One business, numerous careful owners

A spin-out that has successfully negotiated its start-up and early stage funding may well have a varied group of investors. This can include the originating university, one or more business angels, venture capitalists as well as the academic entrepreneurs themselves.

As members of this group begin to look for exit strategies, tensions may emerge. While the university and, up to a point, the business angels, may be more relaxed about timescales, the VCs will have a definite timescale for the completion of their fund and satisfying their investor community. The research project will have to be pragmatic and product-focused, which may lead to conflicts with academics who are more motivated by scientific discovery. The academics in their turn will be coming to a decision as to whether they return to academia or remain in the commercial world.

Maintaining funding at this stage might mean further rounds of VC investment, but this is not the only option. The option of grant funding should be investigated and any company with heavy research costs should investigate R&D tax credits. R&D tax credits can be a fantastic source of funding but need to be approached with some caution. The scheme, introduced in 2000, had some teething problems but has been strengthened recently with clearer guidelines, improved benefits for smaller firms and specialist training for tax officials.

The Ernst & Young Enterpriser Survey 2006 found that the R&D tax credits obtained the highest positive response among entrepreneurs out of all the government initiatives in developing and supporting enterprise – 42 per cent of the survey considered them to be either very or quite successful. However, the early problems mean that the Revenue will inspect each claim very closely indeed. There can sometimes be an “expectation gap” between what the firm believes is genuine R&D spending and what the Revenue is prepared to accept as truly innovative research.

Claiming the credits means that time spent on research has to be carefully documented and justified, and the benefit may be offset by the need to seek specialist tax advice. Claiming R&D tax credits can also lead to conflicts with other sources of funding, as some grants cannot be claimed at the same time as the credit. Any funding programme that results in changes in the ownership structure also needs to be closely monitored. The scheme has safeguards to prevent large companies spinning off loss-making research into subsidiaries and claiming tax credits. If, for example, a new round of funding takes the proportion of the company owned by the VCs over 50 per cent, a claim for tax credits may be challenged on the grounds the company is no longer independent. The same would apply if a larger company took too big an equity stake.

Deals with larger entities should not be ruled out, however. A life-sciences spin-out could license an early version of a product to a more established pharmaceutical company as a way of funding other developments. This sort of deal frequently involves the larger company taking an equity stake to provide further funds. Alternatively, a trade sale of the whole company can also be the final exit route for investors, and the best route for the company and its product. It’s worth bearing in mind that larger companies may also be researching the same areas as spin-outs. A small firm that has already made considerable progress towards a marketable product can be a highly attractive proposition. Conversely, an idea whose stand-alone market potential is looking weak might prove to be highly complementary to a larger corporation’s portfolio.

Private equity funding has grown considerably in recent years. It brings in a fresh investor group and can be prepared to work to longer timescales. A management buy-out of the venture capitalists funded by private equity could be a valid alternative to a trade sale or an IPO.

Although IPO activity is well below the frenetic levels of 2000-2001, there have been a number of successful ones recently. The Alternative Investment Market (AIM) is attracting good quality companies and is not regarded as the poor relation to the main market. This can be an attractive proposition for a spin-out. A main market IPO is also possible, although more demanding to achieve. The IPO is often when the original community of investors begins to break up, as business angels and venture capitalists exit or dilute their holdings. Some of the founding academics may also depart, although key entrepreneurs will often be tied in for a number of years depending on how critical they are to the business.

Once again, the change in finance and ownership of the company will change its internal dynamics. However, because the company is now owned by a broader set of shareholders it is, in many ways, not as dominated by them. The CEO and CFO will find their roles change dramatically, as they become increasingly dominated by investor relations – particularly the need to spend time with investors who do not have direct board representation. While this may not be the last time the company seeks funding, the route to that funding is more defined.

Article by Christine Oates, an Ernst & Young tax partner based in Cambridge who advises fast-growth and listed technology and biotechnology companies on R&D tax credits, intellectual property, overseas expansion and tax structuring of mergers and acquisitions.

Marc Barber

Marc Barber

Marc was editor of GrowthBusiness from 2006 to 2010. He specialised in writing about entrepreneurs, private equity and venture capital, mid-market M&A, small caps and high-growth businesses.

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