Stephen P. Rothman, Esq.
Drafting Win-Win Startup Licenses
The University Startup Company Law Firm
California
Massachusetts
Florida
www.rothmanandcompany.com
steve@rothmanandcompany.com
(310) 993-9664
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Overview
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Why licensing to an academic start-up is different
Taking licensee equity as consideration
Different legal structures for startups
Different financing sources for startups
Dilution
Participation Rights
Board observer rights
Registration rights
Information rights
Litigation
Field limitations and commercialization diligence requirements
Milestones and milestone payments
Restrictions on assignment
Flexibility on terms and conditions
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Why licensing to an academic start-up is different
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They typically start with little cash
It’s usually not clear yet if the technology will be commercially viable
They need to attract investors
The investors expect large returns to compensate for the risk
Many of them will fail
Often have a long development phase
Some modest percentage of them will change the world and become extremely valuable
Those that succeed may look very different from when they started:
• The business plan
• The technology
• The people
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Impact of startup characteristics on licenses
Startup Characteristic
License feature
Little cash
Low or no up-front fees, milestone payments; replace
with back-end royalty and equity
Risky technology
Need to give up more to attract licensee – broader or no
field limitations; easier on milestones
Need investment
Need to think about how terms affect fundability
Some will be home runs
Need to still have meaningful equity if that occurs
Startups change a lot
Flexible license structure and willingness to renegotiate
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Sample License Provision
Granting Equity
Licensee agrees to issue to University, in partial consideration
of Licensee’s receipt of the licenses granted under this
Agreement, that number of shares of common stock
representing four percent (4%) of the outstanding common and
preferred shares on a fully diluted basis, of Licensee pursuant
to an agreed upon stock purchase agreement between Licensee
and University. The stock purchase agreement will contain
provisions protecting University against dilution of its equity
interest in the event the post-money valuation of the A round is
less than ten million dollars ($10,000,000.00), and it will also
contain a provision for the piggy-back registration of common
shares with any other class of stock in an initial public offering.
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Types of Entity
• “shares of common stock”
• Two types of startup entity, corporation and limited liability
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company
Corporations issue “stock” or “shares” and are owned by
“stockholders” or “shareholders”
LLCs issue “membership interests” or “units” and have
“members”
License provisions re equity have to be different for LLC
versus corporation (discussed more below)
Which you are dealing with will normally be in the name –
Inc. or Corp. meaning corporation and ,LLC meaning limited
liability company
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Class of Stock
• “representing four percent (4%) of the outstanding
common and preferred shares on a fully diluted
basis”
• Common Stock and Preferred Stock
• Convertible Preferred Stock
• Participating Preferred Stock
• Participating Preferred Stock with cap on
participation
• Junior and senior preferred stocks
• All defined in certificate (articles) of incorporation
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Class of Stock 2
• Cash investors normally get preferred
• liquidation preference usually equal to price
• With or without cumulative dividends at specified %
• With or without participating feature and cap
• Founders normally get preferred
• What does university licensor get?
• Always have seen common stock but consider a preferred
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stock junior to cash investors but senior to founders
Specific cash liquidation preference is a dollar amount, not
subject to dilution, but also not subject to enlargement
May encounter resistance
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“Fully diluted basis”
• “representing four percent (4%) of the outstanding common
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and preferred shares on a fully diluted basis”
What is “on a fully diluted basis?”
Capitalization Table:
Security
Amount
Common Equivalent
Convertible debt
$A
B shares
Convertible
Preferred
C shares
D shares
Common Stock
E shares
E shares
Options
F shares
Warrants
G shares
Total
H shares
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“Fully diluted basis 2”
• In the startup world, usually used to mean - assume every share
of common stock that could be issued on account of outstanding
securities were issued
• Generally includes unvested options, and also includes shares
issuable upon exercise of options not yet granted but reserved for
grant in an employee option pool
• Accounting definition more involved than that – Statement of
Financial Accounting Standards No. 128 “Earnings per Share”
• “Treasury stock method” for options
• If using the term, include a definition
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“Fully diluted basis 3”
“Fully Diluted Shares” means the number of shares of common
stock that would be outstanding if (i) all convertible debt and
convertible preferred stock were converted, (ii) all outstanding
warrants were exercised, (iii) all outstanding stock options
(regardless of whether vested) were exercised, (iv) all shares
reserved for issuance under an employee stock option plan or other
incentive compensation plan for service providers were issued,
whether or not grants of options to purchase such shares have yet
been made, and (v) all other outstanding convertible securities or
other rights to acquire common stock were fully converted and / or
exercised; no deduction from Fully Diluted Shares shall be made in
respect of any receipt of option exercise prices or relief from debt
upon conversion of convertible debt.
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Dilution
• “The stock purchase agreement will contain provisions
protecting University against dilution of its equity interest
in the event the post-money valuation of the A round is
less than ten million dollars ($10,000,000.00)”
• X% on a “Fully Diluted Basis” referred to a snapshot of the
current capital structure
• This clause is talking about future dilution
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What is “Dilution?”
• Investopedia definition: “A reduction in earnings per share of
common stock that occurs through the issuance of additional
shares or the conversion of convertible securities. Adding to the
number of shares outstanding reduces the value of holdings of
existing shareholders.” Does it?
• SEC Reg. S-K Item 506 “Dilution” – “where . . . there is
substantial disparity between the public offering price and the
effective cash cost to . . .” insiders . . . disclose increase in net
tangible book value per share to insiders and decrease to
purchasers in the public offering
• Term is used either to mean mere reduction in % ownership or
reduction in value as a result
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Dilution 4
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“The stock purchase agreement will contain provisions protecting
University against dilution of its equity interest in the event the postmoney valuation of the A round is less than ten million dollars
($10,000,000.00)”
What is wrong with this formulation?
Meaning of “dilution” is not clear
What the “protection” is if dilution occurs is not specified
What is an “A round?”
• They mean a Series A Preferred Stock financing
• That name comes from the convention of naming successively
authorized series of preferred stock sequentially by letters of the
alphabet
• But that’s not certain to occur. There can be a Series A-1 and Series
A-2 financing. There can be a Series 1 financing.
• What if the company does gets “strategic” rather than VC financing
and issues common stock?
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Revised Anti-Dilution Clause
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Alternative A-1 (Corporation, fixed percentage subject to limitation):
Until the Termination Time as defined below, if and when the Corporation issues
additional shares of stock of any class, whether for financing, compensation or
other purposes, the Corporation shall also issue to the University that number of
additional shares of [common] stock as is necessary such that the University
continues to own X% of the Fully Diluted Shares. The Termination Time means any
of the following events, whichever is earliest to occur: (a) the closing of a round of
equity financing with net proceeds to the Corporation of not less than [$2][$3][$W]
million] at a per share valuation that is equivalent to valuation of the entire
Corporation immediately following such financing not less than [$6][$10][$X]
milllion; (b) the Corporation’s receipt of [$3][$5][$Y] million in Strategic Financing
[or government grants], that is not in connection with any equity financing; (c) the
Corporation’s receipt of revenue from the sale of products or services in excess of
[$2][$3][$Z] million; (d) Sale of the Corporation, or (e) five years from the date of
this Agreement. [Definitions of Strategic Financing and Sale of the Corporation on
final slide]
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Revised Anti-Dilution Clause
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Alternative A-2 (Same as A-1 but for LLC):
Until the Termination Time as defined below, if and when the Company issues
additional Units or membership interests of any class, whether for financing,
compensation or other purposes, the Corporation shall also issue to the University
that number of additional [Class X] Units as is necessary such that the University
continues to own X% of the Fully Diluted Shares. The Termination Time means any
of the following events, whichever is earliest to occur: (a) the closing of a round of
equity financing with net proceeds to the Company of not less than [$2][$3][$W]
million] at a per Unit valuation that is equivalent to valuation of the entire
Company immediately following such financing not less than [$6][$10][$X]
milllion; (b) the Company’s receipt of [$3][$5][$Y] million in Strategic Financing [or
government grants], that is not in connection with any equity financing; (c) the
Company’s receipt of revenue from the sale of products or services in excess of
[$2][$3][$Z] million; (d) Sale of the Company or (e) five years from the date of this
Agreement. [Use definition of Sale of the Corporation with conforming changes]
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Revised Anti-Dilution Clause
Alternative B (more modest – triggered only by dilution in the sense of sale of
issuance of equity for under fair value) (drafted for corporation here)
[Until the Termination Time as defined below], if and when the Corporation issues
additional shares of stock of any class, except as provided below, [at an effective
price per share of Common Stock of less than $X] [or, for consideration other
than fair value], the Corporation shall also issue to the University that number of
additional shares of [common] stock as is necessary to compensate the
University for the resulting diminution in value of the University’s stock.
[Termination concept probably not needed if the fair value formulation is used.
Otherwise define the same as in prior slides.] The provisions of this Section X do
not apply to (a) bona fide grants of stock or stock options to employees or other
service providers in exchange for services [in customary amounts] or [in the
aggregate not exceeding [20%] of the Fully Diluted Shares; (b) grants of warrants
or other equity in connection with bona fide debt financing transactions with
lenders other than Affiliates, . . . [possibly other exceptions] or (c) any other
transaction approved by [the University or a director of the Corporation designated
by the University]
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Participation Rights
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Right to invest cash to maintain pro rata share in future financing (after
any percentage anti-dilution has expired)
This is a “gimme” – won’t encounter resistance nor give up other things
for the right
Request even if the institution never invests cash in startups
Right can be assigned and has value
Make sure language makes it assignable
Osage University Partners, http://www.osageuniversitypartners.com/
$100 M fund that invests exclusively in the start ups of our academic
partners — universities, hospitals, and federal labs.
8 University Partners (original participants, exclusively assigned
participation rights and 45 Associate Partners (non-exclusive
rights). Right to invest is subject to 50% co-investment right by
institutions.
Invests in both early and late stage financings across all technology
sectors, including life science, clean energy, advanced materials
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Sample Participation
Rights Clause
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Pro Rata Participation Rights
If the Company proposes to sell any equity securities or securities that are
convertible into equity securities of the Company, then the University and/or its
Assignee (as defined below) will have the right to purchase up to that portion of
the securities issued in each offering that equals the University’s then current,
fully-diluted percentage ownership of the Company on the same terms and
conditions as are offered to the other purchasers in each such financing. The term
“Assignee” means (a) any entity to which the University’s participation rights
under this section have been assigned either by the University or another entity, or
(b) any entity that is controlled by the University.
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Sample Participation
Rights Clause 2
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Percentage Participation Rights
If the Company proposes to sell any equity securities or securities that are
convertible into equity securities of the Company, then the University
and/or its Assignee (as defined below) will have the right to purchase up
to 5% of the securities issued in each offering on the same terms and
conditions as are offered to the other purchasers in each such
financing. The term “Assignee” means (a) any entity to which the
University’s participation rights under this section have been assigned
either by the University or another entity, or (b) any entity that is
controlled by the University.
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Board Observer Rights
Allows monitoring of investment
Doesn’t entail responsibilities (potential liability) associate with director
position
Old sample clause:
“Licensee grants the Institution the right to have the Director of Technology
Transfer or any other person that the Institution may designate as his
replacement present as a nonvoting observer at all meetings of the “Board”
and all meetings of the Executive Committees of the Board.”
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Better Board Observer
Rights Clause
Licensee grants Institution the right to have the Assistant Vice President of
Technology Transfer or any person that Institution may designate as his
replacement present as a non-voting observer at all meetings of the board
of directors of Licensee (“Board”) and all meetings of the Executive
Committees of the Board. Institution’s Board observer will receive all notice
of meetings and documentation, including but not limited to all minutes,
reports, agendas, actions, resolutions, and consents that other Board
members receive. Observer rights shall survive termination of this
Agreement so long as Institution owns at least 1% of the outstanding shares
of Licensee stock on a fully diluted basis.
Better, but should include all committees, not just Executive Committee,
because authority that can be delegated to a committee is not limited by its
title.
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Registration Rights
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Just because company is public doesn’t mean you can sell all your stock
Restricted Securities covered by SEC Rule 144
Dribble out rules
Exception after holding period if not an affiliate
May need SEC registration to sell
Only Company can effect the registration
Registration rights permit this
Investor registration rights agreements long, complicated and rarely
enforced
“Demand” and “Piggyback” rights
“Underwriter cutbacks”
University license reg rights I have seen limited to piggyback rights
180 day lockup
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Sample Registration
Rights Clause
The stock purchase agreement will also contain a provision for the piggyback registration of common shares with any other class of stock in an initial
public offering.
Not really. Probably need to define piggy-back. The actual IPO is the least
likely offering for selling shareholders to have or exercise registration rights.
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Better Registration Rights Clause, Short Form
Could have a full-blown registration rights agreement (may be over-kill). See NVCA
IRA
Or to save trees and time, see below
Note: this one drafted for LLC, but LLCs generally don’t go public in that form
If Newco (or a corporate successor of Newco) registers Class A Units (or other
securities issued to the holders of Class A Units upon any conversion to corporate
form or other reorganization) under the Securities Act of 1933 for sale to the public,
Newco (or such successor) shall similarly register the Class B and Class C Units (or
other securities issued to the holders of Class B or Class C Units upon any conversion
to corporate form or other reorganization), on a pro rata basis, and shall take such
other action as may be required to provide the Class B and Class C Units with the same
liquidity as holders of the Class A Units. Notwithstanding the foregoing sentence,
holders of Newco securities may be required to execute a customary underwriters’
lockup not in excess of 180 days.
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Information Rights
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Absent contract or public company context (stock exchange and SEC
rules), rights to info defined by state corporate law
May not be very extensive
Put in contract
See form of Investors’ Rights Agreement from a VC deal, or:
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Balance sheet, income statement, cash flow statement
Annual, quarterly; monthly?
Annual budget and comparisons to budget as provided to board
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License Provisions re Patent Litigation
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Prohibits the licensee from challenging patent validity.
Rationale is prevent licensee from having cake while also eating it
Situations where a licensee would legitimately challenge patent validity, that
should be excluded from the prohibition.
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If the validity of the patent has been struck down by a court in litigation with
another party. That leaves the other party free to exploit the technology
without paying a royalty, which puts the licensee at a competitive cost
disadvantage.
Where third parties are infringing the patent and the university is not
enforcing it. This would primarily occur only if the university thought the
patent were likely invalid. Again, it puts the licensee at a disadvantage.
Where the challenge is part of a good-faith disagreement about the scope of
the patent. Licensee wish to protect itself against unreasonably broad
interpretations of the claims.
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License Provisions re Patent Litigation 2
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Pre-allocating litigation proceeds
Giving the university a larger share of infringement litigation proceeds than its
royalty percentage.
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A party taking an exclusive license is buying rights within the exclusive field.
Whether they end up exploiting rights to the licensed technology by selling
products, granting sublicenses or suing infringers, they are still exploiting the
same rights they have paid for.
The split in value between the licensor and the licensee should not depend on
the fortuity of whether some third party happens to infringe the patent.
If pre-allocating proceeds, determine the volume of sales that would have resulted
in a profit margin equal to the net proceeds from litigation, after deduction of
litigation costs (whether ordinary damages or punitive damages).
Then the licensor’s share of the proceeds should be the percentage royalty applied
to that hypothetical volume of sales.
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License Provisions re Patent
Litigation 3
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Refusing to allow the licensee to pull the university into infringement litigation.
Legal doctrine of “standing” -whether a particular party is entitled to sue for unlawful
conduct.
A patent owner can clearly sue for patent infringement.
A non-exclusive licensee of a patent clearly cannot sue for infringement (after all, even if
they won, the patent owner could just give a license to the infringer, so there is no point in
allowing such a suit).
Courts split on whether an exclusive licensee is allowed to sue an infringer, and in some
cases the suit can only go forward if the patent owner is a party. Hence patent licenses
should allow an exclusive licensee to require the patent owner to join an infringement suit.
Situation where the infringer happens to be a university donor and the university does not
consent to being brought into an infringement suit. Then if the licensee is in a jurisdiction
that requires the patent owner to participate in an infringement case, the licensee is ay be
unable to enforce rights, making “exclusive” license actually non-exclusive
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Field Limitations and
Commercialization Diligence
Requirements
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Rationale is to assure full exploitation
Some universities require exploitation in multiple potential fields of use as a condition of the
licensee’s maintaining exclusivity in each
But early stage investments are very high risk
All fields license versus 5 different fields with milestones in each and loss of exclusivity in
each if milestones not met
Someone who is prepared to invest $5 million in a startup technology should reasonably be
able to claim all of the economic benefits of the technology, even if they are not pursuing
every possible application simultaneously
Different from relatively advanced with relatively certain near-term applicability at the time
of license grant to multiple truly distinct fields.
Investing against tough odds, yet it could turn out that the technology really has
commercial potential, but not in the specific field that the licensee first pursued
Possible compromise is compulsory sublicense but only as a last resort, notice, lengthy
opportunity to pursue other field
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Restrictions on Assignment
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Consent or cash payment is sometimes requested if the license is assigned.
Investors don’t see rationale
Company that has paid for a particular technology expects to own it whether it turns out to
be most fruitfully exploited through the initial licensee or an affiliate or unaffiliated
transferee.
Transfer is generally the ultimate point of the license – the investor seeks to make a profit
when the technology, with perhaps some added development, proves more valuable than at
the time of the original license.
Stated rationale for requirement is sometimes transfer without adequate consideration
outside of entity where institution has equity; but that’s addressed by law of fraudulent
conveyance.
Difficult for investor to accept restrictions on assignment other than (i) notice; (ii)
assumption of obligations; (iii) perhaps payment of nominal expenses; and (iv) perhaps
solvency of assignee.
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Certain Definitions
“Strategic Financing” means a transaction or series of related transactions in which (a) the
Corporation receives funding for research and development or other purposes related to
development of the Corporation’s technology or business, from a potential customer, potential
supplier, potential joint venturer or other commercial enterprise, and (b) the consideration
given by the Corporation for such funding is not primarily the issuance of equity securities or
securities convertible into equity securities.
“Sale of the Corporation” means any transaction or series of related transaction as a result of
which (a) a sale or other transfer for consideration of 50% or more of the Corporation’s voting
equity securities; (b) a sale or other transfer for consideration of all or over 50% in value of the
Corporation’s assets (excluding sales of inventory in the ordinary course of business); or (c) a
merger or consolidation to which the Corporation is a party, unless at least 50% of the voting
equity securities in the surviving or resulting entity continue to be owned by Persons who were
stockholders of the Corporation prior to such transaction; in each case ((a), (b) or (c)), where the
purchaser or successor entity is not previously an Affiliate (X) of the Corporation or (Y) of any
Person holding 5% or more of the voting or economic interests in the Corporation prior to such
transaction(s).
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Certain Definitions
“Person” means a human being, corporation, limited liability company, partnership,
Massachusetts business trust, other trust, estate, or other form of legal entity.
An “Affiliate” of a Person is another Person who controls, is controlled by or is under
common control with the first Person.
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Questions?
Stephen P. Rothman, ESQ.
ROTHMAN AND COMPANY, P.A.
www.rothmanandcompany.com
E-MAIL: steve@rothmanandcompany.com
(310) 993-9664
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