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By Simon Goldman (edited by E.L) https://www.uclb.com/our-people/simon-goldman/
Academic spinout companies: looking at the incentive structure for inventors and investors
Why is it that everyone wants a spinout company?
I had a Twitter conversation which revealed that it depends on your incentive structure – and that this differs for academics (and from academic to academic!) and venture investors. It also leads me to believe that there are some situations in which a spinout structure is more relevant than in others.
Many of the academics I meet are chomping at the bit to start a company to support their project’s development. At the same time, many investors will only get involved if they can put a company (that is, an equity structure) around some innovative intellectual property (IP).
I’ve often wondered what drives this desire on both sides, and also whether a spinout really is the most appropriate vehicle for commercialisation of university research. Often it may well be – but academics and investors can work more constructively together when they understand each other’s motivation for choosing the startup-company route to commercialisation in particular.
The academic’s perspective
Many academics are keen for their work to make real-world impact – and in my life-science corner of the innovation landscape (which I’ll focus on here) that means improving health outcomes. But the cost of getting a drug to market, for example, is far beyond the normal kinds of funding available to the average university-based researcher. A spinout can therefore be attractive as a vehicle for raising other forms of external financial support. Also there’s the added bonus that it gives the founder a way of ‘owning a stake’ in the future development of their technology.
Given a number of high-profile spinouts from higher education institutions, it’s also no wonder that so many academics want to pursue their own. It also seems fair that inventors should share in the potentially significant rewards of successful commercialisation (and after all, venture funds and pharma companies are in the business of supporting such projects because they’re profitable!). Who wouldn’t want to be in a position never to have to apply for a grant again?
Quite how that return is achieved – and whether a spinout is appropriate – is my main focus here. And that’s where looking into an investor’s head can help.
The investor’s perspective
Most early stage venture investors quite rightly see a spinout company as a useful vehicle for a number of reasons:
- defining/sharing ownership of some protectable IP;
- attracting and incentivising founders and a management team; and
- raising future rounds of funding on the way to achieving an exit commensurate with the risk of supporting early stage ventures based on academic IP.
Above all, investors are seeking the most capital-efficient route to an exit. This is the reason for ‘tranched’ funding, either within a committed investment round (sequential work packages) or in progressing/de-risking a project to its next ‘value inflection point’ at which further funding can be raised or an exit made.
For me, the key question is: at what point in a project’s development does an investor believe it appropriate to set up a company structure? The responses to my question over the weekend can be roughly categorised into two groups. The first includes all the usual things you’d expect as general reasons for investing: significant potential market/unmet need, backable founding team, a protectable idea that has strong competitive differentiation, etc. However, the second group of responses revealed a bit more about investors’ incentive structures that drive them to favour a startup company format.
Remember there is some cost and effort in setting up a spinout company, even a virtual one, but especially one that aims to recruit a management team/invest in infrastructure. So it raises the bar a bit. But different investors are willing to set a company up at different points on the risk/return curve of product development, and where this point lies for any given investor depends on a few factors:
- Stage of investment: there are many different views out there on what constitutes the ‘proof of concept’ that will motivate an investor to set up a company around an idea. While some investors want to see an optimised lead small molecule, or evidence in an animal model that a therapeutic really works (if you believe animal models); others are willing to set a company up much, much earlier.
- Portfolio considerations: most biotech projects aren’t going to make it to market, so investors will rationally diversify. A bigger fund will have better capacity to do this, and so would likely set up company structures earlier because the cost/risk is a smaller proportion of their overall exposure. Smaller funds might be more circumspect and require more validation to ‘press the green button’.
- Asset versus platform approach: some investors view the company structure as most appropriate when the technology has the potential to deliver multiple products or address multiple markets – the cost of setting up a company and investing in a management team/infrastructure requires and is justified by the pipeline of opportunities. Other investors are avowed single-asset players, and will set up a company around just one technology with one application. Such setups will invariably be run in a very lean way (see above point on capital efficiency!)
- Access to proprietary IP: University-associated funds probably have more scope to provide pre-seed ‘proof of concept’ funding in the form of loans repayable only on success, or ‘project finance’ directly to an academic lab where the returns are divided in the form of a revenue share (similar to the approach taken by many research charity funders). Such funds can very efficiently carry a project through to the point of gaining confidence that a company structure is worthwhile, or at least to attain a better out-licensing package than would otherwise be achievable. This might also be attractive to some academics – and is becoming more common in the UK in recent years.
- Valuation: this is always a sticky point, and probably best left to another blog another time. Suffice to say, academics often have high expectations, and investors low. Having a frank conversation about this early on is a good way to build trust. Further, a project finance approach to progress a project before company formation might both help de-risk it and help both sides understand each other’s expectations.
A final note: one of the great things about the UK venture sector is the wide variation in models and approaches to investing, some focused to a greater or lesser extent on the spinout company format. I’m not going to profess to be able to predict which model is best – the variety is to be celebrated and encouraged. The more the merrier.
Do you want to discuss your options for spinning out? Contact Eleonora Luagra' (e.lugara@ucl.ac.uk) or one of UCLB business managers (Derek, Paolo or Weng)
