Easy Introduction to Economy

There are several problems with the protection of IP in spinouts. The first is the uncertainty that surrounds the question of ownership of IP when university research is carried out in collaboration with a third party. Simply put, who owns the IP, the university or the third party? In the end the decision could rely on the nature of the written collaboration agreement and whether the collaborator is considered to be an agent of the university or not.

This uncertainty over ownership makes negotiations between spinouts and potential investors longer and more expensive than otherwise would be the case, and sometimes prevents investment deals from being completed (and longer-term exit plans coming to fruition).

Probably more worrying for those who set up spinouts is the question of whether they are able to patent their research. This comes down to two separate issues, namely is there any unique property for which a patent will be granted, and has the company itself done anything to prevent it from applying for a patent?

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A prime example for the failure of excellent science to translate into a successful business enterprise, and one that attracted a great deal of attention, is that of the company that cloned Dolly the sheep. The research to enable the cloning to take place was undertaken by academics at the Roslin Institute near Edinburgh. The ground-breaking techniques were taken up by PPL Therapeutics Limited, resulting in Dolly being cloned in 1996. This gave rise to much comment and debate on the ethics of such activities. However, the company appeared set for a bright future, but it was not to be. By 2002 it began selling off its assets and in 2004 the patent rights to the techniques used to clone animals were sold to USA-based Exeter Life Sciences for the relatively modest sum of £760000. Subsequently, the company has struggled to stave off bankruptcy.

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From all these comments it is clear that all is not right with this aspect of spinouts. Lack of management expertise is probably the major impediment to their growth and exit value. It is constructive, therefore to pose the following questions: Should academic researchers be involved in managing the commercialisation of their work? If so, for how long, at what level and on what basis? Is the answer to distance the academics from the strategic and financial management of the company at a fairly early stage and introduce outside professional managers? Does the introduction of professional management improve the success rate of spinouts, both with regard to trading performance and exit?

The failure rate for all start-ups is high: they are by nature speculative ventures. Failures in spinouts, unfortunately for their reputation, often receive a great deal of publicity, because they often appear to offer such promise.

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Once a spinout has moved past its start-up phase and has secured Business Angel or VC funding, it becomes a collaborative venture between the university and the business world. Does this collaboration work in terms of successful management of the enterprise?

The Lambert Report makes the following comments about university management: ‘Companies and universities are not natural partners: their cultures and their missions are different.’ ‘(Academics) … lack understanding of the rigours of the market place.’ ‘Business is critical of what it sees as the slow moving, bureaucratic and risk-averse style of university management.’

Tom Hockaday, Chairman of the University Companies Association, echoed this sentiment when he said: Universities still need to invest more in the type of people who have the skills to work at the interface between academia and business.’

A prominent venture capitalist has, somewhat less tactfully, recently stated: ‘Some academics believe that there is something disreputable in soiling the purity of science by turning it into a money-making enterprise.’ And, addressing both management and IP valuation issues: ‘You have to deal with all those academics who do not have a realistic idea of the value of their company or its IP, and then you have to get in proper managers because those academics aren’t managers.’

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Where a business is set up with outside investors, or where outsiders, such as venture capitalists (VCs), invest in a business in its early stages of growth, it is usual for the investors to insist on entering into a shareholders’ agreement with the founder owners. A good example of this is ‘spin out’ companies, where scientists and inventors at universities, or in industry create businesses to exploit their technological or scientific inventions or discoveries.

As the investors hold most of the cards and many founder/owners have little commercial experience, the shareholders’ agreements negotiations are usually somewhat one-sided. So, what can founders of fledgling companies do to protect themselves when they are in a comparatively weak bargaining position?

In short, I believe that you should be prepared by securing expert advice and familiarising yourself with the content of standard agreements, if possible. In this way, you should be able to secure more favourable terms, particularly with regard to minority protection, including the ‘piggyback’ provisions.

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Restraint of trade provisions directly influence exit planning, as their purpose is to protect business value and, hence, exit value. They aim to restrict competition from co-owners and working directors who leave the business. The provisions should be specific in terms of the time period and geographic area and are usually restricted to the same type of business or industry as the subject business. It is a basic rule of English law that all restraints of trade are void unless they can be justified as being reasonable. Another fundamental principal of the law is that you cannot prevent someone from earning a living. A restraint must, therefore, afford the party who has sought it no more than adequate protection for the interest he is entitled to protect. In practice it is harder to try to prevent an employee from working for a competitor than preventing an owner or director from using the information gathered whilst in your business to compete against you, or to entice away your customers or employees. Where restraint of trade could be vital, is in the area of professional partnership competition. Without such an agreement, the value of goodwill for the whole practice could be in doubt and, therefore, so could the value of individual partners’ equity. This could be particularly damaging to newer partners because they do not have the direct personal contact with a large number of the firm’s clients and, therefore, no way of protecting their own goodwill (by keeping clients) should the practice dissolve and cease to trade.

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General provisions

This part of the agreement does not deal with the sale or transfer of interests: rather it seeks to regulate the way a business is run. It only impacts on exit planning to the extent that anything that detracts from the smooth running of the business and, consequently, its profitability is to be avoided, so I will deal with it only briefly. These general provisions cover such things as:

Initial capital and working capital contributions.

Directors’ responsibilities and spending limits.

Requirement for board approvals.

Investment and dividend policy.

Retirement policy.

Treatment of ‘key persons’ and funding for their loss.

Course of action in case of disagreement between co-owners on major matters, including agreement to wind up and method of winding up. This part of the agreement could also address circumstances that could cause disruption to the business and to the exit strategy planning process. Examples of these are:

Professional negligence by co-owners.

Liabilities as a result of co-owner being a director or officer of another company.

Infidelity of officers and employees.

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Critical illness of an owner

Once again, insurance is the obvious funding mechanism for this circumstance, although high premium costs could be a limiting factor. Most insurance companies link death and critical illness in one policy and the beneficiaries could be either the co-owners or, in the case of a company, the company itself. The policy will be taken out in accordance with a cross-option agreement, mentioned above.

Early retirement

Where there is early retirement not brought on by ill health or injury or death, insurance does not usually provide remaining co-owners with cover, so it is generally difficult to fund for this eventuality. Also, it is not usually in the interests of the business to encourage early retirement amongst co-owners and, for this reason, shareholders’ agreements often state that early retirees will not receive full market value for their interests on retirement.

Normal retirement (i.e. at a stipulated retirement age)

Pension or savings plans can be employed if there is sufficient time available before retirement age and adequate forward planning has taken place. Otherwise, arrangements similar to early retirement (but, perhaps, with a payout more favourable to the retiree) can be entered into. Again this is a matter of policy for the co-owners to decide having received competent advice.

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An important part of all shareholders’ agreements is a funding mechanism through which remaining owners are able to pay for the options that arise. If this is not put in place, the right to acquire interests could be difficult for remaining owners to take up and could even lead to the forced sale of the business, or of its key assets. The funding requirement should be based on a realistic and professional valuation of each co-owner’s interest in the business, with a facility to vary the funding in future if the business valuation changes.

We will now look at some ways of ensuring that funds are available in the various circumstances that trigger the options to buy a departing owner’s interests.

a) Death of an owner

The obvious funding mechanism here is life insurance and there are two basic ways in which policies can be set up:

The co-owners can insure each other (that is, they are each the beneficiaries of the others’ policies).

In the case of a company, the owners can be insured by the company, which will buy back and cancel the deceased owner’s shares.

Other funding methods could be savings plans, pension funds or sinking funds. The problem with this approach is that it is difficult to plan with any precision, as there is no knowing when a death will occur.

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The key question here is whether the agreed value of a departing owner’s interests should be the same in all circumstances of departure. To take an extreme example, should the agreed values be the same for when a working co-owner dies after 30 years’ faithful service as for when he decides to sell out early and leave the business to join your major competitor?

As another example, remaining owners could agree, on the death of a coowner, to pay full market value (including goodwill value) for the deceased owner’s interests for moral reasons and because the funds are available through an insurance policy. But, the remaining owners could have quite a different attitude towards an owner who leaves early to take up a position with a competitor. In this case, an agreed value that reflects net tangible asset value only (or, indeed, par value only) might be considered more appropriate.

So that the agreement does not become too long-winded with many different formulas or valuation methods, it is probably a good idea to agree on one main method (such as a P/E ratio method) for some of the ‘acceptable’ contingencies; and to have one other, much less generous, method (for example, net tangible asset value, or even par value) for those circumstances that the business wishes to discourage (such as leaving early). This is sometimes known as the ‘good leaver/bad leaver’ approach to valuation.

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