From learning to profit

Real Deals, November 2001

With the technology bubble burst, venture capital investors are looking for IP protection. And one place they can find it is at universities. European academic institutions may have lagged behind their US counterparts in commercialising R&D, but they are trying hard to catch up.

For Dr Frank Tooley, the transition from a research lab at Heriot-Watt University to the board of one of the most promising companies in Scotland's optoelectronics cluster was a smooth one. His company, Terahertz Photonics, was launched in 1998 with a government-backed Smart award but stepped fully into the commercial world two years later.

"I was still doing a lot of work on the side as an academic, but the company started for real last year when we got VC funding," Tooley says. "The four founders got together early last year, wrote a business plan, talked to investors for a while and finally got the money through last August."

Terahertz, which manufactures and customises components for the telecoms industry, raised £3m in a first round led by Jim Martin of ADD Partners and Gary Le Sueur of Scottish Equity Partners. "When you take something from a university invention and form an expanding business, it's probably the biggest transition in business," Martin says. "The company has achieved a hell of a lot and they've done it on a very tight basis. It's still relatively early stage but it's got considerable potential, with an excellent management team that very much focuses on the running of the business."

A year after the first round, Terahertz is close to closing a £15m second round. Despite the slowdown in the telecoms market, Martin is confident that the intellectual property developed by Tooley will win favour. "Companies in this sector need to have a certain niche to differentiate them," he says "If you're a new business you really need to be doing something different. You almost have to be changing the mindset of that sector. There has to be nicheness and a lot of that has to do with intellectual property and the transformation of that into something commercial."

Out of the labs
A recent survey of 37 leading UK universities found they had spun out 310 companies in the past three years, more than three times as many as in the preceding three years. "Our perception is there's been an increase in the focus on the spinning out of exciting technologies from UK universities," says Jason Purcell of First Stage Capital, the early-stage finance house which conducted the survey. "We have one of the world's strongest science bases and there's a number of segments where we are literally world class. With the collapse of the whole technology bubble, we've seen the UK VC industry begin to focus much more on backing companies with core IP behind them."

The UK government has taken an admirable lead in promoting entrepreneurial attitudes in academia, including a network of 12 centres to foster business skills and encourage spin-outs.

Professor Sue Birley, one of the UK's fiercest advocates of technology transfer, is director of the Entrepreneurship Centre at Imperial College London. "We have a company whose sole job is to assist in the process of making companies," she says. "We will sort out the IP portfolio, we will help write the business plan, we will help sorting out the management and so on. We also run courses and workshops in IP and legal issues." The faculty now boasts of generating a spin-out company every month.

The second major plank of the government's strategy is the University Challenge fund, which distributed a total £45m seed funding among 15 university consortia. The largest is the White Rose Technology Seedcorn Fund, formed with £4.5m from University Challenge and a further £1.5m from the Universities of Leeds, Sheffield and York. Managed by Gerry White of Aberdeen Murray Johnstone Private Equity in Leeds, the White Rose fund has so far invested up to £250,000 each in 11 start-ups.

Several are already looking for a second round. "Some may be able to continue under their own steam, but in general you can't really do a huge amount with £250,000," White says. "One of the things the White Rose Fund can consider doing is actually raising more money itself to enable us to provide access to second round funding from our own resources. It is difficult to get access to second round funding because of the time and effort it takes."

The seed-funded companies can be reassured that there is an increasing number of established VCs looking for opportunities in spin-outs. Hermann Hauser of Amadeus Capital Partners, a major player on the Cambridge scene, says the government initiatives have helped enormously in encouraging universities to work with VCs. "The University Challenge had a very interesting effect because all of a sudden the universities have a lot of money to invest," he says. "They realised that being a VC was a very hard thing to do."

Making the link
Most universities now have dedicated offices to encourage technology transfer. Isis Innovation, a wholly-owned subsidiary of Oxford University, has assisted in the formation of over 20 companies since 1997. Oxford has around 4,500 researchers in its science and technology faculties, with an annual research turnover of £200m.

"They obviously generate enormous amounts of IP, some of which finds its way to us," says Isis director Tom Hockaday. "We file more than one patent application a week, but it's only a handful that are going to be of sufficient breadth of technology and value to be appropriate to build a new company around."

Nearly all of the spin-outs generated through Isis have been seeded by business angels rather than VCs. "What we're doing is very very early stage stuff - it's so early stage the VCs themselves sometimes find it difficult to do the due diligence on the technology," Hockaday says. "But we've certainly noticed in the past year or so that a number of VC firms have made it very clear to us they are increasingly interested in making initial investments in university spin-outs. That's fantastic because the network and skill they bring in building the company can be enormously beneficial."

Isis last year sealed a major partnership with Beeson Gregory's university-focused subsidiary IP2IPO. Beeson Gregory is providing an upfront investment of £20m for the university's chemistry department to build new lab facilities. In return, the firm acquires half of the university's equity entitlement to any new spin-outs from the department over the next 15 years. "To our knowledge, it's the only agreement of its kind in the world," says IP2IPO chief executive Chris Wright. "By forming a partnership, the expectation is that we can create more value for the university as well as ourselves. "We expect to see a steady flow of spin-out companies in which we have a substantial equity stake. In the past few years, the Oxford chemistry department has spun out Oxford Molecular, Oxford Asymmetry, Oxford Biosensors and Opsys - we would expect at least that rate in the future."

World of knowledge
Spin-out rates in the UK are gradually catching up with those of the US, where high-performing universities such as Stanford and MIT have become bywords for academic entrepreneurialism (see below). Other European nations are also increasing their efforts, despite a general shift to later-stage investments. "Currently lots of VCs are afraid of taking the risk of going into seed capital investment," says Raf Moons, investment manager at Fortis Private Equity in Belgium, who manages seed funds at four Flemish universities. "But these companies are really built on technology and patents which minimises, or at least reduces, the risk."

The German government is meanwhile investing DM1.8bn in a three-year programme to encourage spin-outs from its universities, a move welcomed by the country's VCs.

First Ventury, based in Karlsruhe, is launching Germany's first risk capital fund aimed at technology transfer, with a targeted subscription of Euro100m. "There's been a lot of early stage investing, but not in research-to-business - we want to really get our hands dirty in working with scientists, engineers and entrepreneurs," says fund manager Michael Kelly. "In comparison with the US, Europe in general and Germany in particular is nowhere. The gap between academia and the marketplace is a lot greater here and that's a gap we want to help bridge."

The government programme will also overhaul the IP laws which give individual researchers unrestricted control over their research. Universities are to be given the responsibility for registering and marketing patents, and the lion's share of commercial revenues. Alexander Moscho, an associate at Atlas Venture in Munich, says: "This will cause some dramatic changes in overall technology transfer from universities, because when we have these huge institutions getting primary interest in technology transfer they will try to get more professional." The government investment includes DM100m for technology transfer services. "This is one area the government should focus on but they shouldn't do it on their own," Moscho says. "They should try to get in external partners like VCs and professionals from other companies to really create the most efficient and value-bringing approach possible."

The patent problem
Intellectual property remains at the heart of university spin-outs. With no marketable product and often minimal management, the exclusive rights to exploit some potentially world-changing technology is the nascent company's only real asset. But who initially owns the IP, and how those rights are then protected within the company, can vary greatly.

"In a lot of cases the university wants to keep hold of IP and just issue a licence, and that's a real handicap to getting funding," says Tooley. "Terahertz was assigned outright ownership of all the patents and knowhow we needed to build the company. That was hugely important because investors see that as a real strength."

Most UK universities claim ownership of all IP generated by its staff and students, but will usually assign it directly to a spin-out or to the technology transfer office generating the deal. "When a researcher comes to us and we want to work with them to exploit the research, we establish from funding records who is actually the owner of the IP," says Hockaday. "If it is the university, the university assigns the IP to Isis. It's almost always licensed from Isis into the new company. Typically the licences are for the duration of the patents, up to 20 years. We make a very clear commitment to spin-out companies that we licence technology into them exclusively for them to exploit."

This clear policy helped attract Beeson Gregory to Oxford. "We know there is no risk associated to questions of ownership in established who gets what value," Wright says. "There's just one organisation and we can enter into a quite simple contract. In all other walks of life it's normal for the employer to own all IP. I think the reason that's not been the case for universities is historically they haven't been aware of the value locked up in IP."

Sweden however maintains a system where individual researchers own the IP rights to their work. "The upside of the Swedish system is it enables more of and entrepreneurial spirit, so the scientist can move into the company if they want to and become an entrepreneur," says Gunnar Fernstršm, investment manager at InnovationsKapital, an early-stage investor founded by the university of technology in Gothenburg in 1994. "On the other hand, if those individuals want to stay with the institutions, it's difficult to clarify whether the company really owns the rights."

The important thing is that the spin-out has tight control of the necessary IP, whether through an exclusive licence or by outright assignment. Most investors prefer the latter.

"I'm a firm believer that if you're giving IP to a group of people to exploit and those people have a commercial motivation, those people are the best people to look after IP," says Peter Keen, managing director of Merlin Biosciences. "What very few people have actually thought through is it's all very well to hang on to IP, but what happens when a biotech spin-out then wants to licence the IP to big pharma? Big pharma is going to want to protect itself should the IP revert to the university."

Keen admits his antipathy to licensing comes from dealing with technology transfer offices that insist they retain residual rights. But most universities are now getting used to the harsh demands of serious VC investors. "There's no doubt the university technology transfer groups have come on leaps and bounds in the past three years," he adds. "They are much more flexible because they understand the reasons why it's in their interest to make sure the spin-out is successful."

The relative innocence of university technology transfer offices can work both ways, however. Moscho has made an exhaustive study of the terms of technology transfer deals, and believes that universities rarely get the best terms for themselves. "This boils down to the human factor," he says. "If you observe who is doing technology transfer at universities and research institutions, normally these people cannot really compete with their equivalents in biotech and pharmaceutical companies. Professionals in biotech are probably the highest paid individuals in these companies with a lot of experience and capabilities to do negotiations and get what they want."

From lab bench to boardroom
With some notable exceptions, the lack of commercial nous can also be seen among the founding researchers. "The key job that we have to do as VCs is to make sure we pair the academic excellence with some management excellence," Hauser notes. "It's rare that academics are also outstanding managers of the company."

Whether the researchers leave academia to work for the company full-time, as Tooley has with Terahertz, depends largely on the demands of the company and the preferences of the individuals. Often, the senior researcher will stay with the university but junior colleagues with less advanced academic careers will join the company. "When we talk about spin-outs, we're not talking about faculty taking their piece of IP and leaving the university and starting a business," argues Birley. "By and large the business will be run by hard commercial people and that's what the VCs want. They don't want a bunch of academics running it, and nor do the universities want to lose their academics."

Some VCs maintain a strong preference for the key researchers to join the company, however. "It doesn't make sense from our point of view to take the technology and have other people manage it," says Uwe Feuersenger, chairman of First Ventury. "Most of the value is in the brains of the researchers."

Future vision
With the explosion of interest in spin-outs over the past 18 months, the number of deals is set to grow further. "I think we're at the beginning of a major trend which will see a lot more substantial businesses built out of UK universities," says Purcell. "The area where it's got huge room for growth is value creation in these spin-outs. There haven't been many genuine spin-outs that have become substantial businesses. The demand's there, the technology's there, it's a question of marketing it right."

For VCs, the prime challenge will be in identifying the technologies with potential. Jim Martin at ADD says this is a question of when to invest as well as in what. "I remember seeing flatscreens 15 years ago but it's only now they're beginning to commercialise," he says. "If you invested 15 years ago you wouldn't have made any money. The important thing for VCs is to know what's going on in the universities because it helps us make more knowledgeable decisions about what's going to work and what isn't."

The dedicated, experienced investors will be the best placed to propel the market forwards, Hauser believes. "The problem is this is the hard end of venture capital, because you have to take a view on the technology at a very early stage, and this is a difficult judgement call," he says. "There's not many people willing to stick their necks out on that."

Lessons from the masters
Stanford University, located in Palo Alto in the heart of California's Silicon Valley, is where Europe's early stage VCs and technology transfer professionals look for inspiration. Together with the Massachusetts Institute of Technology, Stanford is regarded as a wellspring of entrepreneurial academics and marketable technologies. Surprisingly, neither Stanford nor MIT tops the league table for licence income, according to figures from the Association of University Technology Managers. New York's Columbia University and the sprawling University of California system take the top honours, followed by the relatively humble Florida State University, which owes almost all of its $57m licence income for 1999 to its patents on anti-cancer drug taxol. Where Stanford and MIT excel is in the sheer number of income-generating patents - 339 and 346 respectively in 1999, topped only by the UCal system's 715.

Stanford's Office of Technology and Licensing was founded in 1970, ten years before Senators Bob Dole and Birch Bayh sponsored an act assigning IP rights from government-sponsored research to the universities rather than to the individual sponsoring agencies. The Bayh-Dole act also stipulated that researchers receive a share of income. The number of invention disclosures at Stanford immediately doubled. "We have been doing it for a long time so we have kind of a reputation," says Katherine Ku, director of Stanford OTL. "The other factor is we are in Silicon Valley. We just play a small part in the whole entrepreneurial scene, but we do play a part."

To help attract outside investment, OTL offers a free online database of technologies looking for entrepreneurs. The majority of licences go to established companies rather than spin-outs, although the numbers still shame most European universities. Of around 130 licences granted this year by Stanford, 16 went to start-ups.

"We don't proactively try to start start-ups - we have to have an entrepreneurial inventor who wants to start up a company, then we will grant him the licence," Ku says. "What we do is try to make the technology visible to the outside world. Most of our technologies are very early stage, typically 10-15 years too early. Very often there's no-one who's interested except for the entrepreneurial start-up."

Stanford, like other US universities, maintains its ownership of IP and issues licences rather than assigning the IP, even with spin-outs. "The companies are going to want all the IP internally, but we wouldn't do that," Ku says. "We actually try and take an equity stake and also the royalties when it makes sense to do so."