struggle to get agreement for this, and these methods can be usefully deployed where an impasse is reached.
“Academic and university stakes should have equal rights. Particularly, universities should not insist on non-dilution policies which make it very challenging for a start-up to raise funding.”
Academic entrepreneur
“Never agree to take funding with an anti-dilution clause attached to it, no matter how attractive this might seem.”
Academic entrepreneur
Company valuation
At this stage, you will begin to discuss the value, or more specifically the pre-money valuation of your company. You will be seeking to extract as much money from investors for the smallest percentage of equity you can; conversely, the investor will be aiming for a shareholding that matches their risk appetite and return on investment goals.
When entering negotiations, you should seek to establish comparables. The best source of these will be valuations of businesses like your own who have also taken on investment. This information may be difficult to find, but Companies House records are a good first point of call, as are press releases and databases such as Beauhurst. You are looking to find sizes of funding rounds, seeing how cap tables develop.
It’s important to understand that the driving force behind your investors will probably not be the same as yours. Any investor needs to be confident they will be able to make their target return, which could be as high as 10-20 times their investment over the coming five to ten years. The investor needs to be confident that the determined valuation will facilitate this sort of a return.
The pre-money valuation of an early-stage company is generally difficult to determine, but the more novel and innovative it is, the more difficult this will become. There is no generally accepted methodology for determining a company’s value, but there are a few key questions an investor is likely to ask:
Have you spunout before, and if so, was this ultimately successful?
How strong is your IP, and are there barriers to entry in place to stop competitors?
Are you generating any revenue?
What is the track record of your management team? Have they managed similar businesses or had relevant experience before – if so, were they a success?
Are any existing investors following on in this next round?
What contracts/deals with customers and other companies are presently in place, and what are the details of these?
If you’re equipped to navigate these questions when they come with a well thought-out plan, you stand a better chance of improving the valuation of your business and thus minimising your dilution. At the same time, it’s important to be realistic and well informed when negotiating, and not lose track of the additional value potential investors can add to the business.
“The very best investors add industry and market insight, and under those circumstances, the university is happy to be completely hands off while seeing the value go up despite dilution.”
TTO employee
Key takeaways
This chapter shows that there are significant points of contention that can arise throughout the negotiation process. Getting all parties to meet early will be helpful, but if you can’t get them in the same room, you should at least be aiming to get them to express their needs to you before looking to move towards a common footing. You need to understand what you, your founding team and each other stakeholder wants to achieve to move forward as a collective. It’s not just about you getting on well with the TTO or investor – you must also be the linchpin that binds all parties.
There are a number of significant takeaways you should take from this section, but we would suggest you focus on the following:
- There is no right answer to the equity split discussion. However, assess early what you will accept for yourself and determine whether or not that is achievable.
- Will the core team be motivated by the offer and is each of the proposed shareholders really committed to making a future contribution that’s commensurate with the equity that they will receive? Consider this early, including what role each member will play in the long term, and what each needs to motivate them.
- It helps if both sides have experience in such negotiations and can take a pragmatic approach. Ultimately you all want the same thing (a successful spinout), so keep the focus on that.
- Rightly or wrongly, the lower the university’s stake, the higher proportion of investors that will be interested. Try to confirm the university’s standard policy and processes early, so you can focus your time on approaching suitable investors.
- Understand what support your TTO is offering to continue to provide, gathering feedback on how effective that support has been elsewhere by talking to previous spinouts. This evidence may support the TTO’s or the investor’s position, and you should be open to each.
- Gather evidence on previous spinout deals. Understand how your proposal is similar or dissimilar to them, and how that factors into the TTO’s desire for fairness and consistency.
- Try to recognise what will happen next with your founding technology, and to what extent you will you continue to need it in years to come.
Stage 3 checklist
This list is indicative only and should be adapted both to your needs and the university’s process.
1) Incorporate a company:
✔ Company name
✔ Articles of association
✔ Create a basic website and dedicated social media profiles
✔ Obtain a dedicated phone number and email address
✔ Build company email accounts and order business cards for yourself and other founders\
✔ Buy software packages required for business operations
2) Secure office and / or lab space
3) Open a business account and register for VAT
4) Select which forms of finance you will look to raise:
✔ Seek grants and/or investors, aiming to gain interest from competitive parties
5) Speak to as many sources, financing bodies and individuals as you can
6) Prepare your executive summary
7) Prepare your pitch deck
8) Determine which investors you will look to approach:
✔ Develop due diligence pack
✔ If VCs or angels are being approached, develop and rehearse a pitch
✔ Negotiate your term sheet and valuation
✔ Finalise the terms and ensure all investors are happy with the performed due diligence and due diligence pack. This should include:
– Business plan – Patents, status and warranties on their viability, including information on any licenses to this IP that have been granted or are in negotiation – Board minutes, and any special resolutions passed – Financial accounts – Details of current shareholdings – Existing contracts/relationships with external parties (if any)\
✔ Finalise investment documentation and secure money transfer
Resources
Freedom to operate
Validate business plan
Approach investors
Spin-out Companies, A Researcher’s Guide
A Founder’s Guide to Spinouts (p.78)
University of Edinburgh Spinout Support Guide
Seed investors: the good, the bad and the ugly, from a founder who’s been there
Due diligence
Negotiating terms
University negotiation
UK University Technology Transfer: behind the headlines
Managing intellectual property and technology transfer
IP Pragmatics: Best practice in equity stakes for University spinouts
Section on why the university takes a share
Step four: Term sheet negotiation and valuation
Determining the university ownership in a spinout
Section on negotiation
Download
You can download a PDF version of the Handbook here.
Contact
If you have any comments on the Handbook or some resources to submit for consideration please get in touch with us at enterprise@raeng.org.uk