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Taking Stock of Equity
Stanford’s OTL was founded 36 years ago and has been working with start-ups about as long. Stanford is surrounded by a host of fledgling companies, all striving to become the next Hewlett Packard, Genentech or Intel, along with a large infrastructure to support them - venture capital firms, seasoned executives, and law firms experienced with start-ups. Add innovative scientists and enthusiastic entrepreneurs from Stanford to the mix, and the possibility of creating ground-breaking products grows even larger. How the start-ups are established runs the gamut from eager doctoral students to well-connected professors to technology-savvy business people. Stanford takes a hands-off approach to its start-ups, in part due to the plethora of local resources available to the new companies. If the founders need introductions to venture capitalists or law firms, OTL can provide these connections. But it does not go much further than providing a good license agreement for the technology that will form the basis of the company. OTL understands that start-ups are accountable to other entities in their growth and development. Likewise, OTL has its constituents to consider, including inventors, administrators, and the U.S. government. The license agreement includes provisions that address and/or benefit these constituents. OTL’s relationship with the company is key for all parties to succeed, and OTL’s policies enable it to be fairly flexible, while maintaining Stanford’s goals of research and education as the primary focus.
Beginning Negotiations When negotiating with a start-up company, OTL often steps into their shoes. What does the start-up have? Where does it want to go? What does the start-up need to get there? If Stanford’s technology can contribute to the company’s potential success, and OTL believes the company can bring the technology to the marketplace, OTL will begin negotiating a license agreement. Since cash is normally scarce for start-ups, equity is one of the components OTL considers when formulating the structure of a deal. Once a license is in negotiations, OTL will typically backload the cash terms of the agreement, putting a larger portion of the upfront due after financing. However, OTL does consider some amount of upfront payment essential. Cash poor start-ups still need to have the wherewithal to pull together some modest amount (usually around $5,000 to $25,000) to secure IP rights to ensure that the company is serious about the license. As with most academic institutions, OTL understands the need to wait until the company is getting value from the technology before the University can realize its value. When negotiating the license agreement, equity, upfront, milestone, earned royalty and other cash payments are all a balancing act. Each negotiation with a company is unique and requires different considerations to promote that particular company and Stanford technology. An important aspect of most licensing deals with universities is that the technologies are often very early stage. For biotechnology inventions, Stanford typically has early stage technologies available to license, with only in vitro data, or in conjunction with very little in vivo data. Therefore, a start-up company based on a licensed therapeutic compound must complete preclinical and clinical studies before a product is commercialized. In medical devices, technologies from Stanford are sometimes more advanced, but may have not been tested in animals or humans before they are licensed to industry. High technology inventions disclosed to OTL often span a wide range of development stages – from the theoretical to the product-ready, although most of the technologies are years away from implementation into a product.
Equity Considerations Since the cash in a license is usually backloaded, OTL will often ask for equity in the start-up company. This is compensation for the risk OTL is taking, but it is also because OTL believes in the company. Although exact amounts of equity taken by Stanford vary, normally it will not acquire more than a 5% equity stake in a start-up and OTL will ordinarily maintain its equity percentage through Series A financing. One area of special concern for Stanford and most universities is conflict of interest (COI). If the inventor is involved in the company, the COI review and potential for clinical trials at Stanford may both weigh in as factors when assessing the likelihood of Stanford realizing value from the equity. Under Stanford policy, it cannot hold equity in companies conducting clinical trials at the University. Therefore, even though Stanford may have received equity in a company that eventually has an initial public offering (IPO), Stanford may have had to divest of its equity earlier due to a clinical trial being held at Stanford. OTL’s license agreements must include provisions for companies to repurchase Stanford’s equity for fair market value before the company begins any clinical trial at Stanford. The current University policy is to cash out equity upon the first liquidation event, which is often at the IPO. Stanford is aware that it is not likely to receive the maximum value that the equity may eventually hold. Although Stanford has realized a good return on a few equity liquidations, there are many others where it could possibly have realized a greater financial gain if Stanford’s policies towards liquidation were different. For these reasons, when equity is a component of negotiations, OTL makes it clear to the other party that it does not value it as greatly as others may. When negotiating the amount of equity, often the biggest hurdle comes when OTL faces the venture capitalists (VCs) who will be funding the start-up. Their perception of the value of the equity is going to be based on a different perspective than Stanford’s. OTL feels that the equity is partial compensation for the lower upfront cash payment, but OTL and VCs valuations can be vastly different. Once Stanford’s equity is liquidated, OTL receives a portion of the funds, but the majority is applied to the OTL Research and Graduate Fellowship Fund, which benefits the Stanford community at large.
History and Return OTL took equity in a company for the first time in 1970. However, for a period in the 1980s, Stanford’s policies prohibited taking equity in faculty-associated companies. Therefore, OTL had very few equity acquisitions prior to 1989. The prohibition was lifted after many COI policies were implemented, resulting in an increased number of equity stakes in companies. As shown in the graph on page 4, these numbers grew throughout the 1990s and then started to drop in 2001. OTL believes that the number of start-ups it licenses, and therefore the number of companies it takes equity in, correlates with the ups and downs of the national economy. In total, between 1989 and 2005, OTL has taken equity in 145 companies through licensing. Of those, 75 of the equity stakes were taken for biotechnology or medical device (biotech/MD) companies, compared to 70 in non-biotechology companies. A partial list of the names of companies OTL has taken equity in as at http://otl.stanford.edu/about/resources/equity.html. Although OTL has taken equity in slightly more biotechnology companies, there have been fewer liquidation events than in the physical sciences/high technology. Additionally, the life sciences have a much lower average liquidation amount compared to the physical science companies. Not a single liquidation in the biotech/MD sector has generated over $1 million for OTL, whereas five liquidations in the high technology sector have generated over $1 million. Some possible reasons why the average liquidation amounts are lower in biotechnology/medical devices include:
New company formation is a gamble, as is each technology licensed and any path chosen to develop that technology. Likewise, taking equity is a risk, and one that OTL does not rely on for its income and budget projections. For Stanford, equity is one of the license term components it considers, but it does not depend on equity alone for its revenue streams. Although Stanford does not seek maximization of its equity value, it considers a liquidation event a success since the liquidation event represents another party’s belief in the company and its technologies. OTL relies on licensed companies to develop and eventually sell products. In order for this to happen, OTL must have a good relationship with the company to help enable it to create the products based on Stanford technologies. One indication of the strength of the relationships is that many of the start-ups founded on Stanford technologies often return to Stanford for licenses to further technologies.
This graph shows the total number of Biotechnology and Medical Device equity acquisitions vs. Non-biotechnology and non-medical device (usually high technology) equity acquisitions per year since 1989. OTL believes the number of companies it takes equity in correlates with the ups and downs of the national economy. This article is adapted from an article by Kirsten Leute, published in the Journal of Commercial Biotechnology, 2005; Vol II, No. 4:318-324.
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