In 2021, over £2.5 billion was invested into UK spin-out companies, up from £405 million in 2012. Whilst no two spin-out processes are quite the same, we explore some of the key considerations for all interested parties.
Spin-outs typically involve creating a new private company limited by shares and either transferring or licensing the relevant intellectual property rights (IPRs) to that business.
The key parties tend to be:
- the founder (e.g. a student, research associate or academic leading the research);
- the university where the founder is based; and
- a third party investor (e.g. a public body designed to encourage innovation or an investment business seeking to profit from the success of the idea as a business).
The early planning phase of a spin-out involves drafting incorporation documents, selecting directors, dealing with governance or servicing issues and deciding the way IPRs will be managed.
The founder(s) and university should consider how much authority they want to delegate to the directors of the new company. Examples of this include the power of directors to allot new shares and the inclusion of pre-emption rights designed to prevent equity dilution in future funding rounds. It is common to see universities having at least one representative on the board of the new company to have an influence on the decisions that will impact the trajectory of the new company.
The key parties may also want to incorporate provisions into the new company’s articles of association that allow for a future clawback of a founder’s shares if they leave the spin-out or otherwise decrease their contribution to the development of the new company. This provides stability by dissuading founder(s) from departing early.
It is important that directors are aware of their fiduciary duty to shareholders. It can be challenging for founders to wear three “hats”:
- that of the driving force behind an idea;
- that of the director with a duty to exercise independent judgment, promote the success of the company and avoid conflicts of interest; and
- that of a member standing to benefit from the financial success of the spin-off.
To avoid this potential conflict of interest, it may be advisable for a founder to appoint a director from the university or third party investor, who may have more expertise in knowing how to grow a business and seek out investment opportunities. This will also have the added benefit of enabling the founder to focus on the technology involved and thereby maximise the new company’s chances of success.
The core value of a company incorporated as part of a spin-out can often be the know how relating to a particular technology. Here, it is important for the parties to ensure that director/employment contracts and company policies define any confidential information and include restrictive covenants with respect to that information so as to reduce the risk of information being shared with competitors.
Assignment or a license?
There are typically two models for how IP rights are dealt with in spin-outs:
1) IPRs are assigned to the new company;
2) the university retains the IPRs but licenses them to the new company.
An assignment is likely to be preferable to a founder but may require them to give the university a larger share of equity. The benefit of an assignment is it will give the new company more flexibility as they will not have to take into account any license conditions. This may appeal to future investors who might be concerned about the licensor withholding consent or not renewing the license. The drawback is that any claims levied in relation to the IPRs will be against the new company which may not have the resources to litigate effectively.
The license model is more beneficial to the university as they are likely to receive royalties based on the profits generated by the IPRs, thereby enabling them to monetise the assets without having to be as heavily involved in the day to day management of the new company. However, it is worth noting that founders will commonly request an exclusive license; this means that a university could be locked into a new company which is failing to fully exploit the IPRs by way of exclusivity provisions. Furthermore, universities may be required, especially where there are third party investors involved in the spin-out, to provide substantive warranties to the new company, which may at a minimum request confirmation of ownership but could go substantially further.
Special taxation rules for spin-outs
Where founders receive shares in spin-out companies, these are likely to be “employment related securities” for tax purposes. This means that absent relief, the share award would trigger income tax (and potentially national insurance contribution) liabilities calculated by reference to the market value of the shares that are issued to the founder. This could be particularly problematic where there is significant value in the spin-out as the founder may not have funds available to pay the resulting liability.
In recognition of the important role that spin-out companies play in advancing the commercialisation of technology in the UK, the government introduced a special tax relief with effect from 2004. This relief operates by excluding the value of certain IPRs when determining the market value of the shares on which the employment related securities tax charge is calculated. In the context of spin-out companies where the value of IPRs is likely to constitute a very material proportion of the overall value in the spin-out company, the relief can be very generous (although, if the spin-out derives value from any other source, there could still be a tax liability for the founder when the shares are issued).
The relief is available provided:
- there is an agreement to transfer or licence IPRs from a research institution to a spin-out company;
- the shares in the spin-out company are acquired before the transfer or within 183 days thereafter;
- the opportunity to acquire the shares has been made available to the founder by reason of their employment (either with the university or with the spin-out company); and
- they are involved in research in relation to the IPRs that are the subject of the transfer agreement.
We anticipate that spin-out companies will continue to be a popular mechanism to monetise the UK’s leading research in life sciences and technology. We provide a more in-depth look at life sciences academic spin-outs on our OTP hub: “University spin-outs: recent sector activity, investment trends and deriving value for academic institutions.”
Any parties to the formation of a spin-out company should carefully consider the issues discussed, taking into account their own respective strengths and weaknesses, so that they establish suitable governance to ensure the long term success of the business.