Orrick's Founder Series offers monthly top tips for UK startups on key considerations at each stage of their lifecycle, from incorporating a company through to possible exit strategies. The Series is written by members of our market-leading London Technology Companies Group (TCG), with contributions from other practice members. Our Band 1 ranked London TCG team closed over 200 growth financings and tech M&A deals totalling $3bn in 2023 and has dominated the European venture capital tech market for eight years in a row (PitchBook, FY 2023). View previous series instalments here.
When academic research breaks new ground, it has vast potential to provide new commercial opportunities.
One of the main ways to commercialise academic innovation (often built on years of fundamental research) is through the creation of university spin-outs – newly incorporated companies whose core product comes from university-owned intellectual property ("IP").
Home to some of the best research universities in the world and a vibrant startup and early-stage investment ecosystem, the UK is in a prime position to foster some of the world's leading university spin-outs.
In the twentieth instalment of Orrick's Founder Series, our Technology Companies Group offer top tips to help navigate key considerations when raising external financing.
Look out for Part 2, which will delve into the second element of the university spin-out equation: IP assignments and licensing arrangements.
- Incorporating your spin-out. The first step in the spin-out journey is to incorporate your private limited company.
Although a relatively easy process administratively, incorporation is also often the perfect time to discuss fundamental commercial terms, including the equity split between the founders. Having these discussions early will ensure alignment from the start and will open up further discussions about rewarding past contribution and incentivising future growth. (See more on this in section 3.)
The founder equity will be issued at incorporation, most likely over ordinary shares.
This is also a great time to decide which founder(s) will be appointed to the board and consider board composition more broadly. (See more in section 9.)
- Due diligence. Most venture capital investors will insist on some form of legal due diligence. This is especially so in IP-intensive university spin-outs, where investors will want to ensure that any licensing or assignment arrangements allow the company to use the IP to commercialise the idea and that IP important to the company is adequately protected (see our Founder Series instalment on Protecting Your Ideas for more on this).
A template due diligence questionnaire can provide you with the building blocks to start populating your data room early – the sooner the better.
- Considering your cap table. Your cap table will include a number of key players, namely the founders, the university, a share option pool and the incoming institutional investors looking to fund the spin-out. You can read more on cap table considerations in our Founder Series instalment on Getting to Grips with the Cap Table.
The founders: At the time that the research idea is spun out, founders will choose whether to retain their research and teaching roles at the university or to join the spin-out full time. This will impact:
- The portion of equity which they will hold in the spin-out.
- Whether they will hold this equity directly or through the university (see below).
- The type of options / equity they will hold. In particular for founders intending to continue to be actively involved with the spin-out, it is worth considering whether they should be issued shares (which can be made subject to reverse vesting, see section 8 below) or granted options (subject to a vesting schedule), to ensure they have an incentive to stay with and grow the business. This will also be influenced by tax considerations, and founders should seek personal tax advice on this point. If options are used, consideration should be given as to EMI eligibility for founders maintaining dual roles. See our Founder Series instalment on Incentivising Your Team for more details.
The university: In recognition of the university's role in creating the innovative ecosystem and infrastructure which fostered the original idea and, in most circumstances, providing the initial funding to bring the idea to proof-of-concept, the university is one of the key and larger shareholders sitting on the cap table at the outset. The university will often hold between 10-25% of the fully diluted share capital of the company, although this could be significantly more in specific circumstances. The university's equity holding is tightly linked to the terms of the licensing agreement, with the university's ultimate position sitting across the two elements. (We will explore in more detail in Part 2.)
The university may also hold shares on behalf of university investors, pursuant to existing arrangements and/or founders who do not intend to remain actively involved in the spin-out and will not hold equity directly.
One of the key considerations impacting the balance between the equity held by the founder(s) and the university will be the degree to which the IP involved is university-derived.
The share option scheme: To power the growth stage of the company, the company should consider approving a share option scheme (and related share option pool). By providing an opportunity to benefit from an increase in the company’s valuation through share option grants, options can play a crucial role in offering attractive compensation packages to facilitate recruitment. See more on the data around share option pools in 2023 in our Deal Flow 4.0, and more on options in the Founder Series instalment on Top Tips to Follow to Incentivise Your Team.
- Institutional investors will often require a preference (most commonly a 1x non-participating preference) through a new preferred class of shares.
In uncertain markets we have seen different multiples of non-participating preference, as well as instances of participating preferences (allowing investors to "double dip"). This is generally uncommon and can lead to misalignment of incentives between the parties in a university spin-out.
- The investment structure. You might find that your lead investor is keen to close, but that your round is not yet fully subscribed for and/or some investors need more time to complete. You might therefore consider structuring your round to accommodate rolling closes, i.e. a close/multiple closes that will occur within 30 to 90 days from the initial close to bring in additional or late investors. All board, shareholder and investor consents should be obtained at the initial close to avoid the additional administrative burden.
Where the investment is for a larger sum, you may also find investors in university-spin outs requesting that their investment be tranched i.e. where funds are released subject to certain key performance milestones over a period of time (typically between two to three years). These should be clearly set out in the documents to ensure alignment and achievability at the outset.
- Other shareholder rights. There are other shareholder rights, including drag along, tag along, pre-emption rights and rights of first refusal, which are common across any financing transaction. These are all discussed in greater detail in our Founder Series instalment on Top Tips to Follow to Get Ready to Raise.
- Licence agreement. One key element of a university spin-out is the role and origins of the original IP, which is university-derived. To account for this, the university may enter into a licence agreement with the spin-out, to license the rights to use the IP. The university also may transfer the IP to the spin-out in exchange for economic and other rights. These could take a myriad of forms, including upfront payments (e.g. repayment of any patent fees incurred by the university), annual fees, development and sales milestones and royalties. There is a lot to unpack here, and we will explore in Part 2 the key terms and considerations in any licence agreements and the interplay between the economic benefits under licence agreements and the equity position of the university.
- Leaver provisions. Once incorporated and ready to receive external investment (e.g. from venture capital funds), one of the key concerns for incoming investors will be to ensure that the founders' interests are sufficiently tied to and aligned with the future growth of the business.
After all, especially in the early stages and in knowledge-intensive businesses, the investors will be investing in the founders' unique talent and expertise of the product and within the sector in which the spin-out operates.
The investment documents will therefore likely include reverse vesting / leaver provisions over founder equity, which put some or all of their equity in the company "at risk" (i.e. subject to re-purchase or conversion into economically worthless deferred shares) during the vesting period.
The market standard position is a four-year vesting schedule, with a one-year cliff, meaning that a lump 25% of the founder shares vest after one year, with the remaining 75% vesting monthly over the remaining three years.
What makes a "Good Leaver" or a "Bad Leaver" is crucial to provide founders with clarity on the potential implications on their shareholding. You can include additional tiers of "leaver" (e.g. "Intermediate Leaver") where the particular circumstances require more refined treatment of founder equity in different "leaver" scenarios. See our Founder Series instalment on Top Tips to Follow to Get Ready to Raise for more details.
- The board of directors. The composition of your board of directors can be a vital element of the company's early growth.
Appointing a university member to the board to provide guidance at the early stages and to help establish an appropriate strategy can be incredibly helpful. That person can also act as a bridge with the university, in particular in respect of any licensing arrangements and continued use of any university resources.
You should consider tying their board appointment right to an equity floor (i.e. a minimum % shareholding of the company on a fully diluted basis), such that the board appointment right "falls away" if the university no longer meets the equity holding % threshold. This ensures that board appointment rights "move" with changes to shareholding, rather than remaining evergreen (even after it is no longer appropriate for the university to hold such right).
Once below the threshold, and to the extent helpful for the company, you may consider transitioning the university's right to an observer right. Through this, the company can continue to benefit from the expertise of the observer, but they will not be entitled to vote on any decisions of the board. The company and the observer should enter into an appropriately robust confidentiality agreement to protect the company’s confidential information (often discussed at board meetings). Unlike directors, board observers do not have a duty of confidentiality to the company by operation of law.
More broadly, a company should consider the board composition as it grows to ensure it remains nimble and able to make decisions quickly.
- Regulatory considerations. The UK National Security and Investment Act 2021 (the "NSIA") now impacts investments involving fast-evolving technologies (e.g. artificial intelligence, advanced robotics and quantum technologies), which may give rise to national security risks face increased scrutiny in the UK.
The NSIA strengthens the UK government’s power to block or impose conditions on corporate transactions in 17 "high-risk" areas of the UK economy with a mandatory notification regime and criminal sanctions for failure to comply.
University spin-outs which fall within these "high-risk" areas will need to give (and will likely be required by their incoming investors to give) additional considerations to the NSIA, which shouldn't be overlooked.
We built Orrick’s UK NSI Assessment Tool to help UK and foreign companies and investors navigate these complex rules.
Our London TCG practice reflects London’s role as one of the world’s leading financial markets and a centre for international commerce. Nothing inspires us more than helping tech companies develop novel strategies and push boundaries. Through our extensive client portfolio, deal volume, and relationships in the tech ecosystem, we provide commercial and legal insight to each company’s strategy. We work with tech companies on all aspects of their business plans: financing strategies, protecting intellectual assets, retaining talent, securing and monetising data, and advocating for innovation-friendly public policy.
If you would like more details on any of the issues above, please contact Jamie Moore and Kristy Hart.