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How do spin-outs of startups from within universities or large companies to independent entities usually work? What sort of compensation does the university etc. receive?
Hello! Thanks for your question, "How do spin-outs of startups from within universities or large companies to independent entities usually work? What sort of compensation does the university etc. receive?"
The short version is that spin-off companies from universities or corporate industry, usually work in an independent manner, having its own separate legal status, employees, management team, and board of directors. In a spin-off, the university is compensated by a royalty, or licensing fee, or an equity stake typically 5% to 10% of the spin-off.
Below you will find a deep dive of my findings.
METHODOLOGY
A comprehensive search was undertaken which yielded several secondary sources ranging from government website, university websites, industry websites, journal websites, research websites, case study websites, news websites and blog posts. These sources were analyzed with respect to researching best practices and standards, for transferring a startup from a university or large corporation to an independent company. Research and case studies regarding how universities have handled this practice was researched. Information regarding the appropriate amount of equity that typically changes hands, was also looked into.
The collected data was analyzed and formulated in suitable paragraphs for easy understanding. This research begins with the paragraph 'Introduction" and ends with the paragraph "Conclusion", which concludes this study.
INTRODUCTION
"A spin-off is a new company formed from an existing one." It creates innovations, impacts managerial compensation and has socio-cultural consequences. The social value of the innovation is created by job creation, and the economic value is created by commercialization of the innovation. A spin-off is one of the three forms of corporate divestiture, with the other two being a sale to a private buyer, and an equity carve-out. Sale and carve-out both include cash changing hands, while in a spin-off, no money is exchanged.
Several spin-offs have come from universities. University spin-offs generally exploit patented/copyright protected innovations. A VentureRadar 2015 blog post lists the top 10 university spinoffs.
Spin-offs are more common in commercial enterprises, "with around 50 occurring in the US alone each year", and they often outperform their parent enterprises. An EY analysis found that spin-offs "outperform the [Standard & Poor's] 500 index by 19 percent over the two years post-close." For example, Chipotle is a spin-off company of McDonald's, and the spin-off "by many accounts, was hugely successful for Chipotle, but only marginally so for McDonald's."
"But just because it might make sense to spin something off doesn’t mean it’ll be easy." Starting a spin-off may mean sharing resources, having a stake in rewards and risks, constant communication, and sharing of improvements between the parent company and the spin-off.
BEST PRACTICES AND STANDARDS FOR TRANSFERRING A SPIN-OFF FROM A UNIVERSITY
A TIM Review 2014 article, critically examines the "what, why, and how" of university spin-offs. From three models of university spin-offs, it generalizes that a university spin-off:
- has an academic institution or a university as its parent organization
- has a separate legal status. It is not controlled by the university and is not an extension of the university
- exploits knowledge resulting from academic pursuits
- aims at commercialization of generated knowledge and technology with a view towards profit generation
A spin-off starts with research, which may be self-funded, university-funded, government-funded, foundation-funded, industry-funded, or private entity-funded. When this research produces a new technology, then the licensing, protection, and retention of the intellectual property rights of the new technology is considered. With corporate/public/state funded research, the application for patents depends upon the terms and conditions, as outlined in their respective agreements.
Research may also be taken up jointly between a startup and an academic institution. In case of joint research collaboration, intellectual property (IP) rights are relevant as they include trade secrets, know-how, and patents. Prior to the collaboration, a background IP is made; during the collaboration, a foreground IP is made and for non-project activities a sideground IP is made; after the collaboration and within a specified time, a postground IP is made. The IP ownership, license (exclusive or non-exclusive; for private use or commercial use), duration, sub-licensing, maintenance of the patents, indemnification, infringement, non-compete clauses, grant of license or ownership and other conditions, are clearly spelt out in the legal agreements between the concerned parties.
"It is essential to understand the nature of funding because that would be the deciding factor in whether a certain invention can lead to spin-off creation." The licensee of the new technology is determined according to the different policies of the university and the funding capacity of the licensee. The capability of creating a commercially viable technology spin-off is important in deciding a licensee. The technology transfer office of the university may offer established companies, to license the new technology, or the researcher may create a new company as a spin-off firm. Generally, established companies become the licensees, since they can better recognize the commercial viability of the new technology. Sometimes, newly formed companies also become the licensees.
CASE STUDY : SPIN-OFFS FROM SWINBURNE UNIVERSITY OF TECHNOLOGY
The research undertaken at Swinburne University of Technology, Melbourne, has given birth to several spin-off companies. For example, in 2004, it developed a technology for anesthesia monitoring and created a spin-off named Cortical Dynamics. A technology for emotional intelligence created a spin-off named Genos. In order to repair blades of turbine engines, a laser surfacing technology was developed that created a spin-off named Hardwear. Other spin-offs include Logometrix, MiniFAB, Purple Panda, Sportsbet21, VROOM, Youthworx Productions, and many more.
CASE STUDY : HELIOCAMPUS FROM UNIVERSITY OF MARYLAND UNIVERSITY COLLEGE
University of Maryland University College (UMUC) created a spin-off named HelioCampus in 2012. HelioCampus analyzed big data of the university and continued "to support UMUC’s operations while marketing its expertise to other colleges and universities in a fee-for-service model. Profits would benefit UMUC, helping to further reduce tuition for graduates of Maryland community colleges."
CASE STUDY : NUTONOMY FROM MASSACHUSETTS INSTITUTE OF TECHNOLOGY
nuTonomy, a Massachusetts Institute of Technology (MIT) spin-off, is "the start-up tackling the most difficult challenge in self-driving cars: urban driving."
Generally, when a spin-off is created, the inventor and the university are both compensated. The inventor is compensated by continued involvement in the process of technology commercialization, and with an equity offer, since "equity is a more effective tool to ensure inventor involvement." The university is compensated by a royalty or licensing fee, and "in many cases an equity stake, typically 5% to 10% of the new company." Nevertheless, in the case of MIT and nuTonomy, no evidence was found to establish that MIT had received either equity or cash as compensation.
According to Crunchbase, in January 2016, nuTonomy raised $3.6M as Seed funding from three investors namely, Samsung Ventures, Signal Ventures, and Fontinalis Partners. Thereafter, in May 2016, it raised $16M in Series A funding from four investors namely, Highland Capital Partners, Fontinalis Partners, Samsung Ventures, and Signal Ventures. According to a Driverless Transportation 2016 article, the Singapore government is also an investor. In the above data, MIT is not mentioned as an investor, either in the Seed funding or in the Series A funding round.
According to the United States Securities and Exchange Commission (SEC) Form D, nuTonomy offered equity for first sale on 2016-05-19, where the total offering amount was $23,351,732 USD, the total amount sold was $20,177,697 USD, and the total remaining to be sold was $3,174,035 USD. This offering was not offered to any outside investor, and a total of 9 investors had invested in this offering.
If MIT had received equity as compensation, then it may be guessed that MIT may be one of the 9 investors. However, the names of the 9 investors is not mentioned in the SEC Form D. Thus, there is no evidence to prove that MIT had received any equity as compensation. Similarly, no evidence was found to verify that MIT had received any cash as compensation. It appears that the agreements made between MIT and nuTonomy are confidential and not available publicly.
TRANSACTION STRUCTURE BETWEEN A PARENT COMPANY AND A SPIN-OFF COMPANY
According to a Macabacus 2017 article, the parent company creates a spin-off by issuing shares of the spin-off to its existing shareholders. The spin-off has its own separate legal status, management team, and board of directors. The distribution of the shares is on a pro-rata basis, meaning that each shareholder of the parent company receives shares of the spin-off company proportionate to his/her holding. No cash is exchanged and the shareholders of the parent company also become the shareholders of the new spin-off company.
The transaction structure between a parent company and a spin-off company may be executed via any of the four models as follows:
- "Regular spin-off." In this model, the distribution of shares of the spin-off company is 100% to all the shareholders of the parent company.
- "Majority spin-off." In this model, the parent company retains a small percentage of shares (less than 20%) of the spin-off company. The majority balance of the spin-off stock is distributed among the shareholders.
- "Equity carve out (IPO)/ spin-off." In this model, a small percentage (less than 20%) of equities having voting rights in the spin-off is carved out. This is followed by an equity carve out either externally by an initial public offering (IPO), or internally among the investors of the spin-off.
- "Reverse Morris Trust." In this model, a buyer wants to buy certain assets of the parent company. The parent company spins off the assets to the tax-free spin-off company. The stocks of the spin-off company are then distributed, but immediately the buyer acquires the stocks of the spin-off company in a tax-free reorganization. Due to this, the buyer holds a minority stake (less than 50%) in the combined parent and spin-off company.
MONETIZING THE SPIN-OFF CREATION
Corporate spin-offs may be "viewed as acknowledgements of failures, bowing to pressure from investors and competitors. In reality, spin-offs can be used very proactively." Spin-offs can be effectively monetized to improve both the parent company and itself.
The spin-off enjoys a tax-free status due to Dividends Received Deduction (DRD) taxation rule. Hence, the parent company levers up the spin-off and siphons the cash as tax-free special dividend. It may also push its own debt to the spin-off company. The spin-off may then declare bankruptcy, and the debt of the parent company is written off. Other techniques include debt-for-equity swaps, debt-for-debt, and exchanges.
Historically, spin-offs are characterized by high bankruptcy rate and high acquisition. "While the elevated acquisition rate is unsurprising, we suspect the high frequency of bankruptcy reflects parent companies’ frequent decision, to load a spin-off with elevated debt levels and/or liabilities." To avoid fraudulent bankruptcies, the spin-off is legally bound to be sufficiently funded during its creation. Additionally, limits are placed on the special dividend and debts. Any amount in excess of the limits is duly taxed.
A Korean bankruptcy court "realized that the spin-off is a very useful tool for reorganizing firms and rescuing them from financial distress." A company could turnaround from insolvency by applying spin-offs. Besides sheer luck, the success of spin-offs depends on three categories of factors, as follows:
- exogenous factors. Here, the business has little or no control. Factors include the growth of the market; the profitability as affected by the intensity of its competitors; and the fragmentation of the market.
- legacy factors. Here, the business can slowly escape from its impact. Factors include starvation of the spin-off by the parent company; and neglect by the parent company.
- current factors. Here, the business has full control. Factors include the operational decisions and strategy of the spin-off; and follow-on investments by the capital available.
It should be noted that a spin-off is not an exploitation of a tax loophole or an accounting trick; rather it is a strategic decision, to provide the best operating environments, for both the parent company and the spin-off. "The right planning, approach and focus on value are the key ingredients to success."
APPENDIX
Watchtell, Lipton, Rosen & Katz, a leading law firm of New York, have prepared a 2015 Spin-Off guide. This is a detailed guide and it outlines all the facets of a spin-off along with its legal requirements. This is attached here as an Appendix signifying additional related helpful material.
CONCLUSION
To wrap it up, it may be concluded that spin-off companies from universities or corporate industry, usually work as independent companies, and they often outperform their parent organizations. Innovators are compensated by involvement in the commercialization process of the innovation and also by an equity offer. Universities are compensated generally by a royalty, or a licensing fee, or an equity stake, which is typically 5% to 10% of the spin-off.
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