Chapter 5

Emergence of the SME as a Source of Market-Ready Technologies

Daniel Satinsky, JD, MALD

Introduction

In the evolving open innovation technology market, savvy entrepreneurs are using an emerging model for developing new technologies that is particularly suited to small and medium enterprises (SMEs). Every entrepreneur knows something about using a start-up or spinout vehicle for realizing his or her dreams of technological and financial success. However, those dreams meet unexpected obstacles with very long business development timelines. In this chapter, we introduce another type of SME, the “spin-up,” as an alternative and quicker route to market.

The specific purpose of the spin-up SME is to capitalize on the opportunity created by the confluence of open innovation and the growing number of early-stage technologies. Spin-ups are SMEs formed with the specific purpose of being acquired or of disposing of the technology under development. They are not intended to become fully functioning companies in their market segment. Under the right circumstances, a spin-up can be a much better vehicle for successful technology commercialization than its better-known cousins, the spinout and the start-up.

The keys to success for a spin-up include the ability to identify an early-stage technology that could find market demand, a team combining entrepreneurial and technical skills, intellectual property (IP) that can be protected and later marketed, market intelligence to adapt the technology to market requirements, funding from available grant and investment capital sufficient to finance the development cycle, and an exit strategy aligned with the overall model. Taken together, this model can be described as a spin-up model.

The fundamental institutional forces that lead to the creation of spinouts, start-ups, and spin-ups, as shown in Figure 5.1, are the same. All are part of the growing trend for an SME to become a source for market-ready technologies. The differences between these different types of SMEs have to do with the different functional purposes for which each is formed. For our purposes, the common basis for all three is the existence of a new technology that appears to have the potential for profitable use in the market. The difference has to do with the ultimate intentions of the founders for each type of SME.

Start-ups and spinouts are founded with the goal of becoming fully functioning companies selling products or services. There is much written about start-ups and spinouts, almost with a mythology of their own. However, from our examination of market trends, we believe that there is an opportunity for spin-up companies in sectors not related to biotech, social networking, gaming, or Internet marketing and service delivery. There is an important gap in the open innovation environment for spin-up companies in providing market-ready, innovative technologies for the more traditional industrial and service sectors that are also undergoing continuous growth and technological change.

Our use of the term spin-up as outlined in this chapter is unique and different in its goals from those of a spinout or start-up. We have conceptualized a spin-up as a model in which promising early-stage technologies are moved up the technology readiness level (TRL) to increase their ultimate value as component parts in a supply chain or as part of a product line. The goal of a spin-up SME from the beginning is to bring the technology into the open innovation market for acquisition by others, either through licensing or through acquisition of the spin-up company.

The business model for a spin-up company rests on a quicker route to market than a spinout or a start-up. The financial model for the spin-up company is based on monetization of the spun-up, developed technology, minus costs for the initial technology licensing, company formation, operations, and development.

Formation of a Spin-Up Company

The basic roadmap for a successful spin-up SME can be summarized as follows:

1. 1. Select a technology that has been evaluated to have commercial potential.
2. 2. Identify the tasks necessary to move the technology to a commercially viable level of technology readiness, expressed as a technology development plan.
3. 3. Create a new legal entity (Newco) to hold the IP rights in the technology and to develop it to a commercially viable TRL.
4. 4. Identify and recruit the development team, including at least a lead principal investigator (PI) and a business manager for Newco.
5. 5. Apportion the equity in Newco to reflect the interests of the inventor, the PI or business manager, and others who are critical for the technology and subsequent successful operations of Newco.
6. 6. Negotiate and close on an option to license the technology to Newco, a no-cost option if possible.
7. 7. Identify the lab or prototyping facility for implementing the development plan.
8. 8. Identify the source of funding for the spin-up company activities and closing the financing for project activities. Depending upon the funding source, a reapportionment of equity may be necessary at this time.
9. 9. Begin executing the technology development plan to raise the TRL of the technology.
10. 10. Exercise the technology license option if the development appears likely to succeed and take a full technology.
11. 11. Market the upgraded technology to a potential licensor or acquirer.
12. 12. Negotiate and close a license deal, including payment of any deferred license or patent fees or sell the company in total.
13. 13. Distribute proceeds or put in place plan for distribution of annual royalties.

The main success factors for practical implementation of this model are technology, team, IP, funding, and an exit plan. All of these factors are described in more detail in the chapter.

Open Innovation Market Opportunity for the Spin-Up Model

As indicated in the introduction to this book, multinational and large companies increasingly look for “outside-in” innovation. This outside-in perspective is that of the large company. The flip side of this formulation is the perspective of the SME that supplies the innovation to be taken in by the multinationals and large companies. In this chapter, we examine the process of absorption of an innovative technology from the point of view of the entrepreneurs and inventors who are forming SMEs to feed this process.

The specific area of opportunity for spin-up SMEs lies in taking technologies that have come out of labs and exist as prototypes but are not mature enough on their own to enter the innovation funnel. These technologies need to be moved up the TRL and adapted to industry specifications before they can be monetized. However, technology development is a complex process that involves sophisticated practical science and engineering combined with business and commercial expertise. The purpose of a spin-up SME is to bring about this combination that is then capable of taking advantage of the growing open innovation market demand for innovation. The spin-up company is the vehicle to implement a process that bridges the gap between technologies and markets and makes money in the process.

The historic roots of open innovation lie in the breakdown in the connection between industrial research and commercialization. The predominant model for innovation up until the early 1980s was based on sourcing new technology through internal company research and development labs. This began to change as companies like Cisco (founded in 1984) used an open innovation model to outcompete AT&T’s Bell Labs, which was at that time the world’s largest R&D center.1 Recent research has shown an ongoing decline in corporate research from 1980 to 2007, demonstrating an ongoing corporate interest in acquiring innovative technology but declining interest in maintaining internal scientific capabilities.2 This and similar developments let to the paradigm shift in innovation management that is captured in Henry Chesborough’s work on open innovation.

This new approach toward sourcing of technology occurred simultaneously with another paradigm shift in the 1980s as the result of passage in 1984 of the U.S. Bayh-Dole Act as the legal framework for the commercialization of government-financed technologies. This Act initiated the expansion of sources of new technologies, as universities, government labs, and private independent research organizations were mandated to put scientific discoveries into practical commercial use.

Increasingly, the mission of many research institutions includes commercialization of their new scientific discoveries and inventions. The results of scientific experimentation can be new inventions but can also be any unique tools developed to manipulate and measure what might also qualify as inventions. The commercialization of these inventions is usually technology driven, not market driven. The pool of IP and early-stage technologies is growing dramatically but is most often driven by science-oriented inventors. These new technologies are rarely developed in response to recognized industry demands. When the new technologies enter the market, they are nails looking for hammers. Therefore, an important part of the success of a spin-up company will depend upon the leadership team’s skill in identifying companies looking to acquire technologies and tying technology development to the requirements of these companies.

The utility of SMEs as a source of market-ready technologies is a relatively new phenomenon. The importance of this opportunity has been obscured by the common focus on start-ups or spinouts as the potential next Google or Facebook. As transformative as these Internet-related applications have been, they are actually quite rare. They are so rare in fact that they are sometimes referred to as “unicorns,” a term used to describe those rare start-ups that achieve billion-dollar valuations. While these success stories drive a lot of media coverage and start-up entrepreneurs, the occurrence of such a company is almost as rare as a unicorn. Venture capitalist Aileen Lee has calculated that as of November 2013, only 1 in every 1,538 startups or 0.7 percent founded in the past decade can be classified as unicorns. For those rare animals to appear as either initial public offerings (IPOs) or acquisitions took an average of seven years.3 The spin-up model is an alternative for entrepreneurs to reduce the time to market with more realistic assumptions for revenue returns. It is a model with a higher potential success rate and an alternative particularly for entrepreneurs and research scientists who expect to engage in serial commercialization activities.

As noted earlier, the key variables for the success of a spin-up are the team, IP, market intelligence, funding, and an appropriate exit plan. Keeping these factors in mind, SMEs interested in being spin-up companies (or entrepreneurs interested in forming them) will need a disciplined and structured approach, such as the one outlined in this chapter to maximize their chances for success.

Technology

There is a lot of technology available for development. According to the Association of University Technology Managers (AUTM) website, prior to 1980, the U.S. federal government held title to 28,000 patents, but fewer than 5 percent were licensed to private industry. After the passage of Bayh-Dole in the United States in 1980, American universities spun off more than 4,000 new companies and licensed many technologies.4

The process of transitioning university inventions into innovative technologies is not a simple, straightforward task. How can you recognize a good one when you see it? This is the critical decision for the entrepreneurial team utilizing the spin-up model.

In general, a good technology should have solid proof of a principle and a benchtop prototype. The path to raise its TRL should be relatively clear, even though it has not been done yet. There should also be a very clear and definite commitment from the inventor to be involved in the technology development process as an advisor or chief technology officer. You should have some reasonable belief that the technology will do what the inventor says it will, that it is scalable, and that it solves some real-life problem.

The technology should not have any obvious IP obstacles. A preliminary Internet search for possible blocking or competing patents should be undertaken using key words for the technology as search terms. This search can provide a quick look at obvious potential IP obstacles, but it is not a substitute for a full patent search prepared by patent counsel. If it appears to be relatively close to other patents in the same subject matter area, there is a risk of being tied up in patent litigation. If all of the preliminary indicators for the technology look good, then a full patent search should be completed a bit later in the process prior to a permanent license agreement. In addition to the technology having no obvious IP obstacles, the patent should have been filed reasonably recently with a good priority date.

A preliminary Internet search of potentially competing or analogous devices or technologies or both will help determine what the potential competitive advantage of your technology might be. In general, there should be some idea of where it fits in the overall supply chain, who the end user might be, and who the actual target purchaser might be, given the position of the technology in an overall product cycle. Even at this early stage, the spin-up SME should have an idea of the competitive advantage that can be exploited from the technology. Usually, competitive advantage criteria are the standard categories of quicker, better, or cheaper—all of which add up to some additional value to the end user from the adoption of the technology.

An evaluation of an early-stage technology should also include an overview of the drivers and potential obstacles for market adoption. Government regulation or certification can drive the market to adopt new technologies or can impose such long time frames for approval that it is very difficult to bring the technology to market. The heart of the spin-up model is the ability to raise the TRL of a technology and bring it to market faster than a spinout or start-up. Therefore, we advise staying away from technologies like pharma, biotech, some environmental devices, and some medical devices when using the spin-up model.

It would also be helpful if the technology can be described relatively simply to a knowledgeable layperson. This allows for clear marketing messages to potential funders and ultimately to targets and end users.

The critical inflection point for the formation of a spin-up is the correct evaluation of a technology to determine if it can be matured in conformance to market requirements. Often the very early stage of its development makes it very hard for any business to recognize its potential or to risk investment in developing it. Judging the actual stage of development and the amount of development required are critical elements of any business plan for a spin-up SME.

The National Aeronautics and Space Administration (NASA), the U.S. space agency, has developed the standard categories for technology development. These categories are referred to as TRLs, as shown in Figure 5.2 (see www.nasa.gov/content/technology-readiness-level/). The University of Southern California’s Marshall School of Business provides a set of TRLs for a variety of different technological areas at www.usc.edu/org/techalliance/pdf/CTC_TRI_Definitions-2007.pdf. A standard web search will discover many discussions of TRLs for most categories of technology.

Market-ready technologies are typically at TRL 6 or higher. Most often, early-stage technologies that are available for licensing are at TRLs 2 through 4. In most cases, we recommend that a spin-up entrepreneur should not consider working with any technology less than a TRL 4, unless they are certain that it might be “the best thing since sliced bread.” In such a case, a TRL 3 might be an acceptable risk. For that once-in-a-lifetime opportunity, a TRL 2 might be considered. The risk associated with any technology is astronomically larger if you cannot “kick the tires” to check it out in fact, which is typically at TRL 4. In mapping out the transition to TRL 6, the spin-up company will need to plan out all of the required technical development steps, resources, budget, and the estimated time for completion.

Team

Successful teams engage in two critical activities. First, they must recognize commercially valuable early-stage technologies and then successfully gain control of exclusive rights to the technology for the development maturation process. Second, after moving the technology up the TRL, they must sell this improved innovation asset to other companies. These two critical activities help define the skills and qualities required in assembling the right team.

The importance of the team cannot be overstated. The conventional wisdom among angel investors is that it is much better to invest in a great team with a mediocre technology than in a great technology with a mediocre team.

A spin-up company entrepreneurial team must correctly select a technology or group of technologies for development by combining entrepreneurial market information and technical expertise. The scientist inventor can provide the required level of technical understanding, but it is a rare scientist who can also provide the business or entrepreneurial skills required.

Some scientists decide to become entrepreneurs, but for most, this is a difficult transition. The success of a spin-up, start-up, or spinout will be determined by accomplishing tasks better undertaken by entrepreneurs. This dilemma was clearly stated in an article on commercialization in the Chemical & Engineering News: “Many scientists intrinsically understand that their discoveries might translate into important, highly profitable entrepreneurial enterprises,” says Madeleine Jacobs, executive director and CEO of the American Chemical Society, which published a report in 2011 on chemical entrepreneurs (C&EN, November 7, 2011, page 47). “But making a discovery or patenting an invention is only the beginning of creating a company. Bringing that idea or invention to commercialization and creating a successful company requires a different set of skills and knowledge than carrying out basic research.”5 This is why, in most cases, the scientist inventor will decide to maintain his or her status as a researcher. The scientist inventor will often provide technical expertise through acting as an advisor or chief technical officer on a part-time basis. Continuity on the scientific side most often comes from including a graduate or postgraduate student who has worked on the technology as PI on the spin-up team.

In addition to technical or scientific skills, the team must include marketing and business skills. One person may have more than one of these skills, but it is highly unlikely that a single person can perform all the tasks required for success.

One of the key skills required is the ability to interact with potential users and lead customers at the earliest-possible stage in the project. These interactions will be critical to the adoption of the technology at a later stage. Adoption of new innovative technology

results from a series of individual decisions to begin using the new technology, decisions which are often the result of a comparison of the uncertain benefits of the new invention with the uncertain costs of adopting it. An understanding of the factors affecting this choice is essential . . . for the creators and producers of such technologies.6

This interaction with the potential end users and target customers is an essential aspect of moving quickly and seamlessly into the market. Therefore, there is value in including entrepreneurs or business development staff who have existing industry experience and contacts as team members.

There is a certain mythology about technology companies that portrays the founders as almost universally young people, primarily university dropouts who create brilliant new companies. While there is an element of truth in this mythology in the Internet software sector, it is not an accurate statement across the board for all technology SMEs, including spin-ups. The skills required for the spin-up entrepreneur are real-life business experience, professional training, and the ability to interact with potential clients, which can often only be obtained over time. Therefore, it would be a mistake to exclude people with business skills from the spin-up team simply due to age. The issue of age and entrepreneurship was examined in a recent study by the Kauffman Foundation, which found that the peak age for entrepreneurial activity is age 40 and that high-tech start-ups are twice as likely to be founded by someone older than age 50, as opposed to someone younger than 25.7

Once it is understood who should be a member of the spin-up team, the question is how to find the required people who are not already part of the team. The commercialization process for early-stage technologies is most successful in places with a full and active “innovation ecosystem” that includes a pool of people with the skills required. The term innovation ecosystem is borrowed from biology to represent a balanced and mutually reinforcing collection of high-quality research institutions, serial entrepreneurs, financing at levels varying from seed to angel to venture, industry or sector professional organizations, supportive state agencies, physical facilities for small companies, and services for legal, accounting, marketing, and mentoring. All of these merge and interact in complex patterns that facilitate matching researchers, technologies, and entrepreneurs to create commercially successful SMEs of all sorts. This mixing process takes part formally and informally through the plethora of agencies, trade organizations, and networking events that characterize a sophisticated innovation ecosystem.

Where no such ecosystem exists to pair entrepreneurs with technologies, it is much harder to match technologies with entrepreneurial teams. This leads to a buildup of technologies without any route to market, which is often the case in many midsize and smaller universities and research hospitals and in government labs and nonprofit research facilities. As a consequence, there is a relatively large pool of technologies that have never been adequately evaluated for their actual commercial potential, which creates a problem for these institutions and a potential opportunity for the entrepreneur looking for spin-up opportunities. Often, this commercial potential lies in applications of which the inventor was unaware. Recognition of the key role of a mutually supportive innovation ecosphere is increasingly driving policy and programs for economic development. The contradiction remains between the opportunity for the discovery of unexamined gems of technology and the difficulties of development in an undeveloped innovation ecosystem.

The simplified objective of the spin-up SME and the real measure of success of the team is realization of profit. With this in mind, an important aspect of assembling the team is finding people who embrace this objective and then incentivizing them properly. Spin-ups, like spinouts and start-ups, typically do not have much in the way of operating funds and what they have should be dedicated to the development process. This means that the incentive for the staff is usually a combination of salary at some relatively low level and a share in future profits through share ownership in the spin-up company.

Allocation of share ownership or potential to earn share ownership is a balancing act that all spin-ups must perform. There are a number of interests that must be accommodated through first-level stock distributions and incentive-based stock options. Beyond the question of incentivizing the team, the spin-up will most likely have other claims on equity, ranging from the holders of the IP for the early-stage technology to subsequent funding rounds that will continually require rebalancing equity interests.

Universities, university research foundations, research hospitals, or federal laboratories hold the rights to a majority of early-stage technologies. As part of the licensing agreement, these rights holders will sometimes ask for equity in the SME as part of the license agreement. Different research institutions have different policies regarding holding shares in SMEs to which they license technologies. Some universities and research hospitals balance requiring lower royalty fees against the opportunity to hold shares in the SME. Some like Carnegie Mellon, Massachusetts Institute of Technology (MIT), and Stanford hold up to 5 to 6 percent equity that they will hold until bought out as part of the first financing event for the SME holding the license. Others like the University of Texas at Austin require even larger equity shares in the SME, with no obligation to sell. On the other hand, government labs almost never take equity shares and many nonprofits prefer not to, as part of their license agreements.

Once any equity has been apportioned to the rights holder, the remaining equity should be allocated in various proportions to the founders, the entrepreneurial leader, the inventor, the PI, and possibly other key staff members. Each situation is different, so there is no real standard division of equity. Furthermore, the equity shares are likely to be changed, diluted, or superseded in subsequent rounds of financing as part of the terms required by lenders. The founding entrepreneurial team will want to hold on to as much equity as possible for as long as possible but should not expect no dilution of their shares as the project goes through rounds of financing. The spin-up management should engage experienced legal business counsel to assist in drawing up bylaws and shareholder agreements at the earliest-possible stage.

Market Intelligence

Preliminary market research is critical to deciding whether to undertake a spin-up project. The objective of this research is to make an educated guess about the market utility of the technology. Put another way, if the spin-up SME can successfully raise the TRL of the technology, will it make money for the SME?

Assuming that your due diligence indicates that the new technology does what the inventor says it can do, is there any potential market demand? This may not be as simple a question to answer as it appears because sometimes the market utility is found in contexts other than the experimental purpose for which it was conceived. Sometimes you may be looking at a platform technology that requires finding the best application.

Determining whether the technology has market utility requires a determination of whether it solves a real problem that no other technology has solved, or whether it can displace an existing technology by performing the same function better, faster, or cheaper. If so, then we can expect that there will be market demand and potential profit provided that it can be competitive in the market.

To be competitive, it must include the physical or technical characteristics to conform to market standards that will assure easy adoption. Many of the technologies that would fit within our model for spin-ups will either improve existing processes or be subassembly or replacement devices or processes within a much larger technological system. This means that as the TRL is raised, the technology will be compatible with larger systems and thus make it easier to adopt.

Ultimately, market research and intelligence will lead to estimates of what the market price could be for the spin-up technology, that is, what potential end users would expect to pay and what potential acquirers would expect to pay. The ability to produce a new technology that can actually enter the market depends upon whether it can be produced at a market-competitive price, relative to its competition. As difficult as it is to project ultimate costs and utility at the initial stage of a spin-up, there must be enough preliminary data to support a projection of successfully satisfying market demand at a reasonable and competitive price.

Preliminary research should include broad Internet searches for market size, competitors, and principal companies in the sector that might want to acquire the spin-up technology.

Determining market size for the spin-up technology poses very difficult problems in assessing the real market for component technologies. Internet searches will often turn up many multiclient industry research reports prepared by large consulting companies like Frost & Sullivan. While these may be a useful starting point, the portion of the report that is publically available is usually too broad in scope to provide the level of specific market information required. The spin-up research needs to narrowly focus on the specific market size for the actual technology. For instance, the market for an improved gas temperature measurement device for gas turbine generators is not the same as the total size of the market for gas turbine generators. Start-ups often incorrectly exaggerate the potential market size as part of their fund-raising efforts, but a spin-up cannot afford to make this mistake in evaluating the market demand for its technology.

Similarly, the research into competitors must be objective and thorough. We often encounter inventors who state that they have no competitors. This is almost never the case. Usually the inventor is solving a known problem using a different method than commonly employed by industry. So while there may not be a competitor who does the exact same thing, there is usually any number of competitors who are already in the market. The spin-up entrepreneur must understand exactly who these competitors are and what potential competitive advantage the new technology may possess. If the new technology truly has competitive advantage, then a competitor could also become a potential acquirer of the new technology to strengthen its own market position.

It is also critical to understand the supply chain for the spin-up technology to determine the exact point of insertion and the potential acquirers. Since spin-up technologies are often improvements for existing processes or equipment, the end user of the product may not be the actual potential acquirer. The real target for sale of the improved TRL technology will often be an intermediate manufacturer or service provider.

Not only should the spin-up team identify potential acquirers but, in many cases, should attempt to speak with them directly as early as possible in the development cycle. Often the target for licensing of the developed technology will not be the end user but may be a manufacturer, supplier, or wholesaler. Thus, targets may be competitors or may be the potential licensor or acquirer of the technology. At the initial stage, the entrepreneur should be directly engaged with both potential users and potential targets in order to gauge the practical commercial potential for the technology. The initial purpose of this contact should be to determine the level of “pain” or market demand that might exist for the new technology and the characteristics that it needs to have for market adoption. These early contacts can also lead to establishing development partnerships and to later monetization of the upgraded TRL technology.

As another component of market analysis, the spin-up team needs to understand the kind of regulatory review or certification that will be required to bring the new technology to market. The team must determine the approximate cost and general time period required to complete these processes. Since the general purpose of the spin-up model is to provide an accelerated path to market, we would advise avoiding biotech, pharma, and some types of environmental technology that require extensive testing, review, and certification.

In the context of industrial and business activity, market utility means determining whether it may be possible to generate new income for the entity acquiring the technology from deploying the invention. Those inventions that can generate additional income can be marketed as assets for acquisition. This is the goal of the spin-up SME. Accurate and objective market intelligence is a key component of this determination.

Funding

The final piece of the development process is funding. Once a team has been assembled, initial license terms established, and a technology development plan created, it will be possible to estimate the overhead, time to completion, and combined budget. At this stage, the team must identify the sources of funding that will be sufficient to carry them through the development period for raising the TRL to reach the exit stage of profitable monetization of the technology.

In devising the business plan and budget for raising the TRL rating of the technology, the spin-up team should be aware of the general contours of various alternative funding sources. The actual financial plan will differ greatly from spin-up to spin-up, but the component parts are most likely virtually the same for all of them.

Fortunately for entrepreneurs, sources of funding for innovative technologies have continued to expand in parallel with the evolution of open innovation and the increasing availability of new technologies from universities and government labs. These new sources of funding include federal and state government programs that support innovative small business, corporate investment funds, angel investors, venture capital investors, and the newest potential source of investment, crowdsourcing.

Augmenting these sources of funding is an increasingly diverse set of business plan competitions, technology parks, technology accelerators, incubators, and innovation zones. Some of these innovative small business support institutions are government supported, some are private businesses, and some are owned by nonprofit organizations. The number and diversity of these organizations is increasing dramatically with many of them offering some kind of preseed investment, seed-level investment, or grant funding.

Business plan competitions have become so prevalent that it is impossible to even list a sampling without missing some important competition. For an example of one website purporting to be the largest listing site, go to www.bizplancompetitions.com/competitions/. Many of these competitions are now focused on specific technology sectors as well. The utility of business plan competitions is usually not the prize money awarded but the exposure to the broader technology and investment communities clustered around these competitions, which gives them the character of technology accelerators. Many of the competitions are not geographically limited in who can participate. See, for instance, Mass Challenge, which claims to be the largest business accelerator program in the world and which draws competitors from around the world (http://masschallenge.org).

Technology accelerators are spreading throughout the United States and becoming fixtures in the tech community.8 One study rated the top three as AngelPad in San Francisco (www.angelpad.com), Mucker Lab in Los Angeles (www.muckercapital.com), and Techstars in various locations (www.techstars.com).9 One of the most famous U.S. accelerators Y Combinator is now considered a seed fund.10

In the United States, there is an increasing development of innovation districts in urban centers in cities like Atlanta, Baltimore, Buffalo, Cambridge, Cleveland, Detroit, Houston, Philadelphia, Pittsburgh, St. Louis, and San Diego. They are also developing in Boston, Brooklyn, Chicago, Portland, Providence, San Francisco, and Seattle where older industrial areas are being remade as innovation districts.11 Some of these new innovation districts offer funding or support programs that are location specific and as such may influence the location of the spin-up company. An example of this type of support is the nonprofit organization, JumpStart, headquartered in Cleveland and providing funding support for start-up companies in Northeast Ohio (www.jumpstartinc.org/).

It is important to understand that all of these evolving support structures for innovative, technology-oriented companies are supplemental and support based. The true test of survival for a new technology company and particularly a spin-up company is whether it can raise sufficient public or private funding to cover its expenses during the development period, a time in a company’s life sometimes referred to as the “valley of death.” Can the company manage to raise sufficient financial resources to prevent death by a lack of operating funds? The answer to this question is usually found in whether or not the company can successful tap programs like the Small Business Innovation Research (SBIR) program, the Small Business Technology Transfer (STTR) programs in the United States, or their international analogues.

SBIR and STTR Programs and Equivalent Programs

One of the principal sources of financing for early-stage companies in the United States is through the SBIR grant program. This program offers competitive grants in phased awards to support the development and commercialization of U.S. applied science. The STTR program is a companion to SBIR and supports research collaborations between small companies and federal research labs.

The SBIR program was established with the passing of the Small Business Innovation Development Act in 1982 to award federal research grants to small businesses. The Act obligates federal agencies that spend more than $100 million per year for outside R&D to allocate a fixed proportion of that funding, now 2.8 percent, to small business grants. Currently, 11 federal agencies participate in the SBIR program, with the largest number of grants coming from the Department of Defense.12 Winners of SBIR Phase I grants can receive up to $150,000 in grant funding for a six-month period and Phase 2 grants can go up to $1 million for a two-year period.13

These grants funds provide nondilutive financing for early-stage technologies that otherwise would have great difficulty receiving financing at this stage. Therefore, this source of funding is strategically important for the spin-up model in the United States.

Similar programs have been implemented around the world. The British government has its own version of SBIR called the Small Business Research Initiative, which began in 2001. Other European governments and the European Union (EU) have developed SBIR-like programs to promote innovation through the support of SMEs. For a summary of various types of seed and early-stage funding in the 34 Organization for Economic Co-operation and Development (OECD) countries, see OECD Science, Technology and Industry Policy Papers, No. 9, “Policies for Seed and Early Stage Finance: Findings from the 2012 OECD Financing Questionnaire,” prepared by Karen Wilson and Filipe Silva and published in 2013 (http://dx.doi.org/10.1787/5k3xqsf00j33-en). Canada has the Idea to Innovation Program www.ic.gc.ca/eic/site/054.nsf/eng/00112.html. Chile has the Production Development Program known by its Spanish acronym CORFO (www2.corfo.cl). Singapore has SPRING Singapore (www.spring.gov.sg). These are just representative samples of similar government early-stage support funds that have proliferated in many countries.

Corporate Investment

The development of corporate contacts is an extension of the market intelligence conducted as part of the initial screening of the technology and should be considered as a critical success element in marketing and exit strategy. Corporate venture funds are proliferating around the world and becoming a critical element of the open innovation strategy of global companies. Between 2010 and 2014, the number of these companies increased by 475 new companies to reach a total of around 1,100.14 The largest corporate venture fund is Google, but many other major international companies have companion corporate investment funds to invest in new technologies, including Intel Capital, GE Ventures, Samsung Venture Investment, Siemens Venture Capital, SingTel Innov8, SoftBank Capital, and many others.15

As indicated earlier in this chapter, corporations remain interested in obtaining innovative practical implementation of basic science, despite their declining internal R&D funding.16 The resolution of these contradictory tendencies is their continuing interest in acquiring the developed fruits of scientific innovation in the form of higher-level TRL technologies. Keeping in mind that the real goal of the spin-up SME is to profitably divest itself of the technology through licensing or sale of the company, early involvement with potential company targets is critically important.

The SBIR program specifically recognizes the utility of this early involvement as one of its criteria for Phase 2 awards. The applicant needs to show industry support as proof of the commercial potential for the technology. Corporate involvement at this point can include a wide range of potential activities including joint research, testing of prototypes, seed funding, and review of product characteristics.

Angel Investors

Functionally, angel investors provide equity funding at an early stage of technology and company development. Although there is a great deal of business media buzz about venture capital companies, they typically do not invest in early-stage technologies and are not particularly relevant to the spin-up model company.

The term “angel” originally comes from Broadway, where it was used to describe wealthy individuals who provided money for theatrical productions. In 1978, William Wetzel, then a professor at the University of New Hampshire and founder of its Center for Venture Research, completed a pioneering study on how entrepreneurs raised seed capital in the United States, and he began using the term angel to describe the investors that supported them.17

Generally speaking, an angel investor or angel is an affluent individual who provides capital for a business start-up, usually in exchange for convertible debt or ownership equity. As opposed to nondilutive grant funding from SBIR programs or their analogues, angel investors will expect to take an ownership interest in the spin-up SME. From a financial point of view, angel financing can reduce the return to the original founders of the SME but may be beneficial from other points of view. Often, angel investors are retired executives or successful entrepreneurs with specialized sector expertise or industry sector contacts that could be critical to the spin-up, in addition to providing funds to bridge the valley of death.

As a general matter, angel investors tend to be very locally focused and hands-on with their investments. This means that the spin-up SME seeking angel funding will need to carefully screen the angel to make sure that they can work together and that the angel buys into the specific business model of the spin-up. It also means that it is pretty unrealistic to expect angel funding from someone outside the immediate driving distance of the spin-up location.

Venture Capital

Venture capital is a specialized outgrowth of small business lending but one focused on taking equity in the new small business. Typically, venture capitalists are interested in larger investments at a later stage of development than angel investors.

One of the first steps toward a professionally managed venture capital industry was the passage of the Small Business Investment Act of 1958. The 1958 Act officially allowed the U.S. Small Business Administration to license private small business investment companies to facilitate financing and management of small entrepreneurial businesses in the United States. These companies evolved into what we now know as venture capital firms.

During the 1960s and 1970s, venture capital firms focused their investment activity primarily on starting and expanding companies. More often than not, these companies were exploiting breakthroughs in electronic, medical, or data-processing technology. As a result, venture capital came to be almost synonymous with technology finance.

Venture capital played an instrumental role in developing many of the major technology companies of the 1980s. Some of the most notable venture capital investments were made in firms that include Tandem Computers, Genentech, Apple Inc., Electronic Arts, Compaq, Federal Express, and LSI Corporation.18

Today, the traditional model of venture capital is under examination, with fewer companies operating successfully and increasing competition from angel investors, as the actual costs of forming new companies and maturing technologies decline.

Crowdfunding

Over the past decade or so, crowdsourcing has developed as a particular form of open innovation that relies on individuals around the world linked by the Internet. In a seminal article in Wired in 2006, Jeff Howe defined the new phenomena of crowdsourcing. In that article, he noted:

Technological advances in everything from product design software to digital video cameras are breaking down the cost barriers that once separated amateurs from professionals. Hobbyists, part-timers, and dabblers suddenly have a market for their efforts, as smart companies in industries as disparate as pharmaceuticals and television discover ways to tap the latent talent of the crowd. The labor isn’t always free, but it costs a lot less than paying traditional employees. It’s not outsourcing; it’s crowdsourcing.19

Along with crowdsourcing as a source of resources for companies, a parallel process of crowdfunding emerged as an innovative new form of finance, also powered by the Internet.

In practice, crowdfunding is actually a complicated amalgam of different kinds of finance, each with a different consequence for the spin-up entrepreneur. See Figure 5.3 for a simplified listing of types of crowdfunding and the return to funders. The term itself has become very popular, and the practice of crowdfunding has become a critical success factor for some projects. Given the popular use of the term and the confusion about the different consequences from different types of crowdfunding, it is worthwhile to carefully delineate each type. The different types of crowdfunding are differentiated by their function and by the return expected by those who participate.

One of the most visible types of crowdfunding is project based, notably through Internet platforms like Kickstarter (www.kickstarter.com) and Indiegogo (www.indiegogo.com). Kickstarter was founded in 2009, and by 2013, more than 5 million people had participated, with more than 1.5 million in more than one project. Some of the projects funded through Kickstarter have raised large sums of money, but the majority still is in the $10,000 range.20 Indiegogo promotes itself as the world’s largest funding website, with the broadest number of categories of funding campaigns. Sampling these two sites only scratches the surface of an exploding number of Internet fund-raising websites. There have been a progressively larger and larger number of websites that allow for the aggregation of small amounts of money as the source of funding for activities ranging from financing independent music production to the production of three-dimensional (3D) printers and every conceivable project in between.

In recent years, the practice of crowdfunding has become a prominent source of funding for innovative technology projects, like, for example, 3D printers. A 2014 article in 3D Printing Digest highlights 3D printers as one of the most active categories for crowdfunding, highlighting 10 highly successful projects. One example cited was the 3Doodler, a 3D printing pen that requested $30,000 and ultimately raised $2.3 million on Kickstarter.21 In considering this type of funding, the spin-up company should keep in mind that this is project-oriented funding, not equity finance. Acknowledgments, discounted products or services, or creative awards compensate the large number of contributors. Others are strictly making a donation.

Another type of crowdfunding is lending based in which the parties making the loans expect repayment with interest from the borrower. One of the examples of this kind of crowdfunding is Lending Tree (www.lendingtree.com/?esourceid=5344230&800num=800-461-0117&cchannel=sem&csource=msn&cmethod=search&cname=branded&ccontent=d&cterm=lending+tree&PPCKW=lending+tree&ADID=1485316649). This type of crowdfunding is targeted toward consumer finance and is not particularly relevant for the spin-up company.

The final type of crowdfunding is equity based. This sort of funding has been forbidden by the United States but is in the process of changing. Ever since the Great Depression in the 1930s, the U.S. Security and Exchange Commission (SEC) has strictly regulated the sale of equity shares, requiring registration for public sale and preventing anyone other than a “qualified investor” from investing in private equity investment. Angel investors are able to invest in small companies and receive equity because they are qualified investors.

In late March 2012, the U.S. Congress passed the Jumpstart Our Business Startups Act, better known by its acronym, the JOBS Act. This legislation was intended to provide an exception to SEC rules to allow for equity crowdfunding. Implementation of this Act depends upon issuance of a new set of rules by the SEC. These have not yet been issued as of the date of writing of this chapter.

Even before implementation, there has been a lot of controversy about the real impact of equity crowdfunding. Some venture investors are adamantly opposed to participating in any crowdfunded company because they would have enormously increased corporate overhead with diverse and numerous shareholders.

Meanwhile, Europe has pushed ahead of the United States with significant crowdfunding platforms in the United Kingdom, Germany, France, and Switzerland. The Swiss and U.K. platforms offer equity shares in companies, while the others are loan or holding company based.22

As the rules for equity crowdfunding become clear and different models emerge in different countries, the spin-up company will have to consider carefully the full range of consequences for such funding before engaging. However, crowdfunding is expected to grow as a broad popular format for investment that should be investigated for possible spin-up funding.

Exit Strategy

The distinguishing characteristic of the spin-up model for SMEs is the declared intention to exit through licensing or sale of the rights to the technology at the earliest-possible stage. The growing adoption of open innovation approaches by multinational and large companies makes this exit strategy more and more possible.

The biggest danger to this exit strategy comes from success in raising the TRL rating of the technology. As the TRL rises, there will be an inevitable tendency to push it just a little bit farther than time or funding allows. An even greater risk will come from the temptation to change the model and become a real operating company.

As the spin-up SME begins to achieve technological success, the company leadership will need to exercise a disciplined approach to the original exit strategy. They will need to correctly evaluate when and to whom to license the technology. They will need a very disciplined approach to the exit in order to maximize return for all the stakeholders within a reasonable time period. It is at this point that technological success can lead to commercial greed.

In start-ups that are intended to become operating companies as either producers or service companies, there is usually a point at which the original leadership has to give way to new leadership. The original leadership carries the company through a certain stage of its development, but they do not have the skills for the next stage. Often this transition is precipitated by outside funding from venture capital or angel investors who insist upon executive change as part of the additional financing rounds.

In the spin-up model, the ideal situation would be to have no outside equity funding and to exit from the technology within a relatively short period of time, meaning from two to four years. The spin-up leadership team has been constructed for this objective and not to build an operating company. Operating within the model, there should not be any inherent need for a change in leadership, provided that the team has the discipline to fulfill the model as planned.

The mechanics of an exit through licensing or sale of the company are not a mystery; however, the art of a successful spin-up exit strategy will depend upon correctly timing the exit and keeping a clear hold on the model.

The monetization of the company will come as either a long-term revenue stream from licensing fees that are divided among the original stakeholders according to the original terms of the deal or through proportional shares in the sale price of the technology as a whole.

Conclusion: Fundamental Success Factors for a Spin-Up Business Model

Assuming that any monetization event may take from two to four years, entrepreneurs need to carefully choose the technologies to commercialize under a spin-up model. It is critical to pay attention to all success factors in order to minimize risk and maximize the possibility of success. The following success factors need careful consideration:

1. 1. Choose technology properly. Coldly and objectively, evaluate any technology being considered for spin-up in terms of its potential for commercialization and potential financial reward. Minimum screening criteria should include the following:

a. Qualify a pool of technologies for which you know there is market demand or a market opening that has been identified through your own research. From this pool, involve industry experts in a second-level review, with the full range of analysis to pick a very limited number from this pool.

b. Get to know the inventor and the current owner of the IP to find out whether they lack some critical capability to commercialize the technology on their own and therefore will be willing to work through the spin-up mechanism.

c. Find out whether the inventor and current owner of the IP will be willing to extend a no-cost option to license or no-cost license to a new spin-up legal entity.

d. Confirm that there is a PI with the sector technical expertise and competency to manage the development of the technology.

e. Select technologies that will not require extensive regulatory approval, meaning the exclusion of pharmaceuticals, medical equipment, and some technologies regulated by the Environment Protection Agency (EPA) because of the time to market required by the regulatory process.

f. Review the development plan to confirm that there is a reasonable prospect that the spin-up process can be completed within two to four years.

1. 2. Human resources. Make sure that the spin-up company team includes people who can manage the science and technology development and who can provide business-oriented skills in marketing and target management.
2. 3. Process map for the spin-up technical development. Prepare cost estimates and an evaluation of the technical capacity required. At the initial stage, the spin-up will need at least an outline of the technical tasks that need to be accomplished to raise the TRL, the resources necessary to accomplish those tasks, and a timeline projection for completion.

A very important aspect of a spin-up model is the time horizon for expected returns. The time horizon impacts the expense level for maintaining the hands-on staff resources and overhead, therefore determining the level of finance needed and sources of funds at each particular stage of development. It is critical to be able to map out the milestones and match those with capabilities, resources, and funding sources to determine whether to enter into the spin-up process.

1. 4. Financial support for development. Identify the source of funding for each stage of technology development, whether government (SBIR and STTR), financial investor (primarily an Angel or a group of Angels), state or local development agency, or industry partner. There are increasingly diverse sources of funding for start-up companies, but except for the SBIR and STTR funding, much of the available funding (including private) is tied to particular localities. This will also be a factor in your financial planning. This is the famous “valley of death” problem for any new technology. A spin-up will have to explore some combination of SBIR and STTR grants, industry partnerships, and angel equity finance to move technologies up the TRL. In this, a spin-up is no different than any other similar type of organization.
2. 5. Exit strategy. Having a credible and disciplined exit plan that will result in either a long-term license for the technology or a sale of the spin-up company is a critical element of any successful strategy. The goal is always to monetize the technology through improving the TRL of the technology and disposing of it.