Entrepreneurs building companies from research, whether from universities or commercial research organizations, often face the decision between a spin-out or a start-up. Start-ups are typically wholly owned by their founders until equity and profits are traded for services, employees, and funding. Spin-outs, on the other hand, have a parent organization (usually a university or higher educational institution) that holds a shareholder stake in the new company. This arrangement arises because the parent institution owns some of the intellectual property (IP) that the spin-out uses.
A spin-out must manage the process of licensing and transferring IP from the parent organization to the new company. These negotiations are often one-sided and can significantly impact the spin-out's structure and long-term viability. Parents and spin-outs aren’t entirely misaligned; after all, a smaller stake in a successful business can be worth more than a larger stake in a failed business burdened with high royalties and low equity. However, the balance between what constitutes an equitable and sustainable arrangement can vary greatly depending on which side you’re on.
This relationship has been the subject of much controversy in the UK, particularly following high-profile cases like Oxford Nanopore, which unsuccessfully sued to avoid paying 50% royalties to Oxford University. In response, the UK government released an independent report on spin-outs, recommending that universities reduce their equity stake to 20%. Further reports have called for lower stakes in sector-specific cases. While many tech transfer offices in universities may have negative views on these developments, this shift is a win for founders, who now have the potential for better terms and more robust organizations.
Nonetheless, founders should understand both the national and global context of spin-outs as they enter negotiations with the parent organization. It's also important to recognize several factors to consider in these discussions, some of which are often overlooked in the focus on equity.
Are You a Spin-Out?
The first question for researchers at a higher education institution (HEI) is whether the proposed company will be a spin-out. This is an important question to address early—ideally before contacting the HEI’s tech transfer office, as they are unlikely to highlight technicalities that might make a spin-out unnecessary.
Start by reviewing the IP agreement between the researcher and the university, particularly regarding different university members (students vs. staff). Payment often leads to stringent enforcement of IP rights, as seen in the case of Oxford Nanopore, where the founder worked briefly as a research assistant. Additionally, it’s essential to consider tech transfer agreements between the HEI and funding bodies. These agreements often include stipulations regarding IP, which may be more favourable to the founder if the funding body is more flexible or if the founder has options for licensing IP through different organisations.
In some cases, seeking external advice from VCs (who typically have access to experienced lawyers) or incubators/start-up organizations can be beneficial.
The Terms
The terms of such agreements vary greatly across universities and countries but typically focus on two main components: equity and royalties based on net sales or profit.
- Equity: There are two primary types of equity—dilutable and non-dilutable. Dilutable equity decreases with each new funding round, as existing shareholders’ stakes are reduced to accommodate new investors. Non-dilutable equity remains at a fixed percentage. While non-dilutable equity is rare in venture capital, it’s more common in the early stages of spin-outs, particularly for HEIs.
In the US, universities typically take a smaller initial equity stake (~5%) but don’t allow it to be diluted. Some universities, like Stanford, have reduced their stake to as low as 1-5% to avoid complaints from VCs, who don’t want universities holding large shares in the cap table. In tougher VC climates, this trend is becoming more common to increase the chances of securing funding.
In the UK, universities historically demanded as much as 50% equity in spin-outs. While this has decreased in recent years, some institutions, like the University of Edinburgh, still ask for equal ownership. However, there are positive shifts in the industry. For instance, TenU, a collaboration between universities and leading UK VCs, has released the University Spin-Out Investment Terms (USIT) Guide, which recommends a stake of 10-25%. Some universities are beginning to align with this, with Oxford University lowering its standard equity stake to 20%, and Imperial College going even further, lowering its stake to 10% for software-based companies.
Imperial’s approach reflects the fact that capital-intensive companies may warrant a higher equity stake, but for less expensive industries like software, a lower equity stake is more appropriate.
- Royalties: While royalties can help founders retain more equity, they can become a burden on the business, particularly if they’re tied to all sales within the company—not just those derived from the licensed product. For mature companies, royalties can become a significant issue, especially as competitors emerge, reducing margins.
A great overview of how to deal with royalties is available from 50 Years, an incubator, which discusses how to cap the scope and scale of royalties.
Operational Considerations
In addition to equity and royalties, founders need to negotiate the operational aspects of the spin-out agreement. Giving tech transfer offices too much control over a company's operations—such as hiring practices or financial decisions—can create bureaucratic delays that hinder the company at a time when agility is essential. Including provisions in the contract that allow for a "turnaround window" after which automatic approval is granted is one recommendation. Failing to address operational issues during the negotiation phase can be just as detrimental to the company as a smaller equity stake.
Final Thoughts
Negotiating a spin-out agreement involves much more than just securing a fair equity split or royalty rate. While these factors determine the long-term financial success for the founder, operational elements—such as IP restrictions, governance structures, and decision-making rights—are equally important. A poorly structured agreement can burden the company with excessive bureaucracy, restrictive licensing terms, and limitations on future growth.
Founders should adopt a holistic approach, ensuring that the agreement supports not only the HEI’s interests but also the company’s ability to innovate, secure funding, and remain competitive. By staying informed about the evolving landscape of university spin-out policies, seeking external advice, and advocating for terms that foster long-term sustainability, founders can increase their chances of building a thriving, successful business.
