Equity Conversations Between PIs and Graduate Students
Negotiating an Equity Split with Your PI
It can be the most fraught of conversations. A graduate student working on research that shows commercial promise seeks a sit-down with his or her principal investigator (PI) about starting a company. How does that grad student or post-doc broach the topic of a university spin-out – and, most crucially, negotiate a fair equity split?
Students at universities around the country confront the challenge of that moment. Those at schools such as MIT, Harvard, and Stanford have a reputation for great success pursuing university spinouts. There’s a robust ecosystem of people, including faculty, alum, and adjuncts, who are versant in discussion of equity splits and “cap tables” (a capitalization table lays out everyone’s ownership stake).
Yet even at these strongholds of entrepreneurship, students and PIs need some handholding. When asked if through osmosis grad students know the basics of pursuing a university spinout, Leon Sandler, executive director of MIT’s Deshpande Center for Technological Innovation, said, “Not always. There’re often questions.”
While this article may be relevant to anyone contemplating a university spinout, below we offer guidance for those seeking to create a startup that grows out of work they’ve done under the tutelage of a BU professor. That guidance is based on interviews with serial entrepreneurs and venture capitalists (VCs) who have direct experience handling spinouts from Boston-area universities. All of them have been granted anonymity so that they could speak freely.
“Keep in mind, you’re talking to someone who is typically much older and more experienced and maybe a mentor,” one investor said. “There’s a huge power imbalance.” Maybe a PI has an overinflated view of his or her contribution to a project, or perhaps they have their own reasons for not wanting to see a company spin out from their research. Another VC warned that there’s not a one-size-fits-all approach given the very different PIs he’s observed over the years working with companies spun out of an academic lab. So, the first piece of advice: “Know your PI and adjust the conversation accordingly,” he advised.
Carving Up an Empty Suitcase
Divvying up ownership shares in a new startup can be delicate, no matter what the circumstances. One VC gave the example of five fellow students who cofounded an academic spinout. There was no faculty advisor involved so they sliced up ownership equally without thinking through the role each would play.
“The question they didn’t ask is, ‘Who’s going to do what?’” this VC said. “Who’s the CEO, who’s going to do the heavy lifting, who is part of the founding team but might be in another job in a year because they don’t have that same commitment?” He recommended having those hard conversations before formalizing an ownership arrangement, whether with classmates or a member of the faculty. “That way you can save yourselves a lot of headaches—and save your investors headaches—down the road.”
No matter who the participants are, the equity split discussion is invariably an emotional one. “Equity is emotional because it’s a discussion about something that doesn’t yet exist,” said one serial entrepreneur. The stakes are high, of course, yet the odds are very good that ultimately the entity will be worth nothing. “At the beginning, you’re carving up an empty suitcase,” he said.
One investor brought up the famous line from Thomas Edison, “Genius is one percent inspiration and 99 percent perspiration.” Maybe your PI had the core insight that gave rise to a startup. His or her reputation secured the funding that made a student’s lab work possible. But this investor said what others also emphasized: the lion’s share of equity in a startup needs to be reserved for those willing to sweat and sacrifice to build and grow a company.
“Most investors will tell you, ‘Look at who’s going to provide what contribution moving forward,’” said someone who has spent the past two decades working with angel investors and VCs focused on university spinout. “It’s not about what has been done to date.”
Russ Wilcox, a partner at Pillar VC, a Boston-based venture firm, posted an article on his firm’s website under the title, “What to Expect When You’re Spinning Out a Deep Tech.” Wilcox estimated that around half the investments made by Pillar, and Petri, its pre-seed fund, have been in companies that spun out from a university. He suggests that a founding team adopt a “20-80” rule. Up to 20 percent of the company should be set-aside to reward the “creators” (professors and students alike) who came up with the technology or idea that gave rise to a company. Wilcox stresses that many creators deserve less than 20 percent (that depends in part on how close a product is to commercialization), and even then, Wilcox wrote, that portion should be allocated “mostly according to each founder’s ability to help the idea overcome future thorny technical challenges.” In other words, if a PI has no role beyond advisor moving forward, then the student(s) deserve a much greater share of that up-to-20-percent cut. The remaining 80-plus percent should be reserved for those devoting themselves to the new startup—founders taking executive positions with the company and future employees. “A first principle I follow is most of the equity should reward the people doing the work,” one investor said.
PIs typically have no intention of giving up their academic perch to risk everything on a startup. There’s the rare professor able to pick up a phone and secure millions in venture capital on behalf of an enterprise but otherwise they are in the “creators” category and the limits in equity that implies. “The IP (intellectual property) is a very important thing but it’s transient, and there’s all these other things that are required to start a company like raising money, hiring people, and doing the hard work of developing the product, talking to customers, and getting sales going,” said a seed investor who frequently works with companies born in an academic lab. “That’s why the PI who stays behind deserves only a modest cut of a spinout.”
Besides, there’s a second way that a PI might receive compensation. A university licensing deal must be hammered out when a company wants to use IP born in an academic setting. In that scenario, the PI would receive royalty payments should a commercial enterprise be successful. “So, if they’re the inventor, if they came up with the core technology, they’re getting compensated through a licensing event,” the seed investor said.
Who’s Driving the Bus?
Those interviewed for this article stressed that a student needs to be prepared for what, by any measure, is a very important conversation. “Don’t just wing it,” one advised. Seek out others who have experienced a university spinout: startup founders, other academics, advisors. Find “comps” –comparable situations – in order to make the conversation as concrete as you can. Then, when sitting down with a PI, respectfully lay out what you have in mind.
“You should explain to your professor that your career goal is not in academia but doing a startup and ask them his or her stance on whether the research that they’re working on in the lab might be suitable for what you have in mind,” a VC said.
Some PIs might be delighted to hear what you have in mind. Maybe they deep down always thought their idea had commercial potential even if personally they were built for the academy rather than startup life. “In that scenario, I would ask the professor if they would support me,” the VC continued. “Basically, present it as you’re driving the bus, and then ask if they would like to be [your] advisor as [you] go through this.” The role a PI plays moving forward, even when they maintain their academic posting, will help inform the equity stake question.
Yet a PI can be reluctant about a spinout for multiple reasons. One reason, said a VC, might be that a professor does not have full faith in the technology. “And if people pour in a lot of money, it’ll be clear it doesn’t work and it’ll humiliate them,” he said.
Maybe a PI is a perfectionist who believes that an invention still needs a few more years in the lab before it might be ready for a spinout. There’s a common culture clash when the commercial world, which is fast moving and profit driven, intersects with academia, which moves more slowly and is research driven. Maybe a professor’s goal is a great publishing opportunity rather than the potential payoff of a startup. One VC said a PI can be like a parent reluctant to let go of a child ready to leave home.
“Keep talking about it, reassure them, remind them of the role they can play as an advisor,” this VC suggested. Like any negotiation, this might take time and require patience and handholding. Investors suggest that, in the meantime, students work on a business plan. That might help sharpen the arguments that the market timing is right.
To help negotiations along, sometimes a third-party – someone in the university’s entrepreneurship or licensing office – can help, according to those interviewed. That can help defuse any tensions. Another experienced hand taking part in the negotiations can also even up the power balance.
Cap Tables Are Not Set in Stone
Every investor interviewed here has seen their share of spinouts with an out-of-balance cap table “because of greedy people, or scared people, or stubborn people,” as one described it. Sometimes that means a startup dies before it is even launched. But they also offer reassuring words for grad students with entrepreneurial dreams who might be confronted by a PI who demands too great a share of a new company.
For one thing, if an idea is compelling enough, a poorly negotiated cap table won’t scare off most investors. For another, that cap table is not set in stone. “If a VC thinks a cap table is out of whack, there’s usually some haggling,” one VC said. The VC’s goal is to make sure those doing the hard work are duly motivated by their ownership stake in a startup, he said, adding, “If a professor has the attitude, ‘Well, this invention wouldn’t exist except for my lab so I deserve most of the value even though I don’t intend to do any work,’ we’ll give them something but make sure if they don’t reduce their share, we don’t have a deal and then their ownership stake will be worth nothing.”
By Gary Rivlin