University Equity Structures in Start-ups

When universities license their technologies to start-ups they often take equity in those start-ups, typically in the form of common stock.  The reason why universities take equity can range from the philosophical – “the work was done in our labs” – to arbitrage by forgoing an upfront licensing fee in exchange for equity in a start-up (saves the start-up $). 

Because universities take equity for different reasons, the way in which they structure how they receive their equity varies by institution.  This presents a challenge for investors looking to license university technologies because most investors wrongly assume that university equity arrangements are standardized. 

Given the lack of clarity around how universities acquire equity in their start-ups, I thought it might be helpful to explain the 3 primary types of equity structures – Upfront, Milestone, Phantom - that universities employ.

Upfront

The Upfront equity structure is the most common type, but also the one that varies the most between academic institutions.  In the Upfront structure, the university takes their equity in the start-up at the time of the company’s founding and the equity is typically baked into the pre-money value of the company.  I have seen pre-money values (note: includes management ownership and options) range from $2.3M to $7M for start-ups.  Those pre-money values directionally represent fully-diluted ownership of 2-40% for the university start-up at the time of its founding.    

The massive variation in the amount of equity a university receives Upfront is primarily dependent upon the value of “sweat equity” the university has put in, the stage of the product, the breadth of the patent portfolio licensed, and the amount of dilution the university foresees itself being subject to.  Sweat equity is typically the most controversial point when negotiating university equity because it is often hard to quantify and the quality of work in some cases is questionable.

Milestone

The Milestone equity structure is typically the most welcomed by investors, but can be quite risky for a university.  In this structure, the university takes no equity upfront, but takes equity at significant milestones such as entering human trials or submitting an NDA.   The equity given at the milestone is based upon the fully-diluted share count at the time of the milestone achievement.   For example, a university might receive 0.375% equity in the company at the time of IND filing and an additional 0.75% upon finishing Phase 2 studies. 

The challenge with the Milestone model for universities is that they only receive equity at 2-4 predetermined milestones.  If a company is sold before a milestone is achieved, then the university does not fully capture their potential equity in the company.  Some universities insert clauses to hedge their risk of an early sale, but that is not always the case. 

Phantom

Only a few institutions use Phantom equity, but it is a structure that has gathered quite a bit of attention over the last two years.  Phantom equity is an arrangement in which the school does not hold equity in a start-up until the time of the company’s sale.  For example, as part of their “Carolina Express License”, the University of North Carolina takes 0.75% of the start-up’s fair market value at the time of a liquidation event (M&A, IPO, asset sale).  Typical Phantom equity can range from 0.5-2% at the time of sale.

Most life science companies raise well in excess of $60M before they are sold.  Raising that kind of money results in massive dilution for early investors, making 2% Phantom equity for a university quite attractive.  The risk for the university is that the company is sold before it raises a lot of capital, resulting in the university leaving money on the table.

Equity & Start-ups

Negotiating university equity in a start-up is often a point of contention between investors and the tech transfer office.  To avoid misaligned expectations, both sides should be upfront in what they perceive to be fair market value and have data points in hand to defend their position.  Having a standardized term sheet outlining equity expectations may expedite license negotiations and align both the company and the university in the pursuit of creating shareholder value.    

A Look at Pharma-Academic Collaborations From the Sidelines

Recently, it seems like every day my FierceBiotech RSS feed brings news of another announcement concerning a major research collaboration between a pharmaceutical company (“pharma”) and an academic research institution. 

The recent collaboration frenzy can be attributed to a pharma-wide strategic initiative aimed at addressing a fundamental problem shared among all major pharma companies; a marked decline in revenue growth due to a lack of new innovative products and weak R&D productivity.  By aggressively reaching out to academe, a community that is a rich source of creativity and scientific talent, pharma companies hope to identify novel drug targets and molecules to refill their new product pipelines. 

Without the launch of new blockbuster drugs, pharma has experienced little revenue growth in recent years and faces looming patent cliffs - a dire situation.  The initial sexy solution to solve the revenue generation problem was to pump billions of dollars into drug discovery units in hopes of finding the next Lipitor or Avastin, but those efforts to produce the next generation of blockbusters have largely failed.  A more recent trend for pharma has been to pursue growth through M&A activity. This is at best a stopgap measure since it does little to ensure long-term productivity. 

Collaborative partnerships with academe could increase drug discovery productivity for pharma companies.

However, it is unclear if these collaborative agreements are a viable business model, or a simply crisis management scheme.  In any event, it appears that pharma is in an all-out sprint to embrace ‘open innovation’ as part of an industry-wide strategic shift to downside (in the face of declining revenue growth), outsource (to cut expenses), and globalize (to reach new markets). 

To get a better handle on how pharma-academic collaborations work, I reached out to my colleague and a Founding Partner of Osage University Partners, Louis Berneman.  Lou is the former Director of Penn’s tech transfer office, past president of AUTM, and active member of the tech transfer community for almost 30 years.

Over the next couple of paragraphs I will share some of the thoughts Lou and I have on pharma-academic collaborations. 

Why Now?

Having thrown everything at the wall - internal R&D, in-licensing, co-development deals with biotechs, and acquisition (of biotechs) - pharma companies are now looking toward academic collaborations to help solve their drug discovery, productivity, and profitability woes.  Past academic collaborations has shown participants that, if structured and managed properly, these collaborations can be mutually beneficial and productive.

Academe’s interest in these collaborations can be largely attributed to securing resources to advance and de-risk novel concepts.   This is an acute need as venture capital has retrenched in their willingness and ability to make investments in early stage technologies. 

Pharma’s troubles are academe’s gain as pharma-academe collaborations, and the funding that comes with it, is providing much needed early stage capital.  Well structured and executed, these collaborations create and maintain small, highly focused, well resourced, outward looking, and expertly managed (science and business) projects.  These collaborations also permit academics to ‘prove’ their worth and contribution in the challenging world of drug discovery / development / commercialization.  Also, academics are incredibly prolific at identifying novel drug targets, which enables pharma to focus on its core strengths of chemistry, clinical development, manufacturing, and regulatory affairs. 

Collaborations are Efficient

Partially outsourcing innovation through academic collaborations is incredibly efficient for pharma because it enables them to access the best scientific talent in areas that compliment their existing commercial activity.  Because talent is outsourced and dollars can be easily reallocated should a project fail, pharma is more willing to spread capital amongst a number of bleeding edge projects in a high value therapeutic area.  

Collaborations, as opposed to startups and licensing, are the most productive contractual basis for advancing early stage discoveries.  Collaborations create mutual and aligned interests.  However, among the various approaches to facilitate moving academic discoveries into the marketplace, collaborations are the most complex to establish and difficult to manage.  Unlike a license, which is for a specific technology that has already been invented, a collaboration is for a future unknown discovery.  This leads to a lot of “what ifs”, which can make for contentious negotiations.

Collaboration Structure

There is no boilerplate deal structure for pharma-academic collaborations, as each appears to be designed based on the particular needs and interests of the parties.  I have heard many stories of pharmaceutical companies acting in bad faith during collaboration negotiations, and while some of those anecdotes might be valid, I sense that most stories typically inflate the facts.  Clearly, these are complex relationships and agreements dealing with issues that go to the core of conflicting cultural values and the common interest in the commercialization of new and useful discoveries.  

The challenge in constructing these collaborations is managing conflicting core values.  Academe values knowledge for knowledge sake, research grant funding, publications, and academic freedom.  Pharma (and other private sector interests) values the management of knowledge for profit, confidentiality, and limited public disclosure.   Structuring relationships and agreements that resolve these conflicting values toward the common interest is a challenge. 

Some of the more important negotiating points in collaboration agreements are:

Intellectual Property: Collaboration agreements typically include definitions of IP subdivided by ownership class (institution, company, and joint).  The commercial partner almost always pays for prosecution costs.  Institutions retain ownership of IP while granting rights to the IP to the company.

License Rights: Rights to IP, extant and ongoing, are the subject of much negotiation.  As I said above, these are complex agreements and there is no boilerplate.  License rights are deal specific depending on the situation of the parties and circumstances of the negotiation.  Obviously, private use issues are a major consideration in the negotiation. 

Joint Steering Committee (JSC):  Most collaborations include a JSC with  representation, perhaps even equal, from both the academic and pharma collaborators.  The primary task of the JSC is to identify, screen, select, track, and manage scientific projects.  JSCs are generally comprised of researchers (pharma and academic).   

Academic Freedom and the Right to Publish: In 1988, the Boots Pharmaceutical company attempted to block the publication of clinical trial results from the Synthroid Bioequivalence study at UCSF.  The outcry against Boots trying to block the publishing of data that supported the notion that a branded drug was no better than generic became the cause de celebrity among consumer advocates like Ralph Nader.  The Boots Synthroid Affair seems to have cast an unfair shadow on pharma-academic collaborations generally, and clinical trials specifically, ever since.  Derek Bok, the former President of Harvard, a key critic in the debate over academic collaborations was quoted in a 1996 Wall Street Journal article on Boots Synthroid as saying “the price of corporate support is eternal vigilance”.

What I find troubling is that too many critics of academic collaborations hold onto an outlying event from almost 25 years ago.  There will always be bad apples on both sides of the equation, and one event does not speak for the entire collaborative model.   That said, there are clearly cultural value differences and ‘eternal vigilance’ is probably wise.

While Boots attempted to hold sway over trial results, it is hard to believe that such actions would prevail over a larger group of academic researchers.  The reality is that academics enjoy being a bit fractious and will always choose to work on what is of most interest to them (and their grant and donor funding sources).   Instead of trying to push academic researchers around, pharma seems to work hard to identify researchers that are already conducting work in areas of mutual and synergistic interest and who have an interest in collaborating. 

Working with industry can create rivalries amongst researchers and departments, which need to be handled delicately.  Also, the best PIs – those that pharma wants to work with – are not only prolific researchers, but also typically involved with competing “commercial” projects as consultants, advisors, and even as entrepreneurial founders.  Pharma, in their selection of investigators and negotiations, need to navigate these political challenges to ensure that the collaboration is a productive one and boundaries are not crossed.

Co-mingling of Funds: The reality is that most labs receive funding from a variety of public and private sources and have to actively manage how dollars are used.  Institutions and investigators differ in their funding and time management arrangements.  Tracking systems to stay on top of things is essential.  In the end, funding sources have to trust who they are working with to ensure they are getting productive use out of their investment.

Ethical Concerns

Managing conflicts of interest – both individual (generally well handled by academe) and institutional (generally not handled at all) requires eternal vigilance. 

Ethical concerns break down into two main groups: ethical considerations surrounding the academic and that if the institution.  As Lou likes to say, “there are two things no institution will risk: its name and its endowment.  Maintaining academic values, including the right to publish and assuring research objectivity are sacrosanct. 

Much has been made about the ethical concerns surrounding academics working with industry, but most commentators have, in my opinion, at least, overstated the risk.   Having worked in academia for almost 30 years, Lou commented, “Faculty will always work on what is of interest to them (and their funding sources).  There is no co-opting of academic freedom”. 

Despite Lou’s sentiments, I always seem to hear anecdotal stories about pharma imposing unethical and prolonged publishing restrictions.  What seems to never make it to press is the fact that publishing embargoes are included in almost every collaboration agreement and the terms seem reasonable and work for both parties. Lou notes that, “counterparties have a right, pre-submission, to review new publication submissions before being submitted (e.g. 30 day window).  If the company wants to file patents, they get another brief period of time to file (e.g. 60 days).”  These are standard terms that are widely accepted. 

Alliance management

At the end of the day, the greatest risk for these collaborations is not the crossing of ethical boundaries, but a lack of delivery and execution.  Pharma understands the need for alliance management and generally does so well.  Academe – not so much, and more’s the pity.  Lou has shared with me horror stories of outstanding collaborations gone awry for lack of academe attention to alliance and project management. 

Thoughts on "Predatory Pharma Practices"

Last month Xconomy interviewed Kevin Kinsella, founder of Avalon Ventures, about the current status of biotech venture capital.  Kevin’s honest statements have been the talk of the town ever since.  One of my favorite quotes is below:

“During one buyout negotiation, Kinsella says, “The acquiring company spent more time asking questions about the cap table [to decipher the amount of venture capital the company had raised] than about clinical trial data.” The first buyout offer that came in was exactly equal to the total venture capital invested in the company”.

There is no doubt that pharma is playing hardball right now with acquisition terms.  This forces venture capitalists to readjust their return expectations and risk assumptions for investments.  Many traditional therapeutics-focused VC shops are now diversifying to medtech, diagnostics, and even services and healthcare IT.  These are areas that traditionally have lower return multiples but offer lower risk profiles and a faster route to market.  

The Xconomy article has been circulating around for the past few weeks, but I wanted to hold off on blogging about it until some comments were posted in response to Kevin’s interview.  There are a few comments that I would like to respond to:

Fewer funds are doing early stage bio investing and those doing later stage are crafting deals to try and get them early stage returns to offset the issues Kevin talks about: True, in that fewer funds are doing early stage bio investing.  However, there are still a number of great shops still doing early stage therapeutics deals: 5AM, Alta Partners, Bay City, Domain, The Column Group, KPCB, Third Rock, TPG Biotech, Pappas, and Versant.  I disagree that any VC thinks they can get a huge multiple on a late stage deal, even with preferences in place.  At Osage, we have made 7 life science investments in the last 18 months and have yet to do a deal with a liquidity preference greater than 1x and all preferences were capped for investors. 

I have seen biotechnology VCs crush entrepreneurs with their board seats, control provisions, cram downs and other tools of the trade and I can tell you that whining when the shoe is on the other foot is quite hypocritical:  Protective provisions are an essential part of venture capital and I don’t know of any VCs who views them as tools to “crush” an entrepreneur.  Protecting the capital of venture fund investors is the responsibility of the Fund’s Partners and is something VCs take quite seriously.  Not to mention, that many VCs, along with entrepreneurs, were crammed down as companies were refinanced.  Cram downs are a normal part of the VC business and the economics of how participants are crammed down is typically boilerplate.  Unlike the venture investors that are crammed down, management options are often refreshed after the down round.  

If VCs don’t like a pharma deal just do what my momma told me when I passed kids smoking on the street – “just walk away”… the VC model which is driven by putting large amounts of money to work regardless of capital efficiency: I found this comment to be rather confusing.  By definition, if VCs were to walk away from all partnering discussions, then they would be fully responsible for funding companies through late stage development. Drug development is inherently expensive and capital efficiency is somewhat of a misnomer, as many people would consider a capital efficient company to be one that burned $35 million to get through Phase IIb studies.  Raising $35 million would have most likely taken the participation of several large VC funds.  While capital efficiency is great and something that I value, it is just not that applicable to drug development.  That is why you see smaller VC funds choose to do medtech, diagnostics, healthcare IT, and other less capital-intensive areas.

Despite the frustrating and anger provoking behavior of some black sheep I do not believe that this is representative for “pharma” as evidenced by many lucrative deals that actually got done:  I would argue that Kevin was on point with his comment about the lack of large scale exits with significant upfront payments.  There certainly have been some this year – Avid Radiopharmaceuticals, Calistoga, BioVex, Plexxicon – but not enough to sustain an industry.  Part of the reason for this, and a key point that was omitted in the interview, is the fact that pharma went through a massive consolidation in 2008 and 2009.

Aside from GSK and BMS, almost every other pharma company is still working through their mergers.  Until those mergers are completed, business development groups will not have clear directives about what companies to hunt for and what gaps to fill in the pipelines.  Acquisitions will pickup but it is unclear when they will start.

Other factors that hamper the prosperity of VCs and their portfolio companies certainly include the unpredictable behavior of the FDA, the recent financial crisis, which shifted the risk-reward paradigm toward risk in red capital letters, the virtual disappearance of the IPO market and, last not least, a certain overindulgence of the VC industry itself, which is now experiencing a drought: Dead on. 

Osage Goes to AUTM

This week I am headed to Las Vegas for the yearly gathering of technology transfer professionals - the Association for University Technology Managers (AUTM).  The event is a great place for technology transfer folks to get together and exchange ideas on how to stimulate the licensing of university technologies.  As part of this entry, I thought it might be interesting to give a brief overview on the history of AUTM.

In 1973, Dr. Betsy Johnson, then the Deputy Secretary of Commerce, gave the keynote speech at the yearly National Council of University Research Administrators (NCURA) meeting.  At that time, the USPTO reported directly to Dr. Johnson, therefore making her a very important person.  During her speech Dr. Johnson noted that the Government’s treatment of university inventions was disgraceful, and university leaders should get together and do something about it.

The lack of university commercialization activities at that time was no surprise, as technology transfer professionals in the early 1970s had little tools in their war chest to promote the commercialization of university technologies.  At that time, universities were generally averse to patenting, let alone patenting inventions that resulted from federally funded research.  With little incentive to patent university research, there was no real need to have formal technology transfer offices on campus.  Without the tools necessary to promote the commercialization of university technologies, only 1/3 of filed patents would go on to become issued and only handful of exclusive licenses were given out per year.  Taken together, only a small number of technologies were finding their way to the private sector.  

Something needed to change.

Following Dr. Johnson’s speech, Dr. Ralph Davis of Purdue, Dr. Allen Moore of Case Western, and Jon Sandelin of Stanford, came together to talk about ways of addressing Dr. Johnson’s challenge to the NCURA. Early in 1974, Dr. Moore took the initiative and organized a meeting at Case Western. During the meeting Dr. George Pickar of Miami proposed that the university leaders should form a society of university people devoted solely to the management of patents. Thus was formed the Society of University Patent Administrators (precursor to AUTM).

SUPA, and later AUTM, would go onto to do great things.  Most notably, SUPA/AUTM playing an instrumental role in the shaping of the Bayh-Dole Act of 1980 that gave universities the right to patent, own, and market inventions that were derived from federal grants. Universities were free to license their patented technologies to whomever they wanted in order to stimulate economic development in the US.

Today AUTM is a global organization with over 2,000 active members.  Osage University Partners is a proud AUTM member organization and we look forward to seeing many of our friends at the conference.