Easing Contractual Burdens on University Start-ups

The vast majority of start-ups with roots in a university are formed by alumni or former students, similar to the process that was depicted in the movie The Social Network. The Zuck had it easy. Since Zuckerberg was a Harvard undergraduate student, not an employee, the university could not lay claim to an ownership stake in Facebook. Had Harvard owned a patent for a core component of Facebook’s technology or business method, the plot of The Social Network may have been different. Imagine the following:

• Zuckerberg works for Harvard
• Zuckerberg uses a Harvard computer, network, and proprietary photos of students from Harvard’s various residence halls
• Zuckerbergs files his invention, as required by his employment contract, with Harvard’s technology commercialization office
• Harvard files for a patent which costs Harvard $30,000 and lots of staff time and overhead
• Zuckerberg decides he *must* launch Facebook commercially, and he and his co-founders approach Harvard’s patent office to see what their options are

Obviously, the movie followed a different course. However, what happens when a would-be entrepreneur wants to build a start-up, but must first license the patent from a university? This article is about a special type of start-up: one that enters into a formal patent licensing agreement with a university. Getting federally-funded, cutting-edge university inventions to market via a start-up sounds like a great idea. It is. The challenges arise if universities inadvertently burden fledgling companies with well-intended, but weighty contractual obligations that may handicap the start-up later, as it tries to find investors, hire staff, and form product-development partnerships with other companies.

Universities do not intentionally set out to handicap their start-ups. University technology transfer staff do their utmost to help start-up founders get through the process. Most universities take their economic development role seriously, and work hard to license university-owned inventions to new businesses on fair terms. In fact, some would say that universities are generous. They believe in their start-ups, despite statistical evidence that the vast majority of start-ups never reach profitability, never find investors, go public or get acquired. Universities offer elaborate workshops, advisory services, even invest from a university-owned seed fund. Then what’s the problem?

A root cause of the problem is that start-ups have no money, and somebody’s gotta pay for the cost of a patent, which these days, can cost up to $40,000 for U.S. protection, and much more for international. In fact, before the 1990s, most universities preferred not to license university inventions to start-up companies since they knew they would likely never recover patent costs, receive license fees or earn lucrative product royalties later down the road. Starting in the 1990s, however, universities started taking partial ownership in exchange for waiving the start-up’s license fees, and delaying its payback schedule for patent costs by a year or two. Today, about 75% of U.S. research universities are willing to take equity.

A second problem is that universities weren’t designed to form new companies. Investing in, and building strong start-ups is a grueling, more-than-full-time, highly paid specialty. In addition, universities must honor their non-profit status (avoid conflicts of interest) and be responsible for making sure that publicly funded inventions don’t get into the wrong hands. Politics can come into play. A university that’s too generous in letting start-ups license university-owned patents for cheap will be in big trouble if they end up licensing to a Google, and everybody will ask why the university didn’t grab a big chunk of equity early on, when it held all the cards.

Another challenge is that universities and start-ups make for strange bedfellows, a bit like a March-December marriage. One side gets someone who’s established and owns lots of nice things; the other side gets someone frisky and with a lot of growth potential. So far, so good. However, unlike a March-December marriage where March’s youth and beauty make for strong market value, there’s a pronounced power imbalance between the cash-strapped start-up and the geriatric rich guy (or gal). The start-up needs the university-owned invention more than the university needs the start-up. As a result, a university’s contractual requirements for a start-up are more likely to protect the universities interests, and provide the start-up what the university thinks the start-up needs, not what the start-up’s founders think they need.

One way to look at this situation is to ask whether university start-up strategies are placing ballast into start-ups (good weight), or unintentionally inserting dead weight (bad weight). Ballast is defined as “a heavy substance, placed in such a way, to provide stability and control (as in a hot air balloon or submarine) and then if necessary, quickly discarded.” Ballast is laid into place with a lot of careful testing for optimal placement. More critically, ballast is quickly and efficiently shed when the vehicle or object needs to quickly rise or move forward.

Here is a *very* brief list of some university start-up practices that could be either ballast or dead weight, depending on whom you ask. It’s important to note here that not all universities follow these practices, and many have a policy of bowing out of these requirements if a start-up receives a large chunk of funding.

Practice 1: Requiring that the university be given a chunk of equity ownership in a start-up as part of the license deal

Ballast (good weight): Patents are expensive and if the start-up can’t pay, the university will front the costs in exchange for partial ownership. Some believe that if universities own equity, they will treat the start-up better and be more invested in its success. For big-name universities, if a university is a shareholder, that brings legitimacy and cachet to the start-up.

Dead weight (bad weight): On average, U.S. universities require 10 – 15% equity, despite the fact that start-ups need every scrap of equity they can get. Further down the road, potential investors shy away from start-ups where a large chunk of equity (more than 10%) is held by an entity with no “skin in the game” such as a departed founder or a university. Also, the more a university takes, the smaller the remaining pie for future employees. Universities are not VCs and though many try to make money from spinning off start-ups, it could be considered a conflict of interest for a university to stake claim to large chunks of equity as a requirement of getting access to a university patent. Oddly, university policies on conflict-of-interest for faculty holding equity are elaborate, but I’ve never seen a conflict-of-interest policy for equity ownership for a university administrator.

Practice 2: The university’s chunk of equity enjoys anti-dilution protection

Ballast (good weight): Unscrupulous future investors can issue huge numbers of new shares in a company and shrink (or dilute) everybody else’s slice of the pie. If such unscrupulous behavior occurs, universities need to protect themselves from ending up with an unfairly small fraction of what they put into a start-up.

Dead weight (bad weight): Anti-dilution protection and liquidation provisions are typically reserved for the big investors. In addition, future investors can be put off if previous investors have the option to maintain the same proportion of start-up shares as the value of the start-up grows and everybody else’s percentage shrinks. Many believe that the university should not be in the business of making money from federally-funded research at all. If a start-up pays back its patent costs, shouldn’t its obligation be fulfilled? If universities are to be stewards, not profiteers, perhaps they should not enjoy special, VC-style anti-dilution or liquidation provisions.

Practice 3: University officials taking a seat on the start-up’s Board of Directors

Ballast (good weight): The thinking behind this one is that if a university is entrusting a new company with precious university resources, then somebody from the university needs to keep an eye on things and have a say in start-up activity.

Dead weight (bad weight): Unless the founder directly invites the university person, it’s not clear what their value is, and in fact, having a university staff member take a Board seat seems a strong conflict of interest, particularly if that start-up gets preferable treatment and sweetheart deals. Most Boards of Directors are between three and five carefully selected people. Board seats accompany big investments and Board members are carefully chosen by founders and investors to make sure everyone’s vision is represented. Board members are a critical source of industry expertise and networking. Unless the university person gracefully exits the Board upon request, their presence may be a barrier to later putting together a high-performing, expert Board.

Practice 4: Imposing university “reach thru” rights onto additional products that do not directly involve the university’s patent

Ballast (good weight): Some universities feel that if a patent for a research platform or a particular method results in profitable downstream products (even indirectly), a start-up should also pay the university royalties on these resulting products.

Dead weight (bad weight): Critics of reach thru clauses believe that universities cripple a young company by imposing far-reaching claims to future products. Consider how nebulous this can get if a university tries to lay claim to products invented and made by the start-up, but that have an indirect, technological relationship to a broad, university-owned patent. Investors do not like to see royalty obligations attached to future products. Reach thru clauses again call into question the university’s ultimate motivation: making money or getting federally-funded university inventions into play.

The list goes on. For example, universities require detailed progress reports on a regular basis. They impose steep sub-licensing fees and milestone schedules, and other mandates that limit the fledging startup’s business flexibility. While these requirements were originally intended as protective ballast, at some point, they risk crossing the line into burdensome dead weight.

Conclusion

Everybody that’s got a stake in spinning out companies from federally-funded university research is groping for the answer. Like most of the issues around university innovation strategy, there are no good guys and no bad guys. Some universities are experimenting with simpler measures, such as transparent express start-up licenses, or offering start-ups an informal “option” period, in which a start-up can test the commercial waters at no cost. On at least one campus I know of, university inventors are actively organizing to push administrators to reconsider policies that had a purpose early on, but have evolved into unrecognizable thickets that entangle the honest and dishonest alike.

Don’t miss an article (2,500+) – Subscribe to our RSS feed and join our Innovation Excellence group!

Melba Kurman writes and speaks about innovative tech transfer from university research labs to the commercial marketplace. Melba is the president of Triple Helix Innovation, a consulting firm dedicated to improving innovation partnerships between companies and universities.