Preparing biotechs for spin-out and beyond

Part 2: The spin-out process – a practical guide

By William Kilgallon and Jeremy Rowson

In Part 1 of this article, we looked at the formation of biotechnology spin-outs from a broad economic perspective and the impact of the recent budget. Now we will consider the process in more detail from the spin-outs’ perspective.

The spin-out process can differ in each case, but typically follows the pathway of:

• Idea validation (pressure testing)
• Preparing for spin-out
• Spin-out
• Growth/Scaling
• Exit.

Here, sometimes following decades of research, the innovation is disclosed to the university. An evaluation is made as to its viability in terms of commercialisation, its stage of development and whether additional work or funding is required to take the concept forward. An initial discussion will usually take place between the academics and the university regarding the sharing of revenues from the commercialisation of the idea.

A team should be created including academic staff plus external commercially and financially experienced members. The team should produce a business plan including operations, manufacturing, human resource (HR), sales and marketing strategies. Financial forecasts will also be prepared to determine the economic attractiveness of the project, the pre-money valuation, likely phased funding needs and the likely returns on investment, given the risks involved, for potential investors.

The team should now appoint legal advisors and receive initial tax advice. The company should be incorporated, and directors appointed.

Xantho Ventures

The spin-out team negotiates with the university over buying/licensing the intellectual property (IP), the university’s equity in the new company and the role, if any, that the university will play in the future of the company. A Shareholders’ Agreement and Articles of Association for the new company will be negotiated that reflect the arrangement agreed between the founders and the university. Other key actions include: opening a bank account; appointing accountants; installing accounting systems and procedures; adopting HR policy frameworks and governance systems.

At the end of this process, the company will exchange shares for an initial investment from the university and the university will often require representation on the company’s Board of Directors

The company should implement its business plan, including a communications plan that includes branding, website, email and social media strategies. The necessary company infrastructure will be put in place, including buying equipment and possibly moving to new premises.

The spin-out team, together with its financial and legal advisors, should produce an Information Memorandum, including pitch decks to attract more funding from VC/PE funds and angel investors. The spin-out should apply for SEIS/EIS approval from HMRC.

At an appropriate time, the investors will want to liquidate their investments. Typical exits include a full or partial sale of the company’s shares to a competitor or strategic partner, an Initial Public Offering (IPO), or sale to another PE company.

The three main issues faced are:

1. Difficulties in assessing business opportunities from university research
2. The flexibility and experience of universities dealing with commercialisation in general
3. An ability to access the right finance at the right time to maintain cash flow and accelerate growth.

The assessment and valuation of business opportunities and associated risks of any concept that is still pre-revenue is fraught with difficulty. This issue is compounded because of the highly technical nature of projects in the medical/biotechnology sector. In the course of guiding companies through Innovate UK’s ICURe programme and other accelerators, we have seen variations of emphasis and approach to this very important subject. One of the key issues is that within any university there will be a very wide range of specialised research ranging, for example, from engineering and molecular biology to food technology.

As a result, it would be unusual for technology transfer offices (TTO) to have the breadth of technical expertise to be able to properly engage with scientists and business professionals across all these areas of interest. To overcome this, universities need to develop meaningful relationships with local business specialists who can better guide the academics down the commercialisation pathway. Always, however, be conscious of the fact that TTOs represent the interest of the university, not the spin-out.

The Royal Society Entrepreneur in Residence (RS EiR) programme. which operates across the whole of the UK, provides funding for industry experts who are linked to individual university projects. The industry expert can both educate academics in business processes and support the whole commercialisation process. The legacy programmes developed should bring more harmony and success to the commercialisation of academic research.

Many universities are new to commercialising research and lack experience with spin-outs. However, a number of universities are skilled in this process and provide good examples for others. Transparency and flexibility will be discussed later in this article; however, it is certain that these universities, skilled in the process, could support and guide others. Typical and best practice is laid out in the government’s 2023 Independent Review of University Spin-out Companies.

Because of the history of innovative commercialisation of university research over the last two decades, universities embarking on this process should not compare and contrast how they are doing with other well-grounded and experienced institutions. It’s not a fair playing field. Rather, universities should decide their own pathway and speed of growth in this sector, being able to tap into the resources necessary to facilitate their progress. Fundamentally, this means being outward looking in respect to advisors, both from the business and finance areas.

Again, the Royal Society’s Entrepreneur in Residence programme is a very good example, where EiRs can advise, support and execute research commercialisation. We have had first-hand experience of this programme and can say that it was fully rewarding, and this is the universal observation that we have encountered from liaising with other EiRs across the UK.

Securing investment for any new business starting out in today’s market environment is both difficult and complex. The chart below gives a broad indication of the various forms of finance available at the different stages of company development. This ranges from government grants and business angel investments to venture capital (VC) and private equity (PE) funds.

The most critical journey for a newly formed company is to navigate through the cash-starved ‘valley of death’ to the later stages of commercialisation where products and services contribute to positive cash flows. This is where many new companies become unstuck and fail.

Securing early-stage funding for biotechnology spin-outs can be very difficult because of the conditions that VC companies and other investors place on their investment capital. These early-stage investors are often very cautious due to the high risk, long development timelines and the complexity of biotechnology research.

In addition to this, start-up companies in this sector are, by the nature of the science utilised, capital intensive in that they require sophisticated technology to advance their research and manufacturing capabilities and trials can be prohibitively expensive. This is a double-edged sword in that although the science may be first class and the potential rewards are lucrative, the risks for the investor will be high in the early stages of development.

Each of the funding sources has drawbacks for the founders. Business angel investment is traditionally of low amounts and funders often have to pitch to several groups to obtain significant investment. The time and effort here may not be so rewarding. With VC investment, although the size of the investment is typically of a much larger magnitude, more equity and control of the business can pass to the investor.

Government grants (Innovate UK) and incubators such as ICURe have a very important role to play in early funding rounds. The disadvantage of Innovate funding is that the demand from small companies is very high while the supply of funding is quite low; for example, the SMART innovate grant success rate is estimated to be very low.

Crowdfunding can be successful; however, the company will have to deal with a very large number of shareholders.

Xantho Ventures

From discussions held with a number of spin-outs from universities across the UK, a common theme expressed to us is the frustration in dealing with university personnel regarding the spin-out process and the details therein. This is particularly apparent when dealing with universities that are new to this environment, rather than those more experienced with the process. In practice, this challenge needs to be grasped, acknowledged and rectified if the commercialisation of university research innovation is to spearhead growth in the UK economy as laid out in the Chancellor’s Budget Day address.

University equity stake is another issue. A recent report highlights that higher university stakes reduce the likelihood of further fundraising success and that reductions in university stakes are also associated with increases in the spin-out rate. A recent government report (Independent Review of University Spin-out Companies, Nov 2023) highlighted the need for more ‘innovation-friendly’ university policies towards spin-outs. This will take a mind shift in attitude. Flexibility is critical when negotiating between universities and spin-outs. Spin-out deal transparency, within the ecosystem across the UK, will also reduce the incline of the learning curve and the time taken to reach agreement for both parties.

Universities have a central role to play in giving birth to new spin-out companies. They need to have a mind shift in attitude from using their potential investment muscle as a controlling measure to a more collaborative partnering model with spin-outs, for the good of both organisations and the economy in general. A true win/win situation for all.

References are available on request.