Spinouts that never spunout

👋 Semi-regular writing about technology and early-stage investing. Investor at Seedcamp, Europe’s oldest seed fund.

If a founder spins out a business from Newcastle University, they could be required to handover 40% of their equity to the university. Manchester University claims 35%, Bristol University reserves the right to hold up to 45% and before 2021, Oxford took over 50% of a company’s equity. Beauhurst found that the mean stake across all universities is a bit lower, at about 23%.

This equity structure often dilutes founder equity, caps ESOP incentives, and sometimes even leads to lawsuits. Nathan Benaich, founder of Air Street Capital has chronicled this excellently in his Spinout project and writing in The Times and FT.

But there is also an invisible category of startups that never spun out in the first place.

Between 2013 and 2022, the amount of financing secured by all venture-backed companies in the UK increased by a factor of ten. The amount secured by university spinouts increased at half that rate from $402m in 2013 to £2.1bn in 2022.

The actual volume of deals for spinouts grew even less - by a factor of two - suggesting that accelerating capital velocity and round inflation has not been been blessed with a growing number of opportunities at universities.

The founders’ deal

The reason for this trend is that founders are diluted too much, too quickly to make ‘spinning out’ an exciting proposition. Whereas VCs can protect their equity stake from dilution with ‘pro-rata’ follow-on capital, the founders’ stake decreases in direct proportion to any new share issuance.

This disincentive can be incredibly strong. When BioVex, a UCL spinout, was acquired for $1bn, Founder David Latchman revealed that he received just $709 from the deal. More recently, Quantum Motion, one of the UK’s fast growing recent spinouts raised a £42m Series B. Founders John Morton and Simon Benjamin owned less than 5% of the company after the round. In today’s funding environment, at least two more funding rounds before an IPO would be typical, diluting each founder to far less than 1% apiece. Compare this to the average founder ownership at IPO of 21%.

The Norwegian ecosystem illustrates how disheartening this is. Norway recently abolished a rule known as the “professors’ privilege”. Under the rule, academics used to own any businesses they started, outright. When the law changed, Norwegian universities were permitted to claim two-thirds.

The abolition of professors’ privilege reduced the velocity start-ups by 50%. The UK doesn’t have such a powerful embedded comparison, but we know that universities that take 19-25% equity generate more spinouts per research investment than those that took 30-35%.

Then there are the spinouts that try to spinout but fall at the earliest hurdle. A paper by the Policy Evidence Unit for University Commercialisation and Innovation (UCI) reckons that one third of university spinouts had lost a deal based on a disagreement between a university’s Technology Transfer Office (TTO) and the business’ founders. I.e. The business was not fundable. Low founder ownership asserts huge downward pressure on the founders.

If the impact of a university’s equity stake means that 50% of founders chose not to start their business and another 33% struggled to raise capital due to disagreements over university equity stakes, the spinout rate could be reduced by 83.5%. And thats before the company building starts!

The UCI paper also finds that there is no significant relationship between the university ownership and the chances of raising successive rounds above thresholds such as £15m or £25m. This may be true, but most potential startups never get that far.

But surely the universities deserve some compensation?

Universities normally justify their ownership stakes in two ways. That TTOs fulfil an incubator role otherwise absent from the financing supply chain and that they add value to company building.

The first point used to be party true, but spinouts are now amply supported from the earliest stages. In 2022, Northern Gritstone raised £215m, Oxford Science Enterprises raised £250 million to invest in the Oxford network, and Cambridge Innovation Capital announced £225 million to deploy locally. That isn’t to mention the other 500+ pre-seed and seed funds in Europe.

It’s also true that TTOs are helpful stepping stones to transition from PhD to the private market fundraising landscape. The technological guidance from a university is valuable in many cases.

But not that valuable. Universities don’t provide a start-ups with their most important resource - capital. Compare a university that takes 30-50% of a startup’s in exchange for $0 (perhaps less than $0 if there is a revenue share agreement) and Y Combinator, which takes 7% in exchange for a minimum cheque of $125k. YC also offers the strongest startup advisory network in the world, 00s of early customers, etc. And YC’s terms are considered extortionate…

The result is that only four of the 116 venture-backed European unicorns were spinouts as of 2022: Collibra, Excientia, MindMaze and Oxford Nanopore. That is a low hit-rate, given that ~9% of capital raised is for university spinouts.

Things are starting to change. Oxford and Cambridge deserve credit for gravitating towards a 5-10% ownership range in recent years. Imperial has introduced the "Founders Choice", where an entrepreneur can forego university assistance and need only give away 5% - 10% of their equity, and Cambridge recently announced that it is launching a new founder scheme.

But what’s the policy solution for the long-run? Benaich suggests the following.

Ultimately, it’s almost certainly more profitable for TTOs to actually take a lower stake. It’s better for TTOs to own 5% of something great than to own 50% of a company that fails altogether. Berkeley is set to make a handsome return on Databricks, which was valued at $43 billion in its funding latest round despite only holding a modest equity share after the company spun out.

Perhaps universities in the UK should learn from Sheryl Sandberg; if there’s a chance to own part of a rocket ship “don't ask what seat!”.