Are Standard Equity Stakes in Spinoffs Misguided?
Most academic institutions take equity in lieu of cash when they license their technologies to startup companies. The university pays the patent costs and, in return, gets a stake in the company. To avoid negotiating the amount of equity separately for each deal, most universities offer a standard “take-it-or-leave-it” price of between 5 percent and 10 percent of the company in return for the university IP. This approach is misguided.
To understand why, you have to know something about university spinoff companies – businesses that are started to exploit inventions made by faculty, staff, or students of a university. Most academic institutions require university inventors to assign the rights to their inventions to the university. The inventor or anyone else who wants to use the technology to start a company has to license it from the institution.
Most of these inventions are protected by patents, which aren’t cheap. Therefore, universities typically offer to take an equity stake in cash-starved startups in place of the cash payments they would demand from more established companies seeking to license their inventions (e.g., filing fees, upfront execution fees, patent prosecution costs, and minimum royalty payments).
Most universities do not negotiate this share of equity with the new startups, but rather present the founders with a “take it or leave it” offer. For example, one university with which I am familiar asks for 5 percent of the company in return for its intellectual property “package.”
Universities prefer not to negotiate the share of equity because they don’t want to bargain with their startups. That is politically difficult and focuses attention on how little most of the spinoffs are worth at the beginning. Moreover, university administrators generally believe that establishing the value of early-stage companies, which have few assets other than the patent license, is difficult. To avoid spending time on difficult negotiations, many universities simply set standard terms.
While universities’ arguments have merit, they ignore what happens when you set a common price for things that vary in value. When the university asks for a share of equity in place of cash for its intellectual property, it is implicitly valuing its spinoff companies. By asking for the same share of equity for all of its startups, a university is implicitly valuing all of its spinoff companies the same.
The problem is that some of the spinoffs are worth more than the others. Some are exploiting stronger patents with broader claims, targeting bigger markets that are easier to reach, with technologies that are cheaper to build, and are run by people with more entrepreneurial talent. This variation creates a problem when the companies are similarly valued. The spinoffs with weaker patents that are targeting smaller and more difficult-to-reach markets with more expensive-to-build technology led by founders with less entrepreneurial talent will find the standard price appealing. The university values them at more than they are worth.
By contrast, the spinoffs with stronger patents that are targeting larger and easier-to-reach markets with cheaper-to-build technology led by founders with more entrepreneurial talent will view the standard price as unappealing. The university values them at less than they are worth.
The weaker, overvalued, spinoffs have an incentive to swap their equity for the university’s intellectual licensing package, while the stronger, undervalued, companies have an incentive to turn down the equity deal and pay cash to license the university’s intellectual property. As a result, by offering a standard equity deal to spinoff companies, universities could end up investing in their weakest spinoffs and miss out on owning a share of the strongest ones.
Scott Shane is the A. Malachi Mixon III professor of entrepreneurial studies at Case Western Reserve University. His books include Illusions of Entrepreneurship: The Costly Myths That Entrepreneurs, Investors, and Policy Makers Live by (Yale University Press, 2008) and Finding Fertile Ground: Identifying Extraordinary Opportunities for New Businesses (Pearson Prentice Hall, 2005).