Shares, Stakes and Shibboleths — Sustaining Spinout Ecosystems
I have a periodic conversation with one of my friendly local-neighbourhood venture capitalists. It’s usually prefaced politely: “why, when you’re 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 prove to be that problematic in terms of equity allocation.
But this shibboleth seems to persist as a common 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’s been picked-up in government sponsored reviews, it’s appeared as a Sunday Times campaign, and it’s been adopted as as the ‘go-to’ tip for entrepreneurial advisors 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, moreover… look at the way they do this in the US… it’s much more founder friendly — is the argument.
In my view this shibboleth is exactly that: an old belief repetitively cited but untrue. It may make you sound ‘founder friendly’ or investment savvy without investigation — but it doesn’t help founders or the development of an entrepreneurial ecosystem around universities. So here’s my view on the matter.
Let’s start with some basic principles that I think we should all be able to agree on:
Principle 1: Anything that impedes the flow of 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 Schumpeter and 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’s have more!
Principle 2: Skin in the Game is the most effective risk management tool Anything that un-balances incentives for those building the business should be avoided. Lack of incentive will stunt growth, too much to those players that are 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 eco-system 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’s 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 — That Technology Transfer Offices (TTOs) don’t understand the operation of the market. I shouldn’t have to deal with this one — but I do have to deal with this one. The most basic misunderstanding to address is the simple confusion that some of the less sophisticated commentators make, is to assume that university TTOs don’t 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 at xx% 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 is 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 lots of deals! And even if they happen coterminously the market will still determine the % of the equity sold.
But I often hear ‘helpful’ advisors to academic founders mixing up founder splits with dilution. I’ve even heard prominent Government advisors 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 that 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 but, 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 don’t understand the role of incentives: “Okay” — so the argument will twist — “but we need to incentivise the founders…” The more sophisticated commentator/begruderer will tack onto a different track: ‘“Ah yes, but, we need to make sure that the sufficient equity is given to the founders to make sure that 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 to squeeze the University share (as a co-founder). This is sometimes heard from investors or VCs that are used to dealing with non-university startups. There’s a couple of problems with this.
Firstly, of course 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: that is to conflate the academic inventors with the ‘founders’. They can be the same person, but preferably are not. By comparison to industry, inventor reward schemes adopted by nearly every UK university are generous — crucially they favour inventorship, as opposed to entrepreneurship. This favouring of inventorship over entrepreneurship is partly historic, it’s partly due to an under-appreciation of the value of the business model and leadership in turning an invention into an innovation or a venture. So, if an academic invents something they generally are in for at least half the return — irrespective of whether they helped convert their invention into economic return or not. That’s fine — they aren’t paid as well as most in industry, and we want to incentivise innovation (Principle 2). But this favouring of inventorship over entrepreneurship does undervalue the hard-yards in turning inventions into innovations that have real market value. This is what Nassim Taleb 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 things: equity and incentive for the external entrepreneur — who needs to have some ‘skin on the game’. And a great deal of effort mainly on the TTOs behalf to find these entrepreneurs. In most instances in the UK it’s the TTO that has to create or tap into an ecosystem to find these unfortunately rare beasts. It’s then for the TTO to broker the deal with the academic founders.
In order to be able to give ‘skin in the game’ for this external there has to be some ‘dilution’ via the grant of starter equity or some option pool created to attract and incentivise them. I’m personally in favour of making this generous if they succeed. This is the missing piece of the pie that some commentators forget about when talking about 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 of 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 on can impede this crucial process.
Secondly, the TTO not only has to work hard to find these entrepreneurs, it often has to engage them on fee basis too in order to get them going before a VC will even look at it. 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 that the proto-venture is in a position to startup. This is very much connected to the issue of place and context — in Northern Ireland this is harder than in San Diego or the South East of England.
Thirdly, 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 that there is a fair outcome. At Queen’s we have a policy that deals 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 will be 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 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 in the UK. But it does not apply to 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 3 proto-CEOs prior to the first seed round as each was lost either by internal team fall out 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 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 entrepreneur community, with executives being involved in a number of spinouts and even cross-investing (which may justify a separate blog post).
So it refreshing that after years of unfavourable comparison with the US that leaders from the US TTO networks have pointed out this very important fact: Dr Katharine Ku and Dr Lita Nelsen of Stanford and MIT advised the McMillan Review that “A direct comparison with terms given by MIT and Stanford is therefore simply not appropriate.” And McMillan 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 spin-outs once formed. Faculty and students involve themselves as private matters in entrepreneurship, working with the eco-system around them. This approach is reflected in the terms upon which Stanford and MIT licence their IP. They licence on an arm’s-length basis to companies that can best take forward technologies, irrespective of faculty or student involvement in these companies”.
Well that approach probably won’t work for what’s needed in the UK or parts of the island of Ireland where the entrepreneurial eco-system is not yet that developed. I can categorically confirm that most of those that we have spun-out would have not made it on their own.
But 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 it’s not just effort and ecosystems development required — its seed funding. Qubis has participated in around 11 syndications for university spinouts over the last two years. No other equity funder came close to that level of activity here.
This is most likely because level of risk at pre-Seed is generally an order of magnitude greater than most VCs would stand — even when they are using publicly provided cash (and rarely do TTO have direct access to that public cash to support investments). Hence the only way to make this activity viable for the TTO/University is to partly de-risk the investments via gaining some equity in return for university IP. This if you like is the crucial balancing figure in the whole of the equation. Otherwise no TTO could take this risk — as no VC would — if they cannot even the odds a wee bit by not always having to (solely) buy equity in its own spinouts.
Myth 4 — the state shouldn’t/can’t play a role in enterprise. This is a broader myth upon which 3 is based. Yet the need to de-risk early technology and the market fairly in this space as well understood as the valley of death. As Mazzacato has argued, the state can also be as an economic player and investor, as much as a provider of grants. And most evidence suggests that in fact public money ‘crowds-in’ private investment. Of course more needs to be done with public procurement etc, 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.
But this raises a matter of principle — not fully addressed in 3 above: why shouldn’t the quasi state bodies like TTOs and universities 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: a process where we have the staff to help spinouts, to recruit entrepreneurs and 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 short sighted, in that it favours the current deal over the health of the system that produced it, but it often, even worse, 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 into the founding team. I’ve seen it kill spinouts. Put simply, if the TTO and the University is 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 get spent on teaching a few kids instead of founder lifestyles, so be it!
Myth 5 — Let them have the IP for free and they will donate back to the University. So the next line that might been taken is: “so okay we get this is risky and that the University needs some share of the upside, but that’s 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 for free of 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’ will simply complicate negotiations.
Personally I think we are missing a trick here: if Alumni Development offices and TTO 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 anyway near a fraction of the resources that universities generate from equity and license deals — and which they recycle back into the system. This is just wishful thinking at the moment. We could experiment, but let’s 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 hard part — creating ventures and supporting it is (see above). The ‘Golden’ (ie undiluted) bit is the problem. Were we to say take 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 on by external investors. There is a good risk that 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 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 sought to benefit from them, and thus encourage inventors to ask for the same).
Even if it worked — and the 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? Well we also have some data for this: A Southern English university have inverted their 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 are run programmes such as Lean Launchpad and iCure have positively impacted their capability to create new ventures.
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 because it doubles the legals — shareholder and licence deal — but because it means we have arrived at a valuation and at a royalty rate for a proposition that is too early 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 to lead the charge into the valley of death and undertake this high risk activity without aid then we can all relax.