There are several reasons licenses make sense. First, startups can leverage the knowledge and resources of research institutions. Second, it can save R&D costs of basic research on fundamental shifts in science and technology. And, third, it can allow a startup to leverage the reputation of the granting institution. If the value of the license is figured properly into the economics of the license, your path to funding and commercialization can be smooth.
Herein lies the rub. Institutions often measure readiness in terms of TRL (technology readiness level). We always measure readiness in BRL (business readiness level). The two are not the same and rarely line up. TRL’s don’t take business risk into account. It appears the logic required to split an atom and that needed to get venture financing are mutually exclusive. Thus, we see the fundamental divide between R&D and commercialization.
Licensed technology from universities and government laboratories are RARELY, bordering on never, ready for commercialization by startups leaving these businesses in a precarious position. They can’t raise capital upon the license alone because the underlying technology is not yet ready for commercialization, and the granting institution will no longer put resources into the project. May startups seek grants to bridge this gap. Otherwise, the startup is faced with dwindling cash resources supporting product development, license fees, and operations. Most don’t survive this previously undocumented “chasm” (al la Moore).
The other great challenge is the granting institution’s mentality and track record. It is a small industry. As investors, we hear which institutions “get it” and which ones are simply not worth pursuing. An institution gets a bad name quickly if they issue the wrong terms or expect startups to fund their success. When we hear of licenses coming out of certain facilities, we are automatically leery. That is never good for the startup seeking capital. This is all to say, the granting institution can be a credibility builder or a boat anchor. And, it is hard or impossible for an entrepreneur to know on the front-end of the deal which one he/she is getting in the bargain.
The first lesson is learn to identify the hallmarks of a bad license deal:
- Licensing of technology before demonstration at bench scale (licensing a concept and a patent)
- Expectation of significant R&D investment to reach beta product ($500k limit for non-biotech)
- Reimbursement of patent fees before sufficient cash flow (should be deferred until the company has EBITDA of at least $2.5M)
- Fields of Use that are overly restrictive preventing investors from exploiting the full value of the technology (e.g. seek a platform/enterprise license)
- Overly restrictive minimum royalties
- Overly restrictive ongoing royalties
- Any expectation of funded research at the licensor’s facility
So, once a company approaches us with a license, what do we do?
The second lesson is what we look for in a license:
- The IP portfolio must be strong and defendable.
- We are looking for seminal works in the space that erect clear barriers-to-entry to fast followers.
- We are looking for issued patents with the intent file internationally.
- We are looking for prior art in the space and for references to the IP from others to validate its worth.
- We are looking for technology that can be commercialized on a reasonable budget and on a reasonable timeframe.
- We are looking for a licensing team that has some clue about how startups are funded and grow. We are looking for an institution that is prepared to put the correct business terms in place to give a startup its best chance at funding and survival.
- We are looking for an institution that is committed to technology transfer. We fund teams with great ideas and technology, not R&D institutions.
- We are looking for a license team that understands the fees, equity, and royalties must be commensurate with the market opportunities! We use the 25% rule. That is 25% of the expected net profit can be allocated to the licensor prorated by the relative contribution of the licensed IP vs. the full IP backing (assuming more than one portfolio of IP is used in a product).
This is all to say, even the most promising technology must conform to the expectations of investors.
The third lesson is investors don’t value licensed technologies in the same way they value homegrown, company owned IP. Investors don’t like license fees, min. royalties, patent reimbursement, or ongoing royalties because these are all costs that take money away from operations and come off the top line revenue. I saw this in stark reality in my past work with a government lab generated IP in one of my companies. I did not realize, as a young entrepreneur, that the terms we agreed to were an albatross around the company’s neck. We had to renegotiate the license three times. In retrospect, the last iteration resulted in good terms, but we spent too much time and energy getting to the correct endpoint. That company did not survive. The license deal was one of the major underlying modes of failure for that company. We paid for a lot of patents and license fees instead of product development. It is not hard to understand the cause and effect in hindsight.
Investors especially don’t like “Fields of Use” at all. The reason is simple. We are paying for developing and commercializing a technology. Most licenses essentially say that anything that is discovered, unless exclusively discovered by the licensee in the process, inures to the benefit of the granting institution and automatically added to the license with the company). That in-and-of-itself is not a problem until you realize that means the granting institution can then sublicense these advances to other licensees of the same technology in other Fields of Use. In other words, your product development capital fuels advances in the technology which are shared with other licensees. Why would an investor pay for R&D for a technology that is going to be shared with other companies and receive zero value back? The institutions will say the other licensees work in reciprocal fashion, but I have never seen that happen in an equitable way. This is why we insist on an institution that is committed to tech transfer and helping the startup create its own IP. It also means the granting intuition needs to issue a platform/enterprise license or take the underlying technology to the point it can be commercialized. The first option is challenging at best for most institutions, especially government labs. The latter option is almost impossible for them because of their complete lack of understanding of marketing, product-market fit, capital raising, and sales processes.
Many startups have taken the approach that they will fund additional research at the lab of origin. That rarely works. Investors want to build capacity inside the company, not inside someone else’s lab…at the staggering overhead rates of most labs. Therefore, startups can rarely raise capital to invest resources into the lab of origin. And, there are problems with IP ownership if you do so.
The fourth lesson is beware of the undocumented gaps that licensing creates! If we find a mismatch between the money required to complete the product development and the money the company could command from investors, we walk away. You won’t be able to raise enough capital to hire the proper subject matter experts and the facilities necessary to commercialize the technology……depending on the revolutionary nature of IP. The more revolutionary in nature, the greater likelihood of funding, but the greater requirement of high cost SME’s. In my experience, it is very hard to find true high risk/reward entrepreneurs in this group of SME’s. That can become a serious flaw in your corporate chemistry and economic and culture stress points in hard times, which are inevitable. I have seen a number of ventures with incredible tech, die simply because the inventor is impossible to work and reason with creating a corporate implosion.
If you, Mr/Ms entrepreneur, find yourself in the gap between license and commercialization, search for maturation funds from the lab or origin, SBIR’s, state grants, accelerators, etc. to bridge the gap. Don’t waste your time pursuing investors. I will not be a fruitful use of your time, money, and energy.
So, what drives investors to invest in these companies?
Investors want access to ground breaking science and technology. But, remember, investors don’t invest in ideas, technology, IP, or even companies. They invest in people in markets they like and understand. It is understood the science has to be sound, the technology development is well understood, and a product is demonstrable and in beta testing with credible clients before any professional investment is going to be made. Too many investors have lost money on promising technologies that went nowhere. They invest in execution now, not potential. So, it is not just the technology and team that must be outstanding. If you license, the licensing team must be equally outstanding.
So, what should you take away from this? Why is this all so important?
Here is the crux. Big companies are doing less and less R&D (see Early Exits by Basil Peters). They rely on startups to license, prove, and establish a market for technology. Then, they cherry-pick! So, there are GREAT opportunities to license great technology from institutions across the Heartland. And, there are typically willing acquirers (do your upfront homework on acquirers BEFORE licensing the technology!). But, if you don’t get the terms right on the front-end of the effort, you have already nailed one foot to the floor at the start of the marathon. We have talked a lot about investors. Please remember that you have to look an acquirer in the eyes with a straight face and disclose the license terms too!
The last point is something few startups really understand, let your investor be the bad guy to renegotiate a bad license deal! Nothing is more compelling to a licensing entity than investor’s cash on the barrel contingent on having the correct license terms. Angel investors are your partners in the deal. Let them add value to the benefit of all!
Copyright Eric L. Dobson 2017
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