Universities are taking too much equity in tech spin-outs and hurting their chances of commercial success, a government report into the commercialisation of AI has said.
The current norm for British university Tech Transfer Offices (TTOs) is to take up to 50% equity in tech spin-outs which energe from academic research. But this is in sharp contrast to universities in the US, which often take as little as 5-10% equity in tech spin-outs.
“Universities are the locus of AI R&D in the UK, and spinouts present the most direct route by which that R&D can be commercialised. However, the value presented by university R&D may not be fully realised owing to large equity shares being retained by the parent university,” said the ‘Understanding UK AI R&D commercialisation and the role of standards’ report, published last week.
“Prospective founders want to be able to grow a business, whereas TTOs are typically structured to be, at least partially, compensated through the equity share to enable the office to stay financially viable,” added the report.
“These objectives can create tension as founders do not want to give up a significant amount of their company early on, in part because this could make them less attractive to private investors and could present challenges for later rounds of fundraising in the UK and beyond.”
‘We struggled to get a bank account’
Rob Oldfield, CEO and co-founder of Salsa Sound, agreed with this. Salsa Sound is a tech spin-out from University of Salford, founded in 2017; it won the Outstanding Audio Innovation award at the 2021 Sports TV Awards, and was used by several large American TV networks to create simulated crowd noise for games played without an audience during Covid lockdowns.
Salford offered the spin-out considerable support in, and paid for, obtaining patents and handling its IP – and provided Oldfield flexibility in being able to work for the university and Salsa Sound at the same time. But it also asked for a considerable chunk of equity.
Oldfield, who was interviewed for the report, told The Stack the university initially asked for a 50% stake in the company, but finally agreed on a “more than 30%” share. He said this has had significant implications for Salsa Sound – even for basic commercial activities.
“We struggled to get a bank account. Because when you are owned more than 25%, you’re not actually considered an SME, ridiculously. At the moment, the only bank account we could get is a commercial bank account. So we actually have a same banker as massive corporations; we bank with the same people that the university does,” said Oldfield.
Salsa Sound has also found it harder to access some funding and programmes, which are often conditional on start-ups having less than 25% ownership by a third party – although Oldfield noted programmes such as Innovate UK make exceptions for stakes held by universities. But he described it as “irritating” and said he’d be “a lot happier” if Salford had taken a 24% stake.
“The biggest effect that’s had on us is basically our appetite for going after investment. And we sat down early doors, and we’re thinking, well, if we’ve already down 30% each, we don’t really want to go after getting investment that would dilute us further and we’ll end up with hardly any stake in this business,” said Oldfield.
As a result, the founders decided to boot-strap the company, a decision which Oldfield said he was “still semi-happy with”.
“But it without doubt means that we can’t grow as quickly and probably can’t grow as much. And I think if the university had been a little bit more giving at the time that we negotiated the equity, then I think that would have given our business more legs – we would have had a bit more freedom to go, do you know what ,we can afford to drop another 10%. Let’s get a few hundred thousand pounds in and really smash this.”
Oxford sets 20% max equity stake
Approaches to equity stakes by TTOs are changing, notably at Oxford, which recently said it would take a maximum stake of 20%, and sometimes only 10%, in tech spin-outs. But depending on their business plans, TTOs may struggle to adapt to lower equity shares, according to the report.
“Should universities move towards a model with lower equity share demands, there is a potential financial sustainability risk if TTOs do not make up for lost equity with a more than proportional increase in total spin-outs,” it cautioned.
“Whilst the examples of the US showcase that universities can thrive financially from lower equity demands and a higher number of spinouts (and follow-on endowment investments from alumni), the right incentives must be in place to ensure that maximising the number of spinouts in a given window of time is a key aim of universities.”
Paul Patras, co-founder and CEO of Net AI, takes a different view of the profit motive from university TTOs: “[Most universities have] charitable status, right? So making an argument that you really want to maximise revenue out of research doesn’t really fare well with the principles of a charity.”
Net AI is a 2020 tech spin-out from University of Edinburgh, which uses AI to automate the optimisation of mobile networks. Last year the company raised £750,000 in pre-seed funding from Techstart Ventures, Nauta Capital, Creator Fund, Edinburgh Technology fund – and Old College Capital (OCC).
OCC is University of Edinburgh’s investment vehicle, and Patras said dealing with OCC was very different to the university’s TTO and its approach to tech spin-outs.
“Their mindset was completely different than that of people who negotiate the initial phase… OCC really looked like proper investors, and at times they were, to some extent, feeling that probably they’re not fully aligned with colleagues that manage the licencing,” Patras told The Stack.
Net AI’s equity situation was somewhat different, as the IP behind the company had several inventors, and the university could only lay claim to Patras’ portion. But he said the spin-out negotiation was still long and drawn-out, although, with University of Edinburgh taking just 10%, Patras acknowledged “we got a really good deal”.
“We shouldn’t have gone through the whole lengthy negotiation process for something which was to me now in hindsight, obvious. Because now if I was in the shoes of a private investor, I would never invest in a company where the majority of the shares are in the hands of an inactive player, who has no incentive and no skills to turn this into a successful business,” he said.
Perhaps unsurprisingly, VC investors agree. Last year Nathan Benaich, general partner at Air Street Capital and an author of the State of AI report, called out European universities for “short-termism” in dealing with spin-outs, and accused them of treating founders as “problem children”.
“Parting with too much equity from day one is a structural and motivational problem. Spinout founders become minority shareholders of their own businesses. This leaves them unable to attract the necessary talent and funding in a globally competitive market,” said Benaich.
Oldfield also pointed out spin-out founders are often in a vulnerable position, making the transition from academia to the less-familiar world of business – and at the wrong end of the power dynamic.
“I did need the university in order to kickstart it. So I had absolutely no bargaining power – they know that I’m not going to pull out. So we’re negotiating in good faith, supposedly, but I was in a much weaker position, and also had no experience in a negotiation ever.”
Patras has seen the opposite experience, where prospective founders walk away from a tech spin-out deal when they see the university’s demands.
“It’s a big commitment, you’re parking an academic career, and maybe you’ve been successful at that. Trying to explore a new opportunity, and when you realise that you don’t have the right support, and this is not really kind of rewarding enough, you’ll say, well, actually, why should I do this?” he said.
What are the solutions?
The Understanding AI report makes two main suggestions to improve the tech spin-out process: create direct government incentives, and subsidy of commercial alumni ecosystems.
“The UK government could opt to provide universities with a new Key Performance Indicator (KPI) which encourages spinout formation, committing TTOs to achieving a certain number of spinouts created in a given timeframe,” said the report on the first suggestion.
Benaich offered a more radical proposal, along the lines of American TTOs: “A globally competitive standardised deal offering TTOs a choice of either 1-5 per cent common equity, 1 per cent royalty on net sales, or 1 per cent of the exit value upon M&A or IPO.”
But his two other suggestions – incentivising universities to boost numbers of tech spin-outs, and alumni ecosystems – are in line with last week’s UK government report.
“Governments must nudge universities into creating cohesive and supportive alumni ecosystems — a US-style alma mater — that feed future investment in the institutions through mentorship and donations. In the longer term, we should create sovereign wealth funds to help strengthen underfunded academic institutions and reduce their dependence on monetising spinouts,” said Benaich.
Oldfield points out universities don’t only benefit financially from spin-outs. Salsa Sound’s success during Covid translated to a big impact on Salford’s Research Excellence Framework (REF) assessment – the crucial measure of success for universities.
“And so regardless of how much equity they got in our business, they’ve not monetised any of that so far. But they have monetised the fact that they are involved in a spin-out company at all, even if they had 2% of our company, they would still have benefited from that,” he said.
For his part, Patras is clear that TTOs need to focus on long-term value in tech spin-outs, rather than short-term equity: “It’s much better to have 5% of a company that becomes the size of Yahoo, then have 50% of the company that exits in one year for £5 million.”