Scotland Is Spinning - The Growing Trend In University Spin-Outs

A recent survey launched by SpinOuts UK, the online database of university spin-outs, has revealed that Scottish Universities have produced more spin-out companies over the past decade than any other part of the United Kingdom. In that period, Scottish Universities have created 172 new spin-out enterprises, 125 of which are still active.

Topping the list of Scottish Universities was Edinburgh, which produced 49 spin-outs in that period, behind only London and Oxford. Strathclyde University has also been the birth place for an impressive 35 new ventures.

Historically, the most popular way to commercialise University research and technology was by license to an established company in the relevant industry. More often now, Universities are forming new companies, with access to University-owned intellectual property, to commercialise the technology. Whether a spin-out is the best route to market will depend on the nature of the technology itself, finding the right management team with both the technical expertise and business skills to take the venture forward, and of course, the investment climate.

As Scotland establishes itself as a recognised leader in the generation of innovative spin-outs, entrepreneurs have the ideal platform to take their ideas to market. Once the idea is in hand, this article looks at the next steps to spinning out, who the key stakeholders will be and how their relationship is regulated.

Who are the key stakeholders?

There will be a number of stakeholders in a spin-out venture, each bringing something different to the venture. Whilst all stakeholders will ultimately want to see a return from their investment, they will each have different priorities:-

• The University – the University will control the intellectual property ("IP") which forms the core of the spin-out's technology, and may also take a stake in the Company.
• The Founder(s) - the founder(s) or management team may comprise both the academic(s) who developed the IP whilst working or studying within the University, and entrepreneurs with experience of launching new-start companies.
• The Investors – to break into the industry, the spin-out will need investment. Funding may come from venture capital investment, government grants and/or business angels.

It is important for the growth of the Company that the stakeholders have a good relationship. Key to this will be clearly defining everyone's role and rights from the very start.

The steps to spinning-out

Each spin-out will differ, depending on the type and level of funding needed to get the project off the ground. This article looks at the main steps to spinning out:-

• seed round funding;
• introduction of the intellectual property;
• external investment.

Stage 1 - Seed Round

If the technology is at a very early stage, the Company may require early seed funding to develop a robust proof of concept which can attract external investment.

Seed funding is likely to include equity subscription by the Founders or early individual investors, for example, family and friends. The Company may also seek external seed capital funding from third parties by way of a subscription for shares or a loan. If external seed funding is secured, the Founders and the Company are likely to be required to enter into investment documentation which contains standard protections for the funder.

Stage 2 - Introduction of IP

The IP may be transferred to the Company by an out-right assignation, or shared with the University by way of a licence. How the IP is introduced will depend very much on the nature of the technology. An out-right assignation would give the Company greater flexibility in commercialisation of the IP whilst a licence will contain various restrictions and controls on use of the IP. Some of the issues to consider when putting a licence in place include:-

• whether the licence is on a fully exclusive basis or exclusive within a particular territory or field of application;
• whether the licence will be terminable on certain events (for example, if the Company fails to exploit the IP within a certain time period);
• whether the licence will need to carve out certain continuing rights for the University to use the IP, for example for non-commercial research and teaching. These continuing rights will need to be carefully agreed to ensure that the value of the technology being acquired by the Company will not be diminished by the University's continued use.

As consideration for licence of the IP, the University will take equity in the Company and in some cases, further royalty income. This way, the University can participate in the upside of the value of the Company should it be successful and at the same time obtain a basic return without draining the cash-flow of the Company in its early stages.

Stage 3 - External Investment

The spin-out of the Company will culminate in external investment. External investment will typically be made by venture capital funds or business angels, often in partnership with the Scottish Co-Investment Fund. Initial funding may start small with investment being made in multiple tranches linked to specific development phases or sales targets being achieved.

The documentation

The various stakeholders in the spin-out will each have different objectives and expectations. Some may be more involved than others in the Company going forward. It is important to manage these differing objectives from the outset by clearly documenting how the stakeholders will interact.

1. Subscription Agreement

The most important document for the investment will be the subscription agreement (also sometimes known as the Investment Agreement or Shareholders Agreement) between the Founder(s), the seed funder, the University and Investors. Key issues dealt within this agreement include:-

• Investor involvement: All of the stakeholders are likely to want to have a say in key commercial decisions of the Company but this might actually hinder the running of the business. It is important that a realistic balance is agreed which enables the Investors and University to safeguard their interests without hampering everyday operations.
• Information rights: Those stakeholders who are not directly involved in the day to day running of the business will be provided with regular information to allow them to monitor financial and operational progress.
• Board representation: The Investors and the University may want to take a seat on the Board of the Company or have the ability to send an "observer" to board meetings.
• Warranties: Although the Company will be a new venture with little or no trading history, it is common for the Investors to have the benefit of some warranties about the Company. For those giving warranties (usually the Founder(s)/management team) it will be essential to take proper advice on the implications of giving warranties and to ensure that a full disclosure exercise is carried out.

Articles of Association

The Company will also adopt a new set of Articles of Association on completion of the external investment, to regulate the rights of each of the key parties as shareholders of the Company. Some issues which the Articles might address include:

• Issue of shares: To prevent dilution of their shareholding, the various stakeholders may seek the right to participate in any further issue of shares in the Company.
• Sale of the Company: All parties will hope to eventually realise their investment through a sale of the Company. The Articles may include provision to deal with a situation where an offer is made to purchase the shares in the Company to ensure that all stakeholders can secure an exit.
• Leaver provisions: The Investors and the University will be keen to secure the services of the Founders until the Company is well established. As well as putting in place appropriate service agreements, the Articles may require the Founder(s) to sell their shares in the Company if they choose to resign or their employment is terminated.

Some important tax considerations

The structure of a spin-out investment will have multiple tax implications for all of the key players. The timing of the various steps to spinning-out will be crucial to maximise the potential for the investment to attract favourable tax treatment. Specific tax advice should be sought before embarking on the investment.

EIS Relief

If business angels are investing in the Company, they are likely to seek tax relief under the Enterprise Investment Scheme. Investments under the EIS scheme attract income tax relief at a lower rate, with freedom from capital gains tax on the eventual disposal of the investment in certain circumstances. In addition, the investment will qualify for deferral relief, allowing an investor to roll the proceeds of a capital gain into the investment and defer CGT on that gain until the investment in the Company is disposed of. The Investors will commonly require an application to HMRC for advance assurance that the Company and the proposed investment will qualify for EIS relief and this must be factored into the timescales for completion of the spin-out.

Our article No BASIS For Celebration? looks at a recent consultation by HMRC to gather views on a new scheme for early stage investment by Business Angels, to be known as the Business Angel Seed Investment Scheme, and on a variety of other reforms which are intended to improve the effectiveness of the EIS and similar schemes.

Employment Related Securities

If the Founders subscribe for equity in the Company at a lower price to that paid by external Investors or the University, regard must be had to the treatment of those shares as employee related securities. If the Founders are directors or employees of the Company and the price at which the Founders acquire their shares is less than what is deemed to be the market value, the difference may constitute a benefit in kind and be taxed as such. Relief from this tax treatment is available for academics and researchers involved in creation of the IP in certain circumstances. Tax advice should be sought before the Founders subscribe for shares in the Company to ensure that the most tax effective structure is adopted and unforeseen liabilities are avoided.

Biggart Baillie regularly advises relevant shareholders in spinning out and commercialising technologies developed in Scotland's universities. We can help navigate the challenges in setting up the new venture, advise on how the objectives of the various stakeholders are best met and document the investment in a clear way to ensure that everyone can move forward in the same direction.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.