Web Guide to Money & Finances

There are no comprehensive statistics available indicating how many successful exits have been undertaken by university spinouts, or the total amount of money that has been raised from selling equity since the spinout phenomenon began about 30 years ago. However, some information is available that can provide some pointers.

The majority of the spinout activity is in the major 20 universities in the UK. Up to December 2003, these 20 universities are believed to have spun-out about 700 companies in total. It is estimated that from 2004 onwards from all UK universities, 300 spinouts will be created each year.

By December 2003, approximately 20 spinouts had floated on the stock exchange, most of these being from Oxford University, although Cambridge University, Edinburgh University and Imperial College have had some notable successes. Although public listings of spinouts are likely to attract the most publicity, a trade sale is a more common exit for spinouts than a public listing. Examples of trade sales in the Cambridge Cluster were the acquisition of Adprotech by Canadian Inflazyme Pharmaceuticals (for an undisclosed sum); Meridica being acquired by Pfizer for £125 million; and Alphamosaic being acquired by Broadcom for £123 million (source the Library House/Grant Thornton Cambridge Cluster Report 2005).

Successful public listings from Oxford University have included Oxford Instruments, Oxford Glycoscience, Oxford Molecular, Powderject Pharmaceuticals, Oxford Biomedical and Oxford Asymmetry. Although there are individual success stories (and several academics and investors have made considerable fortunes from spinout companies), anecdotal evidence suggests that only about one in 20 (or 5%) of spinouts has, so far, been a success in the sense of providing a profitable exit for their investors.

Of course, many more spinout companies have been successful in generating revenues and employment for thousands of people (with several also generating operating profits for their investors) and time will tell whether the successful exit percentage will improve.

From the statistics above it could be concluded that spinouts have had limited exit success for their investors. To quote a leading academic entrepreneur:

‘British scientists, particularly those from our universities, have achieved considerable fame for basic discoveries they have made about such things as the nature of matter, the structures of DNA and the shape of the universe. However, they have an equally lamentable reputation for their efforts, or more accurately, their lack of effort, in making a profit from them.’

The Lambert Report stated:

‘Britain has a world class science base. In terms of productivity and quantity of output it rates fairly highly. But we rate poorly at commercialising that, so the question is what more can be done to make more of the science that comes into the market place?’ Assuming this to be true, what are the factors that inhibit the development of spinout companies, what things reduce their attractiveness to investors or purchasers, thus reducing their saleability and their exit value? Phrased in the terminology of this book, what are their barriers to exit, or impediments to sale?

As Christopher Evans (quoted earlier) has said: ‘Once created, university spinouts face the same challenges as any other start-up…’ and they will as a group generally have the same impediments to sale as other SMEs. But, from my research I believe that four impediments in particular are present in spinouts. These are: Management weakness. Protection of intellectual property (IP). Access to finance. Management/investor relations.

As is always prudent when considering business success or failure, we will begin by looking at the quality of the management.

One of the major pre-requisites for spinouts to receive funding from institutional investors is the successful exit of those investors. In theory, most of the exit options available to SMEs are available to spinout companies but, in practice, exit in spinouts is confined almost entirely to trade sales and public listings. Why is this?

The first way to answer this question is to ask why exit options other than trade sales or listings are not suitable for spinouts. Looking at them in turn:

Family succession. This exit is reserved for businesses in which the owner is an individual, with the majority shareholding who has a suitable heir and a business that is conducive to a family succession. Few, if any, spinouts fit this description.

Franchising. The nature of spinout companies is such that franchising is not a viable exit option. (Note, however that licensing of technology – somewhat related to franchising – is a common way that universities earn income from inventions or research.)

Sole trader merger. Spinout companies are not owned by sole traders.

Management or employee buy-outs. There is no reason why spinout companies cannot be sold to managers and/or employees, but I am not aware of one of any real size or significance that has been exited this way by its original shareholders. Besides a managed close down (which is not considered as a proper exit by purists) this leaves us with a trade sale and a public listing, or IPO.

For many academics the university shareholders’ agreement will be the first one they have experienced. However, when the company embarks on second round funding and the VCs produce their agreement, the academics should, in theory, be better equipped to deal with the agreement and, in particular, to negotiate such things as minority protection.

The following points should be noted about investor agreements:

The investor agreement will seek, above all, to protect the position of the investors. Because investing for profit is their business, it goes without saying that the investors will be intent on maximising their investment through an exit (usually within five to seven years) and will aim to ensure that the agreement facilitates this path.

Despite the experience of the academics when the second agreement comes around, the process of negotiating the terms of the agreement is usually one-sided: the investors have the money and, accordingly, they have the power.

With regard to an exit strategy, however, what is good for the investors (and the university) should, in pure monetary terms, be good for the academics also. The only issue of contention could be timing, as the academics might wish to continue in the business for longer than their investor partners.

There is no ‘right’ way to value business interests, as I explain in Appendix 1 and, consequently, any number of methods can be included in a shareholders’ agreement. Some of the methods that can be included and my comments on them follow below:

P/E ratio method

The widely accepted price earnings (P/E) ratio method, capitalises future maintainable earnings (or sometimes cash flow, or real profit). I favour this method as it the one generally accepted by the business world for valuing SMEs and because it can cope with changes in value that will arise from changes in annual profitability. But, as a word of caution, this method assumes that the current appropriate capitalisation rate will remain appropriate in the future, which is a reasonable assumption in times of stable inflation, but is not so reasonable in times of economic volatility (or in volatile industries) when appropriate rates of return (and, hence, capitalisation rates) can fluctuate considerably.

A valuation by the firm’s accountant’s (or company’s auditors) when the sale arises

The problem here is, firstly, that not all accountants are experts in business valuations and, secondly, it is open to either party to disagree with the valuation and dispute it in court.

A pre-determined amount that might be fixed in advance, or might be adjusted in line with some sort of inflation index
I consider this to be an unsatisfactory method, as values in a particular business can alter dramatically (for example, if their profits fall significantly), and often do so in the opposite direction of inflation.

Many businesses with co-ownership fail to draw up shareholders’ agreements, but even those with agreements in place often fail to address with any thoroughness valuation of interests being sold. This failure can result in agreements being vague and difficult to implement. The other common failure is that although the agreement contains adequate valuation methods, remaining owners make no provision for the funding of a purchase of the interests of the outgoing owners. We will now look at the valuation and funding methods that I believe business owners should consider.

A key question in the shareholders’ agreement is what value will be placed on the interests of the departing co-owner. Here shareholders’ and partnerships agreements can differ quite markedly, because in some partnerships (for example professional practices) no capital value is placed on the interests of incoming and outgoing partners’ interests, whereas this is almost unheard of with company shares. However, despite this difference in practical approach, what follows deals with general principles and, therefore, treats companies and partnerships as being the same.

The reasons for placing a value on interests in a shareholders’ agreement are, firstly, to avoid disagreement and misunderstanding amongst coowners and, secondly, the recognition of the potential problems innegotiating a price with personal representatives, executors, or beneficiaries under a will after a co-owner has died. The method of valuation should be agreed among co-owners and clearly laid out in the agreement. This should include a method of dealing with any changes in the value of the business between the time of entering into the agreement and the events that trigger the options.

I talked about the difficulties minority shareholders usually have in selling their shares and the fact that parcels of minority shares often sell at a discount. Here we will look at provisions that could be included to protect majority and/or minority shareholders in a company when the business is being sold to an outside party. In the case of majority
shareholder protection, the aim is to compel minority shareholders to sell their shares when the majority shareholder wishes to accept a bona fide offer for his shares from a third party. (This is known as a ‘drag-along’ provision.)

Conversely, where the majority wishes to sell, minority shareholders have the right to insist that their shares are also bought by the same purchaser at the same price per share. (This is known as a ‘piggyback’ provision.) Drag-along provisions are particularly useful for dominant shareholders who have brought minority shareholders into a business, or have issued shares of the same class as their own to employees, but who still wish to be in control of their own destiny, particularly with regard to their exit.

The ability to be able to sell all the shares in a private company is important because most purchasers usually wish to acquire 100% of the shares in such companies. The piggyback provisions guard against minority shareholders being left with outside and, potentially, unsympathetic majority partners and should also ensure that a ‘minority discount’ is not applied to the value of the minority’s shareholding.

Unlike the general pre-emptive rights clause above, these provisions address the transfer of interests following certain specific events. These events usually include the death, critical illness, retirement and bankruptcy of a co-owner and the dismissal of directors who are also shareholders for specified reasons. Here the co-owner in question (or his personal representative) effectively grants an option to purchase the interests of the departing shareholder or partner at a price predetermined in the agreement.

In the case of a company, the option is given to either the company itself or other shareholders; whilst in the case of a partnership, the option is given to the other partners.

It is the occurrence of the event that ‘triggers’ the options and where there is any room for uncertainty care must be taken to describe the events as clearly as possible. For example, the occurrence of death and a declaration of bankruptcy are quite unambiguous, but there might be more uncertainty surrounding critical illness or the reasons for dismissal of a director. Also, it is usually necessary to distinguish between retirement at usual (stipulated) retirement age and early retirement (which itself can be for various reasons, for example illness, or desire to join another business), as different types of retirement might give rise to a different valuation of the interests of the retiring co-owner. This is covered in more detail below.

(It is usual for these ‘cross-option’ agreements – so called because the agreement grants each party both a ‘put’ and a ‘call’ option – to be included in separate agreements, which are usually annexed to the general shareholders’ agreement.)

This provision states that if a co-owner wishes to sell his interests (shares or share of a partnership) for any reason he must first offer those interests to his other co-owners, who have the right, but not the obligation, to purchase the interests. This is known as a ‘pre-emptive right’ clause and covers those circumstances where the exiting owner wishes to sell, rather than being compelled to sell because of some event (for example, becoming critically ill). The exiting owner will either have had an offer to buy from a potential purchaser, or will desire to leave the business and, hence, would like to sell. The procedure laid down in the agreement is usually as follows:

In the case of an external offer, the remaining co-owners have the right to purchase the interests at the same price as the offer price.

In the case of there being no offer, the price to be paid by the remaining owners is laid down in the agreement. (How values are established in the agreement is covered below.)

A leading lawyer said recently: ‘The trouble is that when two people start-up in business they don’t think they will ever fall out. But a quarter of all business partners do!’ Similarly, a leading accountant recently wrote when providing advice on a dispute between partners: ‘It is very difficult to solve this problem because you do not have a shareholders’ agreement. We always recommend that every company with more than one shareholder has such an agreement.’

These are reason enough to be convinced of the need for a shareholders’ agreement and in an article below you will see others reasons why I believe a shareholders’ agreement is an essential tool in exit planning where there is more than one owner in a business. But, before we consider these reasons, I would like to look at the many misconceptions that exist amongst business owners concerning the need to have a shareholders’ agreement.