Negotiating a spin-out as a PhD founder

The above table should trigger a key question:

• Do I actually need to make my professor a co-founder, given this is what often makes a company a spinout? They can often be an “adviser” instead. In some cases the professor will undisputedly be a founder, but in others they are not that involved / their name is being added to give a company gravitas. That is a mistake.

Other common mistakes that can make a company a “spinout” unnecessarily:

• Using university money or lawyers in return for filing a patent
• Taking a grant from the university that has the catch of making you a spinout
• Using a piece of university patented IP that you don’t actually need, but that makes you a spinout

Before going down the spinout route, it is always preferable to see if you can make a small change that means you are not triggering university spin out rules in the first place. The two key places to check this are:

• University Intellectual Property Policy: Governs when a university treats a startup as a spinout (unless it is in a country like Sweden where the Government sets a national policy)
• PhD Funding Agreement: The funder of your PhD will stipulate who owns the intellectual property that you generate. Typically that’s the PhD themselves, but sometimes it is allocated to the funder or the university.

Components of a University Spinout Deal

If you are a spinout, you enter a negotiation with the university’s Tech Transfer Office (”TTO”) and this focuses on a number of terms that are important to understand:

(1) Equity: How much equity is the university taking upfront (without paying for it). As a rule of thumb, we believe that it should be 5% or less and any number above 10% leaves an unattractive cap table that makes it hard to raise more capital in the future.

• Does this equity dilute immediately? Sometimes a university will set a threshold for the amount of money you need to raise before their equity gets diluted. For example, the term might be that the university gets 10% and only starts diluting once the company has raised €2,000,000. This means that until you have crossed the threshold of £2mm of outside funds raised, the university will stay at 10% (and therefore the founders will be diluted ever more by new investors).

The challenge of university equity is that VCs will often see this as “dead equity”. Future investors want to see that equity is in the hands of the individuals who will be building the company: it is an incentive for future contribution. The university equity is rewarding past contribution.

(2) Royalty Payments: This is a % fee on future sales received by the business. The university becomes entitled to a portion of money earned. It is important to see how this is defined:

• Revenue or Profit Is it charged on revenue/net sales or is charged on profit? You would prefer royalties on profit, as this is not eating into your gross margin. It is going to be a smaller amount, and you are only paying the university when you are profitable yourself. If it is charged on revenue, you could in theory have a 5% margin on your products, owe 10% royalties to the university, and therefore this royalty pushes you to being unprofitable.
• Is it on all sales?: Does the university receive a % of all sales made by the company? Or does it only receive a % of sales that specifically involve the IP they have licensed. You could be a materials company that has 5 products, and university IP has been licensed for 1 of these products. Do you pay royalties on all 5, or just 1? Alternatively, the university IP might be in a platform technology that has partially resulted in the creation of 3 materials, and directly resulted in 2 materials. Does the % the university takes change depending on the size of its contribution?
• If you restrict royalties only to products that directly use university IP, and not all sales, there is the opaque question of: how do you define this? And how do you decide the contribution of the university IP to a specific product. It is important to negotiate clarity on this upfront.

(3) Milestone Payments: This is less common, but is sometimes asked for by German and USA universities. This is an additional payment when the company achieves X milestone. This X is often revenue based: you will pay €500k when you reach €5million in lifetime sales. On occasion a university will ask for non-revenue-based milestones, for example asking for a payment when you achieve FDA regulatory approval. Non-revenue-based milestones payments are dangerous, because you have no guarantee you will have the requisite cash to pay the sum. This may even be the case with revenue-based milestones if the Cost of Goods Sold exceed the milestone payment that is triggered.

In some universities, they ask for a milestone payment on exit. When you sell the company they expect a preferential payment. This is dangerous as it makes your company less attractive to fund, if the university will always receive cash before investors at exit.

(4) Smaller Costs: There are smaller costs that need to be negotiated, but these are far less significant than royalties and milestone payments. For example, the university might ask to be compensated for the upfront patent costs or patent maintenance costs they have incurred.

(5) Exclusivity: This governs whether other people can use the intellectual property as well. VCs want to see that the IP gives you defensibility (the whole point of IP) and so sharing IP with others is an issue. You want to push back hard on split IP, where the university can license it to someone else in another industry. The gold standard is for the IP to be:

• Exclusive in perpetuity and for all use cases
• Potentially with a carve out for the university to continue to use the IP in non-commercial academic projects only

Our Recommendation:

We think the most important number to get right is the equity percentage. This is also what VCs will focus on. It depends on the industry you operate in. If you are a software-based business, there should be little-to-no IP from the university and therefore you should almost always be 0% university equity. If you are a hardware/BioTech business based on university patented IP it may be harder to escape “spinout” definition. In general if you are unavoidably a spinout (see advice above), then we think:

• 5% and below: Good outcome for everyone
• 5% – 7%: Not ideal, but often a compromise landing zone in negotiations
• 7% – 10%: Sub-optimal outcome which results in a worse cap table for future fundraising.
• 10%+: The university is taking too much equity, you should question whether the founders are sufficiently incentivised, and you will find fundraising hard. It may disqualify you from raising from top VC funds that prioritise founder-run businesses.

These are the ideal conditions to negotiate: