Guide to Spin Out Companies
INTRODUCTION
Research and other activities carried out by the University and its staff and students may give rise to business opportunities best carried out by a new business entity separate from the University. In such circumstances the University will establish a limited company into which it transfers (or in the jargon ‘spins out’) the relevant intellectual assets required by the business in return for shares. The University becomes a shareholder of the company which is known as a ‘spin out company’.
Pursuant to the University’s IP Policy the University team which has contributed to the intellectual assets to be transferred to the spin out company are like the University entitled to shares in the spin out company.
A key factor of success of a new business is finance. So investors will also be shareholders, paying cash for their shares, that cash being used to pay for development, management and raw materials. One of the investors will usually be the University’s own seedcorn fund the University of Bath Crescent Seedcorn Fund and IP2IPO will also be offered the opportunity to invest.
Another factor of success regarded as being as crucial as finance is the right people to run the spin out company. Whilst some University team members may play a role in almost every case professional managers will be required to run the business and may require the incentive of the opportunity to become a shareholder in the future (for example upon achievement of a significant development) and so it may be necessary to create a share option pool whereby the key managers can become shareholders.
Frequently the spin out company requires access to University facilities such as laboratory space, office space and equipment. Because the spin out company once established is a new entity entirely separate from the University it is important that proper contractual arrangements are made in respect of this.
Finally although the University is willing to transfer intellectual assets to the spin out company in some circumstances it may want to continue to use these assets to carry out further research or for teaching. In exceptional circumstances it may wish to reserve commercial rights in particular fields in which the spin out company will not be operating. So the terms of reservation of rights and or licences back to the University also need to be agreed.
The legal process required to establish a spin out is separated into a number of stages. This is because commercially certain matters need to be attended to and explored first, there are tax considerations and investors will want to see everything in place before parting with cash and will require all shareholders to agree between themselves how the company will operate and not to behave in a way which may conflict with the company’s interests.
2. PRELIMINARY ACTIVITIES – Development stage
Usually the academic team will have disclosed an invention or inventions to the University (in the form of Bath Ventures) and secured patent filings. Patents usually take a number of years between first filing and grant but potential protection in the territories of commercial interest should be secured. Spin out companies may be formed around other intellectual assets such as copyright in software and database rights.
Some commercial development of the technology will usually have occurred with a positive outcome. This will often involve engagement with commercial parties in the relevant sector and so will require legal contracts to be drawn up in order to protect the University’s rights in the new technology. The type of legal contracts required at this stage may include confidentiality agreements, consultancy agreements, evaluation agreements, and contracts for services.
Research using the inventions may continue at this stage. Intellectual Property Rights in the results of such ongoing research belonging to the University may be transferred to the spin out. But care must be taken not to award the collaborators rights in such results or the underlying inventions that may prejudice the commercial viability of a spin out company established to exploit such technology. So legal review of relevant collaborative research agreements is essential.
At this stage the contributors to the technology, the subject matter of the potential spin out, should agree their respective contributions to the technology in order to determine the split between themselves of shares to be issued to the founders. The entitlement derives from the University’s Intellectual Property Policy (IP Policy). The staff team leader should notify the Faculty Dean and Head of Department as to which staff have contributed to the inventive step in the case of a patent and/or had effort or ideas input. There is provision in the IP Policy for escalation in the case of dispute. In come cases another institution may have rights in the technology so a Revenue/Equity Sharing Agreement should be entered into, agreeing that the University is to take the lead in commercialisation and the equity or revenue interest of the other institution/s. All such issues should be resolved well before the spin out company is established.
One aspect of the plans for commercialisation of the technology will be to ensure that there are no bars on freedom to operate. In the event that other technology must be accessed in order to work the technology appropriate supply agreements and/or licence agreements must be put in place.
Once all these requirements are satisfied and the University and staff team have agreed how the plans for commercialisation of technology are to be realised, including management personnel and finance the formal process can begin.
3. STAGE 1 – Staff team subscribe
First the University will acquire a ready made off the shelf company with appropriate Memorandum and Articles of Association and arrange for its name to be changed to that desired for the spin out company by passing the relevant Company Resolution. The Deputy Vice Chancellor will be the first Director and the company will carry out no activities. It will remain ‘dormant’ and will not trade until after Stage 3.
The staff team will then subscribe in cash for shares at their par value by signing Applications for Allotment of Shares and presenting cheques payable to the spin out Company. The par value of each share is usually £0.001 so the most an academic would expect to have to pay would be £30.00 or so. Relevant Share Certificates will be issued and the cheques paid into the company’s bank account.
The number of shares subscribed for will depend upon the contributions of the staff team and the number of shares anticipated to be issued to the University and investors at stages 2 and 3.
In order to ensure that there is no activity in the company at this stage the academic team will not be Directors (even if they are to be so appointed at Stage 3) and the existing or new Articles of Association and/or a Shareholders’ Agreement will ensure that no share transfers can be made (the final obligations regarding this and other matters will be set out in the Investment and Shareholders Agreement to be entered into at stage 3).
One reason why the staff team is the first to subscribe for shares in the spin out company is tax. We have been advised that this is best practice. There is a potential charge to income tax and national insurance in respect of the opportunity afforded by the University to the academic team to subscribe for shares to the extent that the price paid represents less than their true value. There is an exemption if certain specific criteria are fulfilled in a case where a research organisation is transferring intellectual assets into a spin out but notwithstanding this we have been advised there should be a gap between the academic subscription (Stage 1) and the transfer of such assets (Stage 2) and cash investment in the spin out company (Stage 3).
For tax reasons it is advisable for the academic staff who subscribe for shares at this stage formally to notify HMRC and elect that any charge to tax arising in consequence should be assessed immediately so each academic should complete and submit a S431 Tax Election.
4. STAGE 2 - UNIVERSITY LICENCES OR ASSIGNS IPRS TO THE SPIN OUT COMPANY (I month after Stage 1)
The technology the subject matter of the spin out company needs to be exclusively reserved to the spin out company in its commercial fields of interest. This will be achieved in a Patent/Copyright and Knowhow Assignment/Licence which will specify the IPRs in question. In the case of an assignment ownership is transferred outright to the spin out company. In the case of a licence the University remains the owner but awards the spin out company the relevant monopoly commercial rights. Which course is adopted depends on the circumstances including whether the University wishes to explore other commercial applications of the patents. Matters such as who pays for past and future patent prosecution costs and who takes and defends infringement actions must be negotiated agreed and specified in this document.
If another person has rights in this technology (besides the University and its staff and students) or further separate technology is required for the successful commercialisation of the technology being spun out of the University separate arrangements must be made with that person. They might be a party to the Patent/Copyright and Knowhow Assignment/Licence with the University and spin out company, on the basis that it concerns the same technology. In other cases however the licence may be on quite different terms, for example it may be a Non–Exclusive Third Party Licence whereby access rights to that third party’s technology are granted for a fee, or royalty (rather than shares as is usually the case with the University).
In return for entering into the Patent/Copyright and Knowhow Assignment/Licence the University enters into a Subscription Agreement with the spin out applying for specified shares in the spin out company. The number of shares will usually equate to 2/3 of the shares in the spin out company, as against 1/3 which will have been already subscribed by the academic team. More shares may be issued to third party collaborators or licensees (which will equally dilute the University and the academic team’s shares).
The University’s continuing research interests must be considered and where necessary preserved. There are limits to the right to use patents for research purposes and in some cases permission must be obtained from the patent owner. The University usually will ensure that it is awarded the right to work patents and knowhow and copyright in its research and sometimes it may be prudent to secure agreement that the spin out company will grant future licences to the University and its collaborators so that the outputs of such research can be commercialised to the extent that such commercialisation doesn’t compete with the business of the spin out company. These terms will be set out in a Research Licence.
5. STAGE 3 FUNDING AND COMMENCEMENT OF TRADING
This is the point at which all matters required in the short term to enable to business to be operated must be put in place by means of concluded legal agreements.
The Investment and Shareholders Agreement sets out the basis on which the funders are willing to invest cash, usually for shares. The investors will pay cash for shares. Where IP2IPO invests the pre money valuation of the spin out will be £750,000. So £500,000 would award the investors 40% of the spin out company. The investors will usually subscribe for ordinary shares with the same rights as the shares held by the University and academic founders.
The investment for shares may be made in one go or in 2 or 3 tranches, dependent upon achievement of technical or commercial milestones. When shares are allotted the relevant Share Certificates must be issued.
The Investment and Shareholders Agreement will set out inter alia the mechanism for completion of the investment, how the Board of the company is to be constituted and operate, the provision of financial information, matters that require shareholder approval (and what majority), confidentiality and any restrictions on shareholders from working with competing businesses. It may also require the Company to be operated as set out in a particular Business Plan.
In addition Articles of Association (a public document) sets out how the company will be operated and will usually include provisions restricting the transfer of shares, requiring a ‘bad leaver‘ to dispose of his shares and how the price thereof is to be calculated, and ‘drag along’ and ‘tag along’ terms whereby a shareholder can be forced or choose to sell their shares in the event that a specified majority of shareholders wish to do so, on the same terms.
Occasionally the arrangements with an investor may involve a Convertible Loan (under which debt is converted into equity).
Space may be occupied by the spin out company, often at the University. We need to ensure that such occupation is on the basis of a proper Licence Agreement under which a fee calculated on a sq m basis is levied and other services e.g. computer network and telephone are provided. The University will be as accommodating as it can but it is important that the Company doesn’t get tenant’s rights.
The spin out may require access to other facilities and/or equipment of the University and a Facilities Agreement drawn up to provide for such shared use. Such agreements are not without complexity in their drafting and operation since times of access, maintenance, repair, consumables, utilities and services such as environmental waste and cooling systems must all be considered and contracted for.
Directors Service Contracts must be agreed with appropriate restrictions and incentives. Although management may want share options we would not usually put these arrangements in place immediately on spin out but would often provide in the Investment and Shareholders Agreement that such an issue is to be anticipated in the future.
Also general staff Service Contracts may need to be put in place together with Consultancy Agreements between the University and spin out company where academic founders are to undertake specific work.
6. CONCLUSION
Numerous documents are required to be drafted, negotiated and completed before a spin out company can be established. The drafts will be prepared by Intellectual Property and Legal Services but require active contributions from Bath Ventures should and the academic founders in relation to technical and practical details and relevant internal consents.
The academic founders will be required to sign various agreements so they and Bath Ventures make themselves familiar with their various provisions.
Documents required are highlighted in heavy type in this Guide. Intellectual Property and Legal Services is preparing basic formats that can be used as precedents to speed the spin out process, though each spin out is unique.