October 27, 2010
Frugality has become the watch word in the start-up blogsphere. It is rare to find a blog that doesn’t advocate lean business models, unpaid founders, and generally spending as little as possible. We are told that the new development tools dramatically lower the cost of your first product and that investors correspondingly like to focus on ventures that burn very little money. All this is true if you are working on a Web2.0 start-up but often completely inappropriate for university spin-offs. There are two major reasons for this: higher cost base and better cost recovery opportunities.
The cost of development for anything other than application software actually hasn’t decreased all that much in the last few years. Costs will still be high for any project that has a hardware component or core technology concept requiring more than a bit of code mash-up. The obvious part of this is the cost of materials and tools but there is a much bigger factor. Building a physical product or developing a core technology requires more professional experience and seniority than most application software. Web software development is a relatively new field and consequently has a lot of readily available young developers (and few “old hands”). If you are working for example on a core technology in camera sensors you will probably need at least a few guys who have been doing sensor engineer for decades. Those skill sets cost money in payroll, working conditions and benefits – all numbers that keep going up rather than down.
Operational aspects of a university spin-off will also be radically different from a Web2.0 start-up. You will generally engage with large companies rather than consumers. That triggers a need for more travel and often more senior business executives to create parity in customer interactions. The rebel kid might be seen as cool in customer-facing outreach to the sub-30 crowd in San Francisco (though the VCs cleaned up even Mark Zuckerberg’s act real quick when things became serious) – trying it in a meeting with Japanese executives at Sony isn’t going to get you very far.
Finally, patents are the lifeblood of most university spin-offs and their cost has only gone up over the years. Add in the related legal cost of licensing and your budget will look a lot different that a start-up with two guys in a garage.
These cost aspects aren’t just luxury. I am not talking about gold-plating your office toilet or hiring executives just because you can. These expenditures are integral aspects of launching your venture out of a university. I have seen the success and failure of this critical mass concept first hand. Early on at Sunnybrook Technologies we had two independent inventions in the company. Both were promising ideas that addressed major market opportunities (Kindle-like electronic paper displays and LED TV – though a decade ago we didn’t call them that yet).
We initially bundled the two concepts for economy of scale and to gain the benefit of multiple “working founders” (something that is intrinsically hard in university spin-offs due to the individual focus of graduate research). After the first Angel round and early development these benefits started to become less relevant so we split into Sunnybrook Technologies and CLEAR Technologies. At Sunnybrook we fairly quickly went on to hire experienced people while CLEAR operated mostly as a research activity at the university. Sunnybrook had a successful exit, CLEAR languished and eventually died.
The difference wasn’t attitudes or skills. Both technologies had the same shareholders and founders, same board members, and similar technological foundation (in fact the same primary inventor). If anything CLEAR had a much deeper initial patent portfolio, more university support, a very talented PhD student investigator (back then I was just an undergrad) and in fact was consistently rated as the bigger opportunity by everybody involved (including myself). Back then electronic paper (CLEAR) was already on the visible horizon while controlled LED-based displays (Sunnybrook) seemed only viable for high end applications such as medical displays.
So what happened? Looking back, I think Clear never achieved escape velocity out of the research program. While there was a lot of research funding, CLEAR never had (or raised) the funds to add experienced business executives or engineers (except a few part-time consultants during different phases). As a result the company was unable to pursue business opportunities with the required focus and bound to the development speed of universities (including the need to explore new science with each wave of students rather than continuous product development). I think most individual decisions made within CLEAR and Sunnybrook were sound and rational (and usually made by the same people), they just happened in two very different environments. Achieving critical mass at Sunnybrook created an environment where aggressive forward progress was mandatory and the tools to make it happen where available. We were still a shoe-string operations but the core dynamics were very different.
University spin-offs cost more money than Web2.0 start-ups is the summary so far. Fortunately, there is also a positive financial effect of building a university spin-off: You can get a lot more money. Very roughly we had about a 1:1 match between invested money (causing dilution) and directly useable non-investment money (not causing dilution). It’s going to be nearly impossible for a traditional start-up to achieve that much verage.
University research grants are the most obvious “free” money, especially early on. Most university spin-offs only come into existence after a long period of research at the university. That investment has value and would otherwise have to be paid for with raised money. Post-launch it is a bit trickier to leverage university grants because their time scale is so vastly different than the needs of a fast-moving start-up. It can still be done but the more sophisticated strategies deserver their own article in the future.
Another source of “free” money are commercialisation grants such as I2I or IRAP here in Canada, government supported scholarships, and so forth. Those usually take the format of research grants but focus on commercial deployment. While they are available to all companies, most require some form of technical risk or discovery. In my experience it is very easy for a university spin-off to meet these requirements and very challenge for a regular start-up. University spin-offs will usually have patented technology, deeply published science and PhDs or Professors as founders. Web2.0 start-ups have a website and some mash-up software. The major cost advantage of being able to use existing open source software elements to build your product actually turns into a disadvantage when it comes to this kind of cost recovery.
The last cost recovery option is probably the most dramatic one in Canada: Scientific Research and Experimental Tax credit (SRED). Depending on your province this allows you to recover 60-80% of all R&D-related cost (and associated overhead). Not as an offset against income but as a straight reimbursement. You spent $1M on eligible research and a little after the end of the year you get $600k-$800k back. This is enormous
leverage if you can get it. Again, it is available to all technology companies in Canada but can be obtained much more effectively by university spin-offs for the same reasons as above. I don’t know a single university spin-off that doesn’t come close to the top of SRED percentage while most traditional start-ups seem to have difficulty achieving more than half of the possible claim size. This gap will only widen as the government tightens the definition of “experimental development”. In particular in Quebec there are now also alternative options to get additional tax credit such as the new 10 year corporate tax holiday for companies commercialising university innovation. Like SRED, that’s a big deal and can save you a lot of dilution.
As a simple example, a university founder can pay herself $100k per year. She gains about $60k after personal income tax deduction and the company recovers about $80k via SRED (in Quebec). It’s suddenly viable to pay an founder a very competitive salary, especially if the payroll enables the founder to invest into the company in the future (re-investing $20k creates a net zero result for the company cashflow, still leaves the founder with $40k net and even some extra equity).
This is a highly simplified scenario (you have to own the $100k in the first place!), but it illustrates the power of these recovery options. As a real example, Sunnybrook raised about $800k in equity financing, obtained a comparable amount in direct cost recovery (IRAP & SRED), and over $1M in directly related research grant funding (2002 to 2004). Add to this several well-funded years of pre-launch research work at the university and the leverage is phenomenal. Even better, the free money is available exactly for this purpose: productize innovation and create jobs (many of my past hires still hold post-acquisition jobs in Vancouver years later – mission
Combine these two factors and you get very different budget dynamics for university spin-offs compared to traditional start-ups. Frugality, hunger for success, and careful growth management are still absolutely essential for the success of any venture, spin-off or start-up, but the requirements and opportunities in the two worlds are fairly different.